October 12, 2011

After Greece, Ireland, Portugal and Spain, Italy is increasingly also taking centre-stage in the European sovereign debt crisis. As the world's fourth-largest borrower with its sovereign debt running to almost EUR 2 trillion, Italy is vulnerable to a cooling of economic growth, increases in market interest rates or the materialisation of contingent liabilities from the banking sector. At roughly 119% of GDP, Italy has the second-highest gross debt ratio of any sovereign in EMU after Greece. If Italy were to lose access to the capital markets, the EUR 440 bn funding of the European Financial Stability Facility (EFSF) would probably not suffice (without further enhancements such as a leveraging of the funds) to bail out the euro area’s third-largest economy. The downgrading of Italy’s credit rating by S&P’s, Moody’s and Fitch should therefore be seen as a warning to the Italian government to shore up the long-term sustainability of its sovereign debt.

While Rome’s austerity package of a cumulative EUR 60 bn until 2014 is a necessary step towards consolidating the government’s finances, it focuses too heavily on the revenue side alone. The Italian economy has seen its competitiveness decline in recent years and has had to grapple with various structural obstacles (e.g. in the labour market). These weigh heavily on Italy’s medium-term growth potential, now estimated to be down to merely 1.2% per year. Structural reforms needed to bolster economic growth (addressing labour, product and services markets, for instance) have been rather thin on the ground. The market uncertainty triggered by the euro crisis and the Italian government’s half-hearted crisis management have already resulted in a significant jump in long-term yields of Italian government bonds. To keep market yields from rising further, Italy urgently needs to “build confidence via debt reduction”.

But just how realistic are the chances of Italy’s being able to substantially and sustainably lower its chronically high debt level over the coming years? In the following we shall use a scenario approach to briefly analyse the sustainability of Italy’s sovereign debt. In doing so we shall project the potential curve of Italy’s gross general government debt in relation to GDP (according to the IMF definition of debt*) up to the year 2020 in six scenarios.

(1) In our optimistic scenario we build on the latest forecasts of the Italian finance minister up to 2014**, assuming that real GDP grows at an average of 1.1% p.a. over the next ten years. Furthermore, Italy succeeds in permanently raising its primary surplus (i.e. the budget balance before net interest payments) from -0.3% of GDP in 2010 to as much as +5.7% of GDP from 2014. Market interest rates, approximated in the following by the yield of 10Y Italian government bonds, come to hover at around 6% p.a. in the medium term. As a result of this, the nominal effective interest rate is assumed to rise gradually to roughly 5.6% by 2020 from around 3.5% in 2010.*** (2) In our more conservative baseline scenario, by contrast, the Italian economy only expands at an average of 0.9% p.a. over the next ten years. Similarly, we assume that the primary surplus inches up to merely 3.75% of GDP by 2016. Here, too, a market yield of 6% p.a. is assumed. In the next four scenarios we fundamentally adopt the same assumptions as in our baseline scenario; however, we vary the assumptions by altering individual variables, i.e. we perform a sensitivity analysis. (3) In our low-growth scenario we calculate the curve of government debt in the case when GDP growth falls appreciably short of expectations over the next ten years, averaging 0.4% per year. (4-5) In our two high-yield scenarios we analyse how a further increase in market rates to 7% and 8% p.a., respectively, would impact the sovereign debt. (6) Finally, we show the debt curve when the savings achieved fall far short of the target, i.e. the primary balance only increases to slightly over 2% of GDP by 2012 and remains at that level.****

Chart 1 shows the findings of our scenario analysis. While the debt ratio in the optimistic scenario noticeably declines to about 90% of GDP by 2020, it falls only slightly in our baseline scenario to just over 110% of GDP. In our low-growth scenario it would in fact remain unchanged at a high level. Whether Italy succeeds in substantially reducing its debt load (or whether this debt load perhaps even continues to increase) hinges largely on the assumptions made – this holds particularly for the future development of market interest rates. For example, on our assumption of an increase in the primary balance to +3.75% of GDP a medium-term reduction of debt falls out of reach from a market interest rate of around 7% per year. Given an even more significant increase in market rates, to say 8% p.a., the debt burden would climb to nearly 130% of GDP no less by 2020. In both cases there would cease to be any further grounds for long-term debt sustainability without additional measures (such as large-scale privatisations) and even more swingeing austerity programmes and/or the implementation of more decisive structural reforms that bolster potential growth.

Finally, in Chart 2 we show what long-term primary surpluses would have to be generated on average over the next ten years in the six scenarios above in order for the sovereign debt to be driven down to 100% of GDP by 2020. Our baseline scenario would require a primary surplus of about 4.5% of GDP. If the economy expanded more sluggishly, a lasting primary surplus of 5.2% would be needed. If market interest rates were considerably higher (8% p.a.) this would even require a surplus of as much as 6.1% of GDP. A look to the past shows the level of ambition needed to generate long-term primary surpluses of over 4% of GDP. While an average primary surplus of around 2.1% of GDP was generated between 1990 and 2010 (according to IMF data), the reading even in “good” years, for instance, between 1995 and 2002 (on much higher GDP growth and better global conditions) was merely 4.1% of GDP.

What this all boils down to is that the Rome government has to rigorously and rapidly consolidate its finances as well as to implement far-reaching structural reforms that aim to bolster economic growth in order to secure the sustainability of its sovereign debt on a medium to long-term horizon.

* According to the IMF (and Eurostat), Italy’s gross general government debt ran to roughly 119% of GDP in 2010, while the OECD definition put the figure at around 127% of GDP.
** See 2011 Economic and Financial Document of the Italian Ministry of Economy and Finance.
*** We approximated the initial nominal effective interest rate for the year 2010 by the ratio of gross government debt interest payments to the previous year’s gross government debt stock. The data employed for the calculation comes from the OECD. The future evolution of the nominal effective interest rate depends on a host of factors such as the market interest rate and the underlying debt structure (for instance the average maturity of debt). You can find more information on the above calculation method in our publication “Public debt in 2020: Monitoring fiscal risks in developed markets” as of July 6, 2011.
**** In our sensitivity analysis (scenarios 3-6) we merely look at how the changes in one single variable (e.g. GDP growth) impact the debt curve. For reasons of simplification we disregard the interplay between the individual variables that occurs in reality.