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Western EuropeSeptember 1 2011

The sorry and familiar story of Italy's debt crisis

Huge public debts, lacklustre political leadership, teetering on the edge of an abyss... For Italy in 2011, read Italy in 1992, or Italy in the mid 1970s. The country has failed to learn the lesson of past crises and will have to make some unpopular decisions if it is to break this cycle.
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The sorry and familiar story of Italy's debt crisis

Think of Italy and imagine the pastoral tranquillity of Tuscan olive groves and Piedmont’s vineyards, mandolins and boater-hatted gondola oarsmen, or the relaxed charms of Audrey Hepburn and Gregory Peck in the romantic comedy Roman Holiday.

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In 2011 the country had a very different feel: frenzied, gut-wrenching and nightmarish for politicians, bankers, small savers and large institutional investors, as they rode the roller-coaster of Italian share prices and treasury bond yields. The right-wing coalition government led by media-mogul Silvio Berlusconi trembled. Just where, when and how would it end, many wondered. With almost €62bn of government debt redemption due in September 2011, far more than in any other month over the next year, this month may provide a pointer.

A familiar scenario

Italians have been here before: the financial earthquake in mid-1992 ended on September 13 that year with the lira ejected from Europe’s exchange rate mechanism. This year has seen a resurgence of the doubts from 19 years ago.

In 1992, after the lira had spent five years tied to a European exchange rate, markets woke up to the fact that Italy’s economic and financial fundamentals were too weak to allow the country to keep pace with its stronger European partners. Italy’s economy was uncompetitive and its public sector finances shaky. The differences between the countries that made up Europe’s currency agreement doomed the lira and it was out of the European Exchange Rate Mechanism (ERM), its value cut by 7%.

Four days later Giuliano Amato, the then prime minister, presented an emergency budget that hit Italians for almost 94 trillion lire (about €47bn, although far more then in real terms), by raising revenues and cutting expenditure, although privatisations were also part of the package. Among the measures there was a tightening of pension rules, higher taxes on large cars, aircraft, motorbikes and helicopters, an extension of a tax amnesty, a tax on the net assets of firms, and an abolition of various tax allowances. That year, Italy’s budget deficit amounted to 10.7% of gross domestic product (GDP), boosting debt from 100.6% to 107.7% of its GDP.

Yet even more history lies at the root of Italy's mid-year turbulence. The problem of public sector finances dates back to before the ERM debacle. In 1970, the gap between spending and revenues was a manageable 4%. But thanks to the first oil shock, by 1975 the budget deficit had expanded to about 10% of GDP, and it stuck there through the 1980s and into the 1990s, with a succession of coalition governments doing nothing. Many politicians were too busy diverting public funds into their parties’ pockets, or lining their own, to worry about the country’s money problems. Six months before Mr Amato found himself facing the lira crisis, tangentopoli (bribesville) had burst in Milan, and the deep-rooted and widespread corruption that infected Italian public life was exposed.

Graft loaded most public sector contracts with heavy overheads. For construction work on Milan’s underground railway it amounted to 4% of the contract price, for example, while for machinery and equipment it added as much as 14% to costs. Huge bribes – 153 billion lire in total – were paid to persuade the government to nationalise Italy’s largest chemicals group. Judges took bungs to swing cases. Politicians took cash in envelopes or through transfers into their offshore accounts. In this septic climate of corruption, it is hardly surprising that public sector debt was not a priority. 

National pride

While Mr Amato’s austerity measures were enough to prevent debt spiralling out of control, it hit 124.3% of GDP in 1994 and only then began to fall, albeit slowly. Four years after Mr Amato’s efforts, the lira’s fading hopes of joining the euro at its launch focused ministerial minds once again on the problem of public sector finances. The European Community was conceived in Messina in 1955 and born in Rome in 1957, and Italy was one of its six founding members. To have been excluded at the birth of the euro would have hurt national pride.

So, with debt still above 120% of GDP, it was the turn of Romano Prodi and his centre-left administration to conjure up a package at the end of 1996 to convince European partners that the lira was fit to join the euro. An additional income tax to be paid in 1997, called the euro-tax, was imposed, raising 4300 billion lire and cutting the deficit by 0.6% of GDP. 

From 7.1% of GDP in 1996, the deficit fell to 2.7 % the following year, allowing Italy to slip under the Maastricht bar of 3%. Yet, at 120.2 % of GDP, Italy was double the 60% that the convergence criteria required for the debt-to-GDP ratio. (Italy was not alone; Belgium and Greece also failed this test.) The euro was launched at the beginning of 1999, but did Italy satisfy the Maastricht requirement that it was approaching the debt ratio target at a satisfactory rate? The figures suggest not, but European leaders fudged the lira’s entry into the euro all the same.

The government that Mr Berlusconi led for five years from 2001 did little to improve matters, and when Italians voted him out in 2006 the debt-to-GDP ratio was 106.6%. Focused on passing laws to solve his personal legal problems, Mr Berlusconi’s failure to deal with the deficit and debt was unsurprising. Sooner or later there would be retribution, and so there has been. For decades politicians dodged the problem of Italy’s public sector debt but, with the debt-to-GDP ratio again at 120% and the euro area’s third largest member under siege, in mid-2011 they could do so no longer.

