Roma non fuit una die condita – Rome Was Not Built In A Day

A short history of Italian government debt

Italy’s titanic national debt, similarly to Rome, was not built in a day. In Italy, like much of Europe, the saga begins benignly in the ashes of World War II.

The economic miracles experienced by states such as Greece, Germany and Japan in the 1950s-60s as the countries rebuilt their economies from the ground up (with aid from the US Marshall plan) resulted in two decades of breakneck economic growth. In Italy this period was known as il miracolo economico’. GDP growth averaged just below 6% until 1963 and 5% thereafter until 1973.

This boom eventually gave way to fiscal largesse in an attempt to continue the dramatic growth rates and associated quality of life improvements the domestic population had grown accustomed to. With the puncturing of ‘il miracolo’ during the 1973 global oil crisis, subsequent Italian governments borrowed their way to increased prosperity. From the Years of Lead in the 1970s to Rampartism in the 80s and the Second Republic of 1992, Italian debt steadily rose from 30% of GDP, along with real living standards.

Italy Debt to GDP ratio 1900-2018. Source: Bloomberg

By the early 90s where our overview begins, Italian debt to GDP had risen to over 100% and inflation was running at high single digits. The nexus of government borrowing and its corrupt misappropriation had been recently exposed by the Tangentopli scandal.

The advent of the euro however was about to tie the fate of Europe’s debt markets much closer together.

Convergence & the New Era

In investors’ minds, a common currency and common central bank presaged an eventual harmonisation in the fiscal behaviours of the various European states. The varying interest rates across Europe had until then reflected the difference between fiscally loose Southern states that used ‘easy money’ to paper over structural economic problems and austere economically ‘disciplined’ Northern economies.

The unspoken mantra was ‘we would all become Germans’ (at least in fiscal and monetary terms) and government bond yields would converge to reflect this.

The ‘convergence trade’, as it became known, was simply the purchase of Italian BTPs and simultaneous shorting of German Bunds. This resulted in receiving the higher Italian bond coupons while paying out the lower German coupons and also insulating oneself from general European interest rate risk.

The potential of this trade can be seen below. From the highs of a 650bps annual pick up of BTPs over Bunds in early 1995, traders and investors ground this spread steadily lower as the reality of the Euro and its impacts became more tangible.

GBTPGR10: Italian 10y Yield, GDBR10 German 10y Yield (Top) / Spread of Italian over German 10y Yields (Bottom). Source: Bloomberg

With the introduction of the euro on midnight of 1st January 1999, a new era was dawning in the political and financial unification of Europe. This was reflected in the spread of BTPs (and other peripheral bonds) over Bunds, which reached a steady 0.3% after a euphoric dip to zero on the eve of the Euro adoption. Convergence was complete.

The existential crisis of the Euro

The financial crisis of 2008 shook investors faith in the concept of credit worthiness to the core. The failure in pricing methodologies and the resulting catastrophic losses across multiple ‘safe’ asset classes, which brought down venerable financial institutions, caused a re-examination of many basic principles around ‘risk’ and ‘safety’ in financial markets.

This soul searching collided with the developed world’s drastic monetary expansion to stave off the spiral from an economic recession into a multi-decade depression. Banking system bailouts by concerned governments transferred the accumulated private losses into sovereign debt.

GBTPGR10: Italian 10y Yield, GDBR10 German 10y Yield (Top) / Spread of Italian over German 10y Yields (Bottom). Source: Bloomberg

In an attempt to avoid making the same mistake twice in such a short period of time, financial markets began to fret over the debt loads of Southern European governments.

Particular doubt was heaped upon the PIIGS (Portugal, Italy, Ireland, Greece & Spain) with their high debt to GDP ratios. The unspoken assumption that simply sharing a currency and a central bank would mean unity in the face of a Eurozone sovereign default was uncovered, examined and summarily rejected.

As a result, the spread between Bunds and BTPs, hitherto considered near ‘equivalent’ since their bonding, re-emerged. During the crisis this spread (along with other peripheral European bond spreads) behaved as a barometer for the perceived credit risk of Italy as a sovereign default case, the risk of member exits from the Euro or a complete dissolution and every other fear in-between.

This reinforcing loop of panic over government borrowing that itself increased borrowing costs (causing spreads to blow out to 550bps at the depths of the crisis) was only broken by the now legendary statement of Mario Draghi. On a warm summer day in July 2012 at a speech in London, the president of the ECB drew a line in the proverbial sand: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

Antebellum

The ECB began to engage in unparalleled experiments that blurred the lines between monetary and fiscal independence almost totally. OMT (Outright Monetary Transactions), announced in August 2012, were the initial ‘threat’ of potentially unlimited purchases of sovereign bonds in European states experiencing ‘stressed bond yields at excessive levels’. This of course required the acceptance of EU imposed austerity measures in the form of a ‘Memorandum of Understanding’.

GBTPGR10: Italian 10y Yield, GDBR10 German 10y Yield (Top) / Spread of Italian over German 10y Yields (Bottom). Source: Bloomberg           

The calming of market psychology about the continued unity of core and peripheral Europe resulted in a slow re-convergence of Italian yields in the half decade to today. With the threat of breakup and redenomination risk into profligate national currencies receding, investors in a yield starved world jumped back into BTPs and other peripheral government bonds with renewed vigour.

This was also helped by actual bond buying programmes by the ECB. For example, from March 2015 to May 2018 under the umbrella of the PSPP, the ECB accumulated almost €345bn (16%) of the total Italian government debt stock.

Although spreads never reached the exact pre-crisis lows, an uneasy peace persisted until the past few weeks.

Barbarians at the Gates of Rome

On the political front, the trauma and real economy repercussions of the euro crisis (and some might argue the fundamental structural issues of the Eurozone) have percolated into voter anger.  Extreme political shifts occurred across Europe during and post-crisis as years of unending austerity caused decades of debt fuelled growth to reverse and unemployment to soar.

This began with the hardest hit countries such as Greece and Spain but has recently exploded in Italy with the election of the Five Star and Lega Nord parties as the 2nd and 3rd largest parties in parliament in March of 2018. These two manifestations of the rejection of Europe politically and economically advocate measures such as a 15-20% flat tax rate and quasi universal basic incomes, all funded through increased borrowing.

Shudders of terror shot through markets at the receipt of the coalition’s 48 page document outlining these views. The 2 and 3 year Italian BTPs registered the largest one day fall in value in their entire history.

Once again, the maelstrom was calmed by Italian President Sergio Matarella exercising his constitutional powers to block the appointment of virulent Eurosceptic economist Paola Savona to Finance Minister.

This delayed the implementation of such radical measures but opened the door to the prospect of new elections in the coming months.

As the ECB discusses ending its experiment of low/negative interest rates and its bond buying programmes, the Italian 10 year BTP yields 2.84% and trades at a spread of 230bps to Bunds. We believe the risk reward is rather poor for holding Italian paper.

Debt to GDP still hovers at 130% with the prospect of fiscally belligerent parties being repeatedly voted into power by an enraged electorate.

Italy as an economy, and its related debt pile, will likely be too large for even the ECB and the whole EU to solve in the instance that Italy were to adopt a new lira or crash out of the euro.

About the Author:

Ion is an investment analyst and supports the portfolio team on implementation and consistency on both individual portfolio and the strategy levels. His investment work is across all the firm’s strategies with a specific focus on the macro component and non-equity classes. Ion joined the firm after completing internships at Credit Suisse and Bank of America Merrill Lynch in London. Previous to that he had completed internships at Cerno Capital and other asset-management institutions. Ion holds a BSc (Hons) in Statistics & Finance from the London School of Economics.