Government bond yields in the eurozone surged after the ECB’s hawkish shift at its February meeting. The shivers were felt throughout the EZ (Figure 1). The periphery was hit hard, with yields jumping 90bps in Greece, 55bps in Italy, and 45bps in both Spain and Portugal. The question of public debt sustainability once again returned to the fore – and, in particular, the sustainability of Italy’s debt.
Figure 1: Markets are repricing eurozone sovereign debt after the ECB meeting in early February
For now, though, there’s little alarm over the issue of debt sustainability. The effective interest rate paid on the Italian debt is estimated to have remained close to 2% in 2021 (at around €60bn), down sharply from the 5% in the decade from 2000-2010. This means any increase in bond yields will start from a very low level. The seven-year government bond yield (proxy for the average costs for Italian debt given its maturity profile) is currently 1.6%, around 50bps below the expected effective servicing cost for this year. Despite the increase, the cost of debt servicing relative to GDP could decrease going forward.
The difference this time is that Italy isn’t lagging the eurozone
The current situation is completely different compared to previous episodes such as the 2011-2012 debt-crisis or the 2018 political turmoil, when the Five Star-Lega government took a confrontational stance towards the European Commission. Besides the low cost of debt, we believe the situation is dissimilar due to the following factors:
- Limited idiosyncratic risk: With markets now expecting two ECB rate hikes this year, the current sell-off in bonds has been triggered by the repricing of the risk-free asset (the Bund), rather than specific factors linked to the Italian situation. This does not mean that Italian debt will be unaffected. But it does suggest that a market move in the other direction is still possible (although not likely over the coming months) if inflation surprises to the downside. Moreover, it means that in case of larger increases in all peripheral spreads, the ECB could intervene without favouring any single country.
- Draghi government to last at least another year: With the reappointment of President Mattarella to another term, the current Italian government is likely to continue until mid-2023, when elections are scheduled. Politics thus will not be a major drag on confidence – and for once it is not likely to trigger a market reaction. Plus, the chance of a political realignment towards the centre is rising. While it’s still too early to tell, Draghi’s experience would prove a boon in leading such a government, allowing for the current reform agenda to continue – an upside risk to our less optimistic baseline.
- Italy not lagging the eurozone: The prompt, forceful policy response to the pandemic has limited the divergence in recoveries across eurozone countries. Moreover, Italian GDP had almost returned to its pre-pandemic level already at the end of 2021, a better outcome than in Spain and Germany. In 2022, we expect another strong year of growth, with nominal GDP projected to expand by nearly 6%. Mechanically, this will cut off a decrease in the debt-to-GDP ratio of around 6 ppts, with debt over GDP seen decreasing by 4ppts as fiscal policy will still be broadly expansionary. While growth risks are weighted to the downside, the swift economic expansion expected in the spring and the summer will be enough to prompt strong GDP growth, in our view, helping to improve fiscal metrics. Moreover, the implementation of the recovery plan could result in stronger growth than expected in the medium term.
- External metrics are improved: Italy has been able to run a current account surplus every year since 2013. And, despite the increase in imported energy prices which will negatively impact the merchandise balance, we expect the current account to remain in surplus in 2022, before gradually reaching the recent historical average of 2%-2.5% of GDP over the medium term. This means that Italy has been reducing its liabilities towards the rest of the world, shielding the economy against the unlikely scenario of a sudden end to foreign financing.
- Large portion of public debt is held by the eurosystem: The Bank of Italy currently holds around €65bn of Italian sovereign debt (Figure 2), a small portion of which is a pre-QE legacy. Excluding this, public debt is actually close to 120% of GDP. The debt metric is less worrying than the headline debt figure would suggest. And as the ECB is planning to reinvest the maturing principal payments from securities purchased under the PEPP until at least 2024, rollover risk is minimal.
- Banking system is more resilient despite its exposure to sovereign debt: Italian financial institutions hold a large portion of domestic public debt (around 15%). But in contrast to the past, banks’ capital and liquid positions are healthier, with the common equity Tier 1 ratio at 15% and the bad debt-to-loans ratio at 2%. This should limit the impact of a “doom loop” scenario.
Figure 2: The ECB, via PEPP and PSPP, was one of the main buyers of Italian debt over the past few years