Italy's unacceptable yield spread
A need for a 'whatever it takes' from the government
by Lorenzo Codogno in London and Giampaolo Galli in Rome
Fri 29 Jun 2018
Apart from Economy Minister Giovanni Tria, it seems the Italian government does not particularly care about the yield spread between Italian and German government bonds, which has fluctuated around 230-270 basis points over the past few days. Prime Minister Giuseppe Conte has rightly said that 'the exit from the euro has never been questioned, has not entered into the government contract and is not a goal that we propose in this political term.' He added that 'we do not make the spread our flag', as if to minimise the seriousness of the issue compared to the needs of citizens that must be addressed as a matter of priority.
The spread is a tremendously serious matter and presents significant dangers to the real economy. First, a high spread is an unacceptable waste of resources, because it leads to higher taxes or lower spending opportunities. One hundred basis points of higher interest rates translate into an additional cost to the state of around €2bn after a year, more than €4bn after two years and more than €22bn at regime. Second, a high spread on government bonds translates into a higher cost of credit for households and businesses and reduced credit growth. The increase in the spread raises the cost of funding on financial markets for Italian banks and reduces the valuation of the €341bn government bonds on their balance sheets. This constrains their capacity to provide credit.
These effects are significant, as shown by the trying experience of 2011. Italy entered a recession in the second half of 2011 when the restrictive measures introduced by the three budget packages approved between July and December had not yet had their effects. Even if GDP had not contracted further in 2012, the carry over into the second half of the year, mainly due to the spread, would have caused a recession of around 1%. The further drops in GDP recorded in 2012 added another point and a half to the recession and were mainly due to the quasi-credit crunch. In fact, bank loans to companies slowed sharply in mid-2011 and even contracted from December 2011 and throughout 2012. In parallel, bank rates for households and businesses surged. Companies were forced to reduce their financial exposure to the banks.
Today, the spread is still far from the levels reached in 2011, but in recent weeks has increased at a pace similar to that of July-August 2011. Any internal or international tensions can produce sudden shifts, such as the one recorded on 29 May. Although Italy's growth and debt fundamentals have remained the same, uncertainty about the country's euro membership has made conditions very fragile. Under these circumstances, seemingly minor events could trigger a chain reaction and lead to loss of market access. For the small group of anti-euro ministers in government, a severe financial crisis is not an event to be afraid of, but hoped for. The fear that the reaction of the Italian government to a crisis would be to exit the euro risks making it a self-fulfilling prophecy.
The cost of the new government debt is more than 100 basis points higher than a month ago. If the government wants to avoid this intolerable waste of resources, while the European Central Bank has already announced a gradual exit from quantitative easing, a sort of 'whatever it takes' policy is needed, this time not by the ECB, but by the government itself. As Tria has already begun to do, the government will have to try to convince markets that it will do everything necessary to avoid conditions that put Italy's euro membership at risk. This also applies to compliance with budgetary discipline. If this does not happen, the spread will remain high and Italy will remain exposed to imponderable risks. It seems improbable that a government, albeit an anti-establishment one, wants to take on a responsibility of this magnitude for the future of the country.
Lorenzo Codogno is Visiting Professor at the European Institute, London School of Economics, and was Director General of the Italian Treasury from 2006-15. Giampaolo Galli is a Senior Fellow of the Luiss School of European Political Economy. He was a member of parliament in the Italian Chamber of Deputies between 2013-18, and worked for the Bank of Italy between 1980-95.
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