Italian premier Giorgia Meloni recently announced a €24bn package of tax cuts and government worker salary rises to boost the economy. It will increase government borrowing by €16bn.
Further spending plans are balanced by rising excise duties and charging foreigners a flat rate of €2,000 to use Italy’s health service. Meloni’s plan is to stimulate domestic consumption at a time when the European Central Bank (ECB) is trying to combat inflation.
Meloni has clearly taken a leaf out of the Liz Truss book of fiscal dereliction. I was frankly surprised the market did not immediately send Italian bond prices lower – then I remembered – the ECB must be the largest holder of Italian government debt.
In November 2012, 10-year Italian government debt looked utterly unsustainable at a 7% yield and 126% debt/GDP ratio. Then the market expected a potential default, a messy compromise, or even the uncertainty of Italy exiting the euro.
The situation was only resolved when ECB president Mario Draghi promised to do “whatever it takes” to restore order, which basically meant the ECB buying Italian bonds and taking over the direct funding of Italy. Yields quickly fell to 5% and then traded down in line with Europe’s zero interest rate policy.
Now, Italian yields are back up testing 5% again. The debt/GDP ratio is trending towards 140% by year end. Italy’s fiscal deficit is headed towards 5.6%, above its announced 4.3% target, which was already well above the EU’s fiscal deficit limit of 3%. Something has to give.
Why doesn’t the European Commission complain? As we are all aware, but politely ignore, the problem of the euro is the lack of any real fiscal agreement between its members.
There are vaguely acknowledged and frequently dodged fiscal rules about debt to GDP levels. Since 2012 I’ve been watching the ECB insert itself into the sovereign debt funding process, winning rights to allocate recovery funding to the member states in the pandemic. It’s not terribly democratic but it controls the picture.
Ultimately, the ECB would like a single European government bond market, which would be fascinating in scale and potential liquidity, but it would largely be financing Europe’s high-debt south with transfers from pensions-rich northern nations, which is unlikely to prove a vote winner for pro-EU political parties.
Italy’s demographic crisis does not help. Its pension bill is the largest in Europe and is growing the fastest. Other nations in trouble with demographics, for instance Japan, have the advantage of being financial sovereign nations.
Japan has successfully funded itself via its JGB bond market (some 225% debt/D+GDP) ratio. Normally this would raise a crisis, but Japan owns the printing press and controls the print button. It has kept rates effectively at zero meaning the cost of money is zero. It has been able to keep the yen competitive despite zero interest rates, only now coming under mild pressure.
In short, despite its massive debt, Japan illustrates a great example of the virtuous sovereign trinity – a stable currency, a sustainable bond market and boringly dull, predictable competent politics.
Try to apply the same tests to Italy and you cannot. It does not control interest rates or its currency. It is effectively a sovereign credit, not a financially sovereign nation. Its spread is entirely vulnerable to its political competency and how well it addresses the crisis of an ever more expensive debt load. Many commentators have spoken about Italy’s interest payments increasing by €13bn per annum because of higher rates.
Italy is a medium sized, low-growth nation on the soft underbelly of Europe with a host of economic issues to solve, which it cannot do as a sovereign nation because it does not control its currency or rates. Not the least of these problems is its massive outstanding debt load. Yet, any answer to Italy’s woes would require a European-wide fiscal solution. Will that ever be agreed?
This is going to run and run, and I have few expectations of a smooth process or outcome.
Bill Blain is a strategist at Shard Capital. The views expressed above should not be taken as investment advice.