Will the Italian government contract yield?

In the past few weeks, volatility in Italian government bonds and their spread over their German equivalents have increased. The current 10-year BTP/bund spread is only a whisker from its high in May. Back in May the presentation of the government’s very expensive agenda (see below) was the main starting shot for financial market stress. Over the past few weeks, statements by government officials that they will honour their election pledges, no matter what, have again intensified concerns over Italy’s public finances. The comments by the Italian finance minister Tria that: “public investment in infrastructure is a priority of the current government for which there will be no budgetary constraints, as overcoming the inability of spending and intervention is a priority," as a reaction to the collapse of the Genoa bridge, have made matters worse. Also, the ECB will stop increasing its balance sheet at the end of this year which, during the remaining months of this year, will likely result in the gradual disappearance of the so called QE premium. We currently estimate this premium at 35 basis points for 10t BTP’s. Thin liquidity further exacerbates price movements at the moment. Not only the government, but also banks are bearing the brunt, due to their large exposure to Italian government debt.

In a publication earlier this year, we already focussed at the expected costs of the government’s plans that were presented in the government contract in May. The most expensive ones include a basic income, a two-rate income and corporate tax, and a reversal of the 2011 pension reforms. The total annual costs of the plans range between a 100 and a 150 billion euros. If these plans would be implemented in full, the government budget deficit as a percentage of GDP would be between 5.5 and 8.5 percentage points higher in 2019 than under a no policy change scenario, pushing the deficit way above the 3% maximum threshold as set in the European budget rules (figure 3). And these calculations do not even take into account possible additional spending on infrastructure and the costs of cancelling the planned VAT hike in January. According to Transport Minister Danilo Toninelli an infrastructure ‘Marshall Plan’ could cost up to 80 billion euros. Just imagine what that would do to public finances if it’s not compensated for.

The impact of fiscal stimulus on the deficit ratio would obviously be smaller if GDP growth were to increase as a result as well. But even if nominal GDP grew by a highly unlikely 10% instead of our current estimation of 2.5%, the impact on the ratio would only be a half percentage point less.

For now the big question is which plans will eventually be incorporated in next year’s budget. Government officials haven’t brought much clarity yet. On the one hand, they have stated that they will execute all plans and neglect the European budget rules and market turbulence. On the other hand, they have underscored the importance of debt reduction and told the press that they will start working on their election pledges, but that implementation will come only in stages.

Currently, financial markets are awaiting the update of the Economic and Financial Document (DEF), which sets out the government's economic forecasts and policy plans for the next three years. The DEF will be submitted to parliament no later than 27 September. A draft budget plan for 2019 has to be sent to the European Commission by 15 October. Finally the budget has to be approved by the Italian parliament by the end of this year. This means that for the remainder of this year markets will have to cope with a significant amount of uncertainty, implying market volatility isn’t going away any time soon. Until more clarity is provided regarding Italy’s budget, strong swings in yields on Italian government bonds are likely to continue. The uncertainty over the budget and its implications has also resulted in Moody’s postponing its credit rating review in order to: ‘gain more clarity on the country's fiscal path and reform agenda’.

Ultimately we foresee a budget including a rather significant fiscal impulse, resulting in tough negotiations with Brussels. Yet we don’t think that the government will push through all the plans in the government contract including an extensive infrastructure plan. For one because it would rapidly become clear that the government cannot finance all the plans at affordable interest rates. Second, defections within the government’s parties based on fears for market stability could spoil a too recalcitrant agenda. Third, the government would just not be able to push through all the measures next year, due to the difficulty of some and the lengthy processes of implementation involved, and it is likely the government knows that. Finally, there is the issue of the Constitution. Article 81 stipulates that “The State shall balance revenue and expenditure in its budget, taking account of the adverse and favourable phases of the economic cycle”. Judgement of the phase of the economic cycle and the impact of expansionary measures is to a certain extent subjective, and Italy’s worsening growth outlook could prove helpful for the government in this respect. But it is unlikely that President Mattarella would approve an extremely expansionary budget in line with the plans in the government contract. That said, disapproval by the President could trigger a constitutional crisis. It is impossible at this stage to estimate what kind of budget would be sufficiently in line with the constitution for Mattarella to approve it.

