Italy Has Built a Buffer to Shield Debt From Higher Rates

Whatever the outcome of next month’s election, Italy’s bonds should be safe for a while yet.

With a debt of 2.3 trillion euros ($2.8 trillion), or about 132 percent of the country’s yearly output, investors are well aware that Italy’s finances risk coming under pressure every time spreads widen — a realistic prospect after a vote in March that will prove inconclusive at best. Further down the road, the European Central Bank’s exit from ultra-low rates is set to raise borrowing costs in coming years.

Yet this is unlikely to rattle the euro area’s third largest economy in the short term. The country took advantage of the ECB’s 2.6 trillion-euro asset-purchase program to extend the average maturity of its bonds and reduce interest payments, making it less vulnerable to shifts in market conditions or sentiment.

This means that, even if analysts have pinpointed the March 4 vote as having the potential to slow Europe’s momentum, ECB officials are sanguine.

“We have a debt-sustainability analysis, we have put in the shock and we have read the figures, and debt is relatively sustainable, relatively resilient, because duration is quite long,” ECB Executive Board member Peter Praet said at an event in Frankfurt on Feb. 9. “They had a very big lengthening so the sensitivity to an interest-rate shock is not that high in Italy actually.”

In fact, this has been a long-run trend of Italy’s public debt management. The average maturity of outstanding debt has risen from less than 4 years in the 1990-1998 period, just before the introduction of the euro, to 6.9 years in 2017. The sovereign-debt crisis threatened to reverse this trend but Mario Draghi’s anti-deflation policies have helped put things back on track.

Long-Term Trend
Italy’s debt average maturity, in years (left) and yield at issuance, in % (right)

“As long as market rates rise only gradually, Italy will continue to issue debt at lower rates of interest than the interest rate on the debt that’s being redeemed,” said Marchel Alexandrovich, an economist at Jefferies in London. “Debt interest payments as a share of gross domestic product are likely to continue to fall for another several years.”

Moreover, Italian banks have been unloading domestic bonds since the start of QE — and the pace of the divestment has increased in recent months as the vote draws near. And, while Italy’s public debt is high, private and household debt is relatively low compared to other European countries. Overall, this means the economy as a whole is less vulnerable to market reversals.

“Betting against Italy proved wrong many times,” said LC Macro Advisers Ltd. founder Lorenzo Codogno, a former chief economist at the Italian Treasury. “So far, the Italian government bond market has been remarkably resilient to potential risks stemming from the outcome of forthcoming polls.”

Yet this expected calm may also contain the seeds of longer-term problems.

Italian growth was already weaker than its euro-area peers before the crisis, and its economic output still has to recover to its 2007 level. Low productivity growth and high labor costs are endemic.

Structural Weakness

The lack of market pressure, and the likelihood that no clear winner will emerge from the ballot, means that the country’s structural weaknesses won’t be addressed by the next government. Luigi Di Maio, the anti-establishment Five Star Movement’s candidate for Italian premier, is unlikely to be given a chance to govern by President Sergio Mattarella even if he wins the election, according to a senior state official.

In fact, what small progress Italy made in tackling a sclerotic public administration, low competitiveness and widespread corruption could be reversed after the vote, especially if populist initiatives take priority in Parliament.

The inability to lay the groundwork for a healthier economy is the real cause for concern, rather than any volatility following the vote, according to ECB and International Monetary Fund officials who asked not to be named because they can’t comment on Italy’s elections.

While the election probably won’t produce a government capable of enacting major structural reforms, Italy still retains “multiple credit strengths,” according to Scope Ratings. The credit ratings company says its A- grading of Italy’s debt as of November was, on average, two notches higher than those of major rivals.

“The impact of any change in financing rates would be mitigated by expected continued primary surpluses, and the relatively long average maturity of the debt stock,” Giacomo Barisone and Dennis Shen, analysts at Scope, said in an e-mail. “In addition, nearly 70 percent of debt is held by residents, amongst the highest such ratios in the European Union.”
Source: Bloomberg