Italy has recently witnessed a progressive removal of controls on its international capital flows, the creation of an efficient primary and secondary market for government securities, and a sizeable increase in government debt. In Discussion Paper No. 720, Programme Director Alberto Giovannini and Gustavo Piga compare the performance of bonds issued by the Italian government on the Eurodollar market and by the World Bank on the global market during May 1991-May 1992 to determine the cause of the high interest rates on Italian government securities. They find that only a small part of this yield differential is attributable to fears of financial crisis caused by the government's financial situation, which suggests extremely small risk premiums and equally small expected proportional losses of return. They compare various governments' bond yields with the rates on interest rate swaps to show that as much as 100 basis points of yields on Italian Treasury bonds may be attributed to the ways in which the withholding tax is levied and reimbursed to foreign institutions.

With international capital mobility and interest rate parity, the domestic interest rate equals the foreign rate plus the expected percentage change in the exchange rate. Ignoring the risk premium, the ex post rate-of-return differential thus equals exchange rate surprises. Giovannini and Piga explore the effects of Italian exchange rate policies by comparing estimates of average interest rates on Italian and German debt. In lira terms, the differentials between the ex post cost of Italian and German debt were as low as <196>0.47% in 1983 and <196>1.11% in 1987, rising to 6.6%, 4% and 4.85% in 1989, 1990 and 1991 respectively, which overwhelm the effects of default risk and withholding taxes. They also account for the persistence and size of the recent excess returns on Italian debt, which reflected the government's failure to make the tougher exchange rate stance since 1987 fully credible since this was not official and investors' information about policy-makers' intentions was imperfect. They therefore required returns on Italian securities to reflect their own assessment of the likelihood of a depreciation of the lira relative to the Deutschmark, but no such depreciation occurred during the sample period.

Understanding the High Interest Rates on Italian Government Securities
Alberto Giovannini and Gustavo Piga

Discussion Paper No. 720, October 1992 (IM)