Four Reasons Italy’s Huge Debt Is Not an Issue, Yet

Summary

• BTP yields are trading near heights last seen in 2014, even after recent rallies. With public debt/GDP above 150%, the interest burden is making headlines again.
• Comparisons to previous Italian debt crises are overly simplistic. The dynamic within the EU and EZ has changed a lot since.
• Real yields look less onerous, and the government’s funding requirement may have improved since January.
• Even net of ECB buying, duration supply for Italy is set to be more typical than other major EZ countries.
• However, Italian politics may  become an issue again, particularly with splits widening within M5S.

Can Italy Fund Its Debt?

Despite the rally across the BTP curve following the ECB’s commitment to ‘de-fragmentation’, 10Y BTP yields remain above 3.6%. On an outright basis, these are levels last seen in 2014 when Italian debt/GDP was 20pp lower (Chart 1). Italian 5Y CDS was trading 50bp wider then than now. So, is a new blowout all but inevitable?

Below, we discuss four reasons it is not time to panic just yet. But we also note that with an election scheduled for next year (at the latest), politically driven worries could still arise.

1) Italy’s Nominal Growth Is High

Italy may struggle to grow its economy at anything like the +3.5% that most of its curve is trading above, but fortunately it does not need to. The issue is that when people quote such terms, they compare a real rate of growth with a nominal rate of interest. In real terms (less current CPI), Italian yields look much less onerous (Chart 2).

The distinction between real and nominal is also important for growth rates. Around 10% of Italian debt is linked to Italian or Eurozone CPI (a similar proportion to France), leaving the vast majority of Italian bonds vulnerable to inflation’s devaluating effects. While real GDP growth has been revised consistently lower since the start of the year, nominal growth has been revised up (Chart 3).

2) There are Tailwinds for Italy’s Budget Balance

Italy’s funding requirement for this year may have dropped since the Italian Tesoro estimated it at the end of last year (Chart 4). This is partly on the back of a stronger labour market, supported by one-off energy profit windfall taxes. There is room for further stimulus to come and for declines in revenues if the economy takes a substantial hit. But for now, the changes look relatively favourable.

3) Supply of BTP Duration Looks Less Unusual Than Other EGBs

Taking the monthly supply of debt duration net of ECB buying, the end of 2022 will clearly see a marked increase in duration on account of dwindling ECB QE (Chart 5). However, relative to historic levels of net-supply duration (i.e., what the market has previously dealt with), it is less of an increase than the average of Spain, Germany and France (Chart 6).

4) The ECB/EU Dynamic Has Improved Immeasurably

Finally, while the ECB’s recent comments and actions to defend Italian spreads are relatively paltry, the member states are immeasurably more unified than they have been in previous crises. Entering the GFC, the ECB was legally restricted from sovereign debt purchases. Its balance sheet in 2014 was around 20% GDP (near the Fed’s and BoE’s). Now it is over 60% (the BoE and Fed are both <40%). The ECB will remain a major player in the market for now (Chart 7).

Meanwhile, on the fiscal side, EU joint issuance has transformed from an impossibility, to a €150bn pa reality (Chart 8). EU funding will continue to contribute (via loans and grants) to a fiscal boost of over 1% of EU GDP pa out to 2024. The effects of the step-change in approach are already apparent. There is still resistance to additional EU issuance, but the dynamic of the conversation has changed. An additional €9bn of joint issuance to support Ukraine’s rebuilding is already being mooted. Meanwhile, joint EU approaches to energy and defence procurement are also under discussion.

But Italian Politics Remains an Issue to Watch

Italian politics will likely become more of an issue towards the end of the year as electioneering kicks off again. However, an early election is always a risk. At recent local elections, the right-wing FdI gained strongly while M5S suffered. Calls for greater unity among the right are gaining traction, while M5S is fracturing over the debate to send arms to Ukraine. Polling since the start of May puts FdI in prime position (around 22%) with Lega in third place (15%) and Forza Italia in fifth (8%). New party ‘Italexit’ (a splinter party from M5S) is polling 3%. Together, this indicates a strong risk of a populist, majority Eurosceptic coalition at the next election.

Conclusions       

Italy is not out of the woods yet. Many of the most frequently quoted issues are valid: high debt, high gas exposure, and relatively low productivity growth. And as we enter a world of higher interest rates and hawkish central banks, the burden of financing debt will rise across all issuers. However, the picture is not all bad. Nor is it significantly more negative than in the past. So beware simplistic comparisons with 2010-12.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)