Widening spreads 

After Greece, Ireland, and Portugal cracked, and with Spain teetering, investors looked more closely at Italy and reduced their holdings of Italian debt. Spreads against German debt widened and Italian yields moved higher. A budget was drawn up at the end of June and quickly won parliamentary approval. But its main measures for deficit reduction were to become effective in 2014 and little would be done in 2011 and 2012. Not enough and too late, said investors. Italian debt was for selling and the spread of Italy’s BTP medium/long-term bonds against Germany’s Bund, which had hit 300 basis points (bps) on July 11, widened.

For a while Mr Berlusconi, back in office since 2008, kept out of sight, and an apparently leaderless Italy made investors even more nervous. Eventually the prime minister surfaced but his lacklustre address to parliament on August 3 contained little to reassure holders of bonds. He said that Italy “has a solid political system... and solid economic fundamentals”. It was unconvincing, and not helped by his reference to his own companies.

By August 5 the spread had risen to 410bps and the yield on BTP had soared. European bosses in Brussels and at the European Central Bank (ECB) took fright at the prospect of Italy bringing down the euro and decided during the weekend of August 6 and 7 that Italian government bonds should be propped up. Helped by ECB purchases, the spread eased to 308bps on Monday August 8.

However, the support from Frankfurt came at a price. Europe’s monetary authorities agreed with investors that Italy's budget needed strengthening. A letter from the ECB’s governor, Jean-Claude Trichet, and his successor, Mario Draghi, the Bank of Italy’s governor, told the Italian government that action was needed. Italy had no way out and Mr Berlusconi and Giulio Tremonti, the treasury minister, appeared before a press conference on the evening of August 12 to say that there would be more taxes and more cuts, raising €20bn above what was originally planned and bringing the deficit down to 1.4% of GDP next year. Measures worth a further €25.5bn aimed to balance the books in 2013.

Banks suffer

Inevitably, worries over Italy’s sovereign debt hit the country’s banks. Mr Berlusconi had told parliament that “our banks are liquid and solvent”, but his words did not reassure foreign investors. Frightened by the risk implicit in Italian banks’ holdings of government bonds – UniCredit had almost €39bn on its books at the end of June and Intesa Sanpaolo €64.5bn – they preferred to sell and the banks’ share prices slumped.

“Domestic investors take up the slack in times of crisis, as international investors reduce, and that has happened in the past two months,” said Laurent Fransolet of Barclays Capital in mid-August. “Italian banks have always been heavy on Italy and were already long. There are limits to what they can do,” he added.

At the end of July, Italian banks had underperformed the European sector by more than 10% and when the stock market closed at month-end, the price of shares in Intesa Sanpaolo was one half of its 12-month peak. Shares in UniCredit had fared equally badly. Matteo Ramenghi at UBS expects that “Italian banks' share prices will remain inversely correlated to sovereign spreads”. So the volatility of Italian treasury bond spreads and yields look like continuing to be echoed in movements in the banks’ share prices. 

Out of control

Worries over Italy’s sovereign debt are understandable. At about €1900bn, the bel paese’s mountain of public debt is enormous and, with yields soaring, many economists thought that a vicious spiral was approaching in which debt would spin rapidly upwards, and out of control. Matteo Cominetta of UBS is contrarian on this. On the question of the impact of a hike in bond yields on debt dynamics, he replies: “The short answer is: little.”

Mr Cominetta notes that Italy is currently paying an interest rate that in real terms is among its lowest in the past 25 years. During the ERM crisis it paid real rates of more than 6%. And at seven years, the average debt is longer than that of the US, Germany and France. Increases in yields will impact debt servicing and sustainability only if they are prolonged, says Mr Cominetta. The efforts of the treasury’s debt management department to lengthen the life of government debt that began in the early 1990s – it was then about three years – have borne fruit.

Yet the department faces a huge task in managing the vast debt that Italy has accumulated. It does so through an annual programme of auctions announced towards the end of 2010. The 20 primary dealers who participate – of which just three are Italian – are each expected to take more than 3% of the total auctioned each year and, in fact, account for almost all of it.

Last year Barclays headed the table that the treasury draws up of its best specialisti, as the dealers are called. Deutsche Bank, Citigroup, Société Générale and RBS were the runners-up in a table based both on amount of debt and on quality of bidding. The decision about how much debt is auctioned and the timing lie with the department, but the automated procedures governing the auctions are managed by the Bank of Italy. They run smoothly: they have to. “It’s rather like a shop which has a large stock it must sell. High debt calls for high efficiency,” says a senior executive. Efficiency counts for little, however, if shoppers lack liquidity or simply refuse to buy.

As much as central bankers, treasury officials and politicians might wish differently, the challenges that Italy has faced over the past months are unlikely to be solved before the year is up. Indeed, austerity will be an unwelcome theme in the second half of the year. “The right economic background is needed and that means growth in the world economy,” says Mr Fransolet. But the global scenario is unlikely to help. Such is the context in which the debt managers at the Italian treasury face a daunting series of redemptions this year and next. The decades of Italian debt delinquency have left a troubling legacy. 

Italy: a decade going nowhere

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