Despite all the above, the risk that the new populist government pushes it too far and that markets lose faith, can’t be neglected. Especially since threats from Brussels to penalize countries that exceed a 3% budget deficit have never credibly been enforced.

An Italian administration pushing it too far would not only be a problem for the financing of new plans, i.e. additional debt, but also for the refinancing of hundreds of billions of maturing outstanding debt in the coming years. This won’t become any easier as ECB gradually winds down its expansionary monetary policy. The Italian government has come to realise that its financial position could sour should interest rates would rise significantly. This has led several Italian politicians to call for an extension of the ECB’s asset purchase programme and to suggest that the ECB should make sure that the 10-year BTP/Bund spread not exceed 150 basis points: both are highly unlikely.

Over the past year(s), the banking sector has become stronger. Asset quality has improved on the back of the improving economic environment, but also because of notable disposals of bad loans. The non-performing loan ratio has dropped from its peak of 17% in the final quarter of 2014, to 10.8% in the second quarter of this year. Obviously this is still very high and while most Italian banks have substantially increased loan loss reserves and capital ratios over the years, weaknesses persist and certain banks look especially vulnerable to adverse funding and economic growth shocks.

Moreover, the Italian banking sector is particularly susceptible to deteriorating Italian public finances. According to Bank of Italy and IMF data, Italian financial monetary institutions, mostly banks, hold around 600 billion euros of Italian government debt. This is around 15% of their total assets (figure 6) and more than three times their core equity (figure 7). A back on the envelope calculation tells us that if banks have to write off 20% of their Italian government debt, their common core capital (tier 1) ratio could drop from its current 14.4% to around 5%.

Moreover, Italian banks have stepped up purchases of Italian government debt in the second quarter of the year, breaking the trend of divesting seen in the second half of last year. In the second quarter, Italian banks increased their holdings of Italian government debt by more than 40 billion euros (figure 7). So if anything, the risk of a potential ‘doom loop’ between banks and the Italian government is again increasing. As the European sovereign debt crisis has demonstrated very clearly, a chain reaction can occur. If investors doubt whether a country can service its debt, those same investors will also distrust the major holders of this sovereign debt. This further puts the position of the government in the spotlight, since investors will worry that the already vulnerable position of the banking sector could quickly further undermine the state’s financial position.

Meanwhile, the increase of Italian government debt holdings of Italian banks in Italy’s stands in sharp contrast with foreign holdings of Italian government debt, which declined by 34 billion euros in May.

The combination of Italian banks’ large exposure to Italian government debt and increasing bond yields could eventually also lead to a diminishing supply of credit. Ignazio Angeloni – a member of the ECB’s Supervisory Board – confirmed this in a recent interview. When asked why the recent rise in Italian government yields didn’t have a negative impact on the credit supply yet, he said: “But this is unlikely to continue if the spread increases further. A credit contraction would endanger the recovery, which is already fragile for other reasons”.

Italian yields have been rising and we expect these yields to remain under pressure for the remainder of this year. One reason is the disappearing QE premium (currently estimated at around 35bp). Uncertainty with regard to the budget negotiations and questions about fiscal discipline will likely add to volatility in interest rates on Italian (government) debt in the coming months.

However, markets eventually have to wait and see and things might well turn out to be a storm in a teacup. It is well known that markets can force governments to get their house in order to avoid a financial collapse. Furthermore, if it would turn out that the government lacks money to implement the ambitious agenda, disputes could arise between the two governing parties. It wouldn’t be the first time that an Italian government finishes its term prematurely. Still, investors better prepare for a rocky ride when it comes to holding Italian debt.