Italy not feeding at the same trough as the PIGS

THE EURO crisis has taken on a new and more urgent dimension as contagion, long contained to Greece, Portugal and Ireland, has moved beyond Spain and dragged the previously impenetrable Italian sovereign into the front line.

The global slowdown focused investors’ attention on Italy’s pitiful low long-term growth rate, while political difficulties raised concerns regarding the country’s ability to introduce the necessary reforms to address the longstanding problem.

The unwanted attention had a pronounced effect on government bond prices as yields registered the largest increase since the creation of European Monetary Union – even larger than the sell-off observed following the collapse of Lehman Brothers in the autumn of 2008. The yield on 10-year bonds has jumped by more than one percentage point since the beginning of the month to close to 6 per cent, while the increase in the yields attached to short-term debt securities has been even greater at more than 150 basis points.

The unwelcome jump in the cost of new government borrowings has caused investors to question whether the country can avoid the humiliation heaped on Ireland, Greece and Portugal as each of these was forced to seek financial assistance. The concern would appear to be legitimate given that Italy’s public debt-to-GDP ratio is already close to 120 per cent and the second highest in the euro zone after Greece.

Focus on the relatively high level of public debt alone, however, paints an incomplete picture as Italy does not suffer from many of the macroeconomic imbalances evident in the periphery and possesses important strengths that should mitigate the negative impact arising from the desirable fiscal adjustment.

The cold facts reveal that Italy does not deserve to be grouped alongside the so-called PIGS (Portugal, Ireland, Greece, Spain) even though emotive financial markets have decided otherwise.

First, the Italian private sector did not previously engage in an ill-advised consumption and investment boom. Indeed, private sector debt is less than 130 per cent of GDP as compared with a euro zone average of almost 170 per cent, and well below the comparable figures for Ireland, Portugal and Spain. The facts suggest that Italian businesses and households do not need to restore balance sheets to health and as a result the economy should avoid the private sector deleveraging that is proving so painful in Ireland and elsewhere.

Second, the absence of an inherently unstable economic boom like that of Ireland and others means that the country did not accumulate a dangerous level of foreign credit with a corresponding increase in the economy’s vulnerability to a “sudden stop”. Indeed, Italy’s net external liabilities account for just 15 per cent of GDP despite the relatively high level of public debt, versus comparable figures for both Greece and Portugal that are north of 100 per cent.

Third, the relatively low level of external debt combined with large private sector wealth means that more than half of Italian government debt outstanding is owned domestically as compared with foreign ownership of 60 to 65 per cent for Greece and Portugal. Large private sector wealth has contributed to a more stable investor base in the case of Italy, while a household savings rate of 12 per cent should allow the bulk of issuance to be absorbed domestically without excessive dependence on foreign investors.

Fourth, a high gross national savings rate of 17 per cent as compared with 3 and 8 per cent for Greece and Portugal respectively has helped to reduce the financing gap with the rest of the world and lessen the need for external adjustment. Indeed, Italy’s current account deficit – below 4 per cent of GDP – is relatively modest and well below the 7 to 8 per cent numbers for Portugal and Greece.

Fifth, the Italian government responded in a cautious manner to the global financial crisis such that the cyclically-adjusted fiscal balance was virtually unchanged between 2008 and 2009. The deficit never exceeded 6 per cent of GDP and efforts to lower the figure have proceeded ahead of plan with the deficit falling to 4.6 per cent of GDP last year versus an initial target of 5 per cent. Furthermore, the primary balance – the deficit before interest costs – is close to balance and the Italians are expected to have the highest primary surplus across the euro zone this year.

Finally, effective public debt management has contributed to a relatively comfortable duration and average life of Italian public debt of 4.9 years and 7.1 years respectively. This fact, combined with primary fiscal surpluses in the medium term, means that it would take several years for the current increase in yields to be fully reflected in interest costs. Indeed, the effective interest rate on government debt was close to 4 per cent of GDP last year, and should yields persist at present levels it would take almost five years for the interest cost to reach 5.5 per cent.

The facts demonstrate that Italy possesses many strengths that are absent in the so-called PIGS. However, it would be unwise not to point out that the country does suffer from a disturbing potential growth rate of no more than 1 per cent that could deteriorate further in the absence of much-needed structural reforms. Should bond prices continue their current sell-off then primary surpluses in the region of 4 to 5 per cent could be required in the years ahead simply to stabilise the public debt – though this is still within the realm of historical experience.

The euro crisis continues to gather pace and Italy is the latest victim of the bond vigilantes. The facts suggests the Mediterranean country is no “PIG” and in no immediate danger. Nevertheless, without decisive action a Lehman-style moment becomes more likely across the euro zone.

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