Föhrenbergkreis Finanzwirtschaft

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ECB Taper Talk Puts Spotlight on Italy

Posted by hkarner - 11. Juli 2017

Date: 10-07-2017
Source: The Wall Street Journal By Simon Nixon

Any sharp rise in borrowing costs risks reviving questions over the sustainability of Italian debt.

The ECB is standing firm on its policy that its task is to set monetary policy conditions for the whole eurozone, not an individual country. Above, ECB President Mario Draghi.

The recent volatility in bond markets has stirred up old fears in Europe. Investors have long been concerned about the possible impact of the end of the European Central Bank’s quantitative easing program on the eurozone’s periphery, not least Italy—the country long-regarded as too big to save. Now with markets abuzz with talk of central bank monetary policy “normalization,” those concerns are once again front of mind: Without the fire blanket of ECB government bond-buying, will Italian borrowing costs soar once again, plunging the eurozone back into crisis?For the moment, there is no sign of any panic—or any immediate cause for alarm. Italian 10-year government bond yields have risen sharply in the past two weeks to just over 2.2% in tandem with other eurozone government bond markets. But the spread between German and Italian bond yields—a measure of the perceived riskiness of Italian bonds—has widened only modestly to 1.7 percentage points, well below the recent peak of 2.2 percentage points ahead of May’s French presidential election though still above the 1.3 percentage points a year ago before fears about Italian political risks started rising in the run-up to a November constitutional referendum.

Nonetheless, investors are wary because at some point rising Italian government bond yields run the risk of creating negative feedback loops into the real economy via higher domestic borrowing costs. With the trifecta of Italian government debt equivalent to 132% of gross domestic product, growth not expected to exceed 1.4% this year, and inflation still below 1%, any sharp rise in borrowing costs risks reviving questions over the sustainability of Italian debt. Italy can cope with bond yields rising above 2%, but what if they rise above 3% or 4%? asks Marchel Alexandrovich, European economist at Jefferies International.

These concerns are shared by policy makers, though ECB officials say they won’t allow this to influence its decision-making: the ECB’s task is to set monetary policy conditions for the whole eurozone, not an individual country. Besides, there is no reason why any ECB decision to taper its purchases of government bonds should trigger a crisis. After all, the Italian government benefits from a deep and liquid domestic market for its bonds: the Italian household sector holds €3 trillion worth of liquid assets and is currently adding to those savings at an annualized rate equivalent to more than 8% of GDP.

At the same time, the government is running a primary budget surplus which means that Rome only needs to issue new debt to roll over existing debt and cover its interest expense—a task made easier by the Treasury’s efforts to lock in current low-interest rates and extend the maturity profile of its debts. Policy makers also note that a rise in interest rates may not be as damaging as investors fear since higher household investment income could boost spending and growth.

The real short-term risk is that ECB tapering might crystallize existing fears about Italian political risks ahead of the general election that must be held by the end of February. If the outcome was a populist 5 Star Movement committed to taking Italy out of the euro, the eurozone would be plunged into crisis from which there is no obvious escape. Under such circumstances, Rome is unlikely to request the kind of bailout program needed to unlock further ECB assistance.

Yet even if the eurozone survives this test—continuing this year’s pattern of market-friendly political surprises—policy makers fear that long-term political risks will continue to hang over the government debt market. True, Italy is currently enjoying a cyclical upswing, helped by a buoyant global economy. It should also reap some benefits from the recent, belated efforts finally to clean up its banking system and tackle the legacy of bad debts. Other recent overhauls should also contribute to stronger growth including reforms of the labor market, judiciary and new incentives to encourage equity investment which should help unlock access to capital markets.

But these reforms are unlikely to lift Italy’s long-term growth prospects to levels that would remove concerns about its long-term debt sustainability. In a recent speech, ECB executive director Benoît Coeuré drew attention to the striking correlation between the quality of a country’s institutions as measured by the World Bank’s Worldwide Governance Index and its GDP/capita. Italy’s position at the bottom of the eurozone governance league, ahead of only Greece, may partly explain why Italy’s GDP/capita growth performance has also languished at the bottom of the European league, having remained stagnant for the best part of two decades.

This suggests that the key to sustainably boosting Italy’s long-term performance lies in deeper institutional overhauls that will speed up the reallocation of resources to the most productive sectors of the economy and discourage the kind of rent-seeking that continues to drag on productivity and GDP/capita. For that, Italy needs a stable government committed to delivering reforms. Until it finds one, the specter of crisis will continue to stalk Italy—and the eurozone.

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