In late 2011 as risk spreads on Italian government bonds surged to levels that had been associated with debt crises in Greece, Ireland, and Portugal, some leading economists called for a restructuring of Italy’s debt.1 With the recent easing in borrowing rates, such proposals look at best highly premature and at worst reckless. A pre-emptive move to restructure debt for the world’s seventh largest economy, especially in a manner imposing debt reduction, would likely trigger bank runs, a severe new round of financial instability, and perhaps the breakup of the euro.
The calls for debt forgiveness tend to leap from a simple combination of the 120% ratio of debt to GDP with an interest rate of 7% to reach a diagnosis of insolvency. In contrast, my calculations indicate that Italy could manage even such high interest rates for some considerable time, for two central reasons.
- First, Italy has reasonable prospects of achieving a relatively high primary surplus (fiscal surplus excluding interest payments) that can pay for most of the interest bill rather requiring ever more net borrowing.
- Second, the relatively long maturity structure of debt means that only about 10% of long-term debt needs to be refinanced each year. This profile delays the effective arrival of higher interest rates and provides time for demonstration of good policies (including especially growth-oriented reforms) to restore market confidence and reduce interest rates once again before the bulk of the long-term debt needs to be refinanced.
I have recently applied my European Debt Simulation Model (EDSM) to examine the sustainability of Italian debt (Cline 2012). I conclude that Italy is not on the precipice of insolvency, and could avoid an explosion in the debt-to-GDP ratio even if its risk spreads were to persist at the late-December levels for an entire decade – so long as the government meets reasonable fiscal targets.2 However, the risk of a liquidity crisis in the event of a return to such rates strongly recommends the speedy construction of a more credible lender of last resort than currently exists.
The interest rate shock in the second half of 2011 was severe (Figure 1). From 200 basis points in early July, spreads on ten-year Italian public debt above German bunds rose to 300–400% after the 21 July package for Greece with its requirement of private sector involvement (PSI), and then rose to 400–500 basis points after the 27 October package that escalated PSI to a 50% haircut. Domestic political uncertainty about commitment of the Berlusconi government to fiscal adjustment compounded the problem, but similar shocks for Spain suggest that much of the impetus was from contagion from Greece. By December interest rates peaked at about 7.5%. Interest rates then moderated substantially in January and February, however. The new Monti government enacted additional fiscal cuts designed to bring the fiscal deficit to zero by 2013, and adopted a set of structural reform measures opening up competition in numerous domestic professional and service sectors. The €489 billion in three-year ECB lending to Eurozone banks launched in late December provided a powerful boost to the easing in interest rates. By 23 February, the ten-year sovereign spread was down to 365 basis points, and the interest rate was at 5.55%. The improvement has come despite the calendar for refinancing, which rose from €15 billion in December to €53 billion in February (including short-term debt).
Figure 1. Italy 10-year bond: interest rate and spread over German bund (basis points)
The late-February rates are thus back to the levels assumed by the IMF in its September 2011 World Economic Outlook (IMF 2011). Applying these rates and the WEO assumptions on growth (recovering gradually to 1.2% by 2016) and the primary surplus (2.6% of GDP in 2012, rising to 4.5% in 2014–16), in the EDSM projections Italy’s public debt to GDP ratio would decline from 122% in 2012 to 113% by 2016 (virtually the same as projected in the September WEO). Extending the horizon, even with a more modest primary surplus of 3.5% of GDP in 2017–20 and more modest growth of 0.8%, by 2020 the debt ratio would be down to 110% (Figure 2).
Figure 2. Public Debt as% of GDP under Alternative Scenarios
Notes: HIR: high interest rate LPS: low primary surplus HIRLPS: high interest rate and low primary surplus
But what if interest rates return to their 7.5% peak? If they were to do so and remain at that level through 2020, the model projects that nonetheless the debt-to-GDP ratio would not rise above the 2012 level. However, the debt ratio would remain as high as 118% in 2020, sacrificing most of the improvement otherwise achieved in the baseline. A simulation in which interest rates are as in the benign baseline but fiscal performance falters and the primary surplus does not exceed 2.5% shows a worse outcome: the debt ratio edges up to 123% by 2020. In the adverse combination of 7.5% interest rates and a ceiling of 2.5% of GDP on the primary surplus, the debt ratio escalates to 132% of GDP by 2020, an outcome that would look much more like the path to insolvency.
The good news in these simulations is that even if the high interest rates of late 2011 returned and lasted for a full decade, Italy’s debt ratio would not spiral out of control. The sobering news is that achieving the domestic fiscal adjustment targets will be crucial to assuring solvency. The average primary surplus in 1990–2008 was 2.4% of GDP, so the IMF baseline of 4.5% and the Monti government’s new programme targeting 5.5% represent a significant and sustained step-up in fiscal performance.
Although Italy does not stand on the brink of insolvency even if recent peak interest rates were to return and persist, there is a considerable chance of a severe liquidity squeeze under these circumstances. The classic remedy for sovereign debt difficulty given a diagnosis of solvency is that a liquidity problem should be resolved with temporary lending from a lender of last resort. It is thus the duty of the official sector in Europe and internationally to move quickly to provide some credible lender-of-last-resort vehicle in the immediate future.
ECB bond purchases under its Securities Markets Program are highly unlikely to be sufficient for this purpose, especially given the ECB’s statements that even last year’s purchases are strictly temporary. So far the 26 October pledge of leveraging the financing capacity of the EFSF and alternative proposals of launching Eurozone bonds jointly or with partial guarantees have become bogged down. The 9 December EU commitment to lend €200 billion to the IMF, to be supplemented by lending from other countries (especially emerging market economies with large reserves), was a useful first step toward building a firewall. Similarly, the ECB’s large package of three-year lending to the banks at end-2011 has helped ease sovereign borrowing conditions. Nonetheless, further steps to expand the EFSF (and its successor, the European Stability Mechanism) or launch Eurobonds should be pursued promptly, without lengthy procedural delay for institutional change.
Bank of Italy (2011), Financial Stability Report No. 2, Banca d’Italia, November.
Boone, Peter, and Simon Johnson (2012), The European Crisis Deepens, Policy Brief PB12-4.
Cline, William R (2012), Interest Rate Shock and Sustainability of Italy’s Sovereign Debt, Policy Brief PB12-5, Peterson Institute for International Economics, February.
IMF (2011), World Economic Outlook Database, September 2011, September.
Roubini, Nouriel (2011), “Time to Act – Italy Must Restructure Debt”, Financial Times, 29 November.
1 Roubini (2011) has called for a reduction of at least 25% in Italy’s public debt, from 120% of GDP to no more than 90%. Boone and Johnson (2012) argue that “… the GIIPS will need to restructure their debts by extending maturities and reducing coupons to levels that they can afford …Italian debt writedowns might be close to 50%” (pp. 9–10).
2 The Bank of Italy (2011) has made calculations reaching the same conclusion, for the period through 2014.