THE TAPERING OF THE QE: RISKS AND POSSIBLE FALLOUTS FOR ITALY (1st part)
In light of tapering of the Quantitative Easing, this script intends to investigate whether and to what extent ECB’s unconventional monetary policy has affected Italy’s economy over the last 5 years. In doing so, the script aims at shedding light on the mechanisms and procedures that affect country risk assessment and consequently the measurement of sovereign risk premium incorporated by sovereign debt. Thus, this part will go over the last decade to present a clear picture of the ECB’s Asset Purchase Program.
Then, the paper wants to enact the worst-case scenario for Italy, namely the likelihood of a default afterward the end of QE. Therefore, this work carefully presents the distortions and macroeconomic imbalances of Italy’s economy through which a major debt-crisis could break out. Above all high level of debt to GDP ratio and inability to meet debt obligations, infringement of Maastricht criteria in terms of deficit-to-GDP ratio, sluggish productivity and lethargic growth. Plus, the high rate of NPLs in the balance sheet of the major banks and the unlikely scenario of Ital-exit from the Eurozone. The paper eventually tackles the global and Europe’s impact of a possible default of Italy, in terms of balance of payment crisis and sovereign debt crisis.
Started in August 2007 and exacerbated by the bankruptcy of Lehman Brothers in September 2008, the Financial Crisis swept across continents and had severe implications for financial markets in both advanced and emerging economies. The crisis can be split into two parts.
The first is geographically located in the US and is labelled as subprime mortgage crisis: in short, the boom and then the bust of real estate assets, strictly intertwined with the (ab)use of financial leverage by households and high-level of securitization within the banking and financial system of real-estate linked assets, led to a general collapse of the entire financial architecture. The “subprime mortgage crisis” can thus be described using the model of financial accelerator set out by Bernanke and Gertler: an overheated real estate market and a borrowing binge relying on low-interest rate that brought about a banking crisis with a series of defaults on the collaterals on loans, eventually transmitted to the whole financial system through a high-grade of financial innovation.
The second part is located in Europe. It broke out with the Greek debt crisis in May 2010. At that time, international investors became increasingly worried about the sustainability of southern-Europe countries’ debt, denominated in fixed-income assets such as bonds and debentures. Simply put, long-term government bond yields rose significantly at danger level for most euro area countries with regards to Germany-Bunds, used as a benchmark. More specifically, due to a crisis of confidence sparked by structural weaknesses in the Greek economy and manipulated figures on government debt levels, Greek-bond yield spread and risk premium in credit default swap widened. At that point, the basis of European monetary union started to crumble and Greek-debt crisis caused a ripple effect on sovereign risk premium for heavily-indebted European countries- Italy, Spain and Ireland above all.
As far as Italy is concerned, in the aftermath of the outbreak of subprime crisis (during the period 2008-2010), Italy’s sovereign risk steadily shot up. The Italian spread vis-a-vis German bund stretched by almost 200 basis point from about 30 basis points, the average level after the introduction of the euro in 1999. Situation has become even worse since the mid-2011, when the yield differential of Buono del Tesoro poliennali (the Italian long-term government bond, BTP) broadened considerably. In the late months of 2011 it went above the threshold of over 550 basis points. On November 2011, when the major threat of a combination of political crisis and financial default was looming ominously over Italy’s, PM Silvio Berlusconi stepped down and was replaced by a technician government run by Mario Monti. Just at the end of 2012 the surge in the spread quietened down and the yield differential stabilized around the 300-basis point level. This unparalleled increase in the risk premium requested on sovereign bonds is associated with growing concerns by investors and markets about governments’ capacity to meet their future debt obligations: its increasing spread reflected a significant risk premium demanded by investors when lending to finance its public debt. Accordingly, Italy’s economy has suffered from the higher cost of borrowing and a limited capacity to access capital markets. Broadly speaking, Italy’s country risk was very high up to 2012 and then reduced steadily.
According to Damodaran, country risk can be split and assessed along three lines: economic, political and legal. As for the first, notwithstanding that Italy has a diversified economy and is not dependent upon one or a few commodities that are volatile to market price, various weak points contribute to increase risk premium associated to its sovereign debt obligations. First and foremost, a fragile banking system dealing with a large number of NPLs in its balance sheet: although the harmonization of Italian laws within the frame of BRDD (Bank Recovery and Resolution Directive), issues concerning the corporate governance of Italy’s banking system and the creation of a secondary market for distressed assets continue to threaten the resilience of the system, with all the drawbacks that follow. To make things worse, specific features of Italy’s business environment add risk on the dismal situation of the economy. Regardless of the existence of ecological niche in certain industries, heavily-reliant on exports, on average Italy’s enterprises invest few funds in R&D. This is due to cultural aspects, such as technology resistant entrepreneurial mindset, but also to structural factors, such as crippling tax burden-that inhibits firms to expand- and dull job market.
As for political risk, since the reconstitution as a republic in 1946, Italy has had 64 governments, each one lasting for a little more than a year on average: in this sense, political stability, respect of rule of law and enforcement of norms and procedures by bureaucracy matter for investment. As Damodaran notices, “If those who enforce the rules are capricious, inefficient or corrupt in their judgments, there is a cost imposed on all who operate under the system”. Nevertheless, as stated by Economic Freedom Index, “the economy remains burdened by political interference, corruption and the poor management of public finance”. Bureaucratic inefficiency costs an estimated €30 billion annually in wasted public resources and court procedures are very slow if compared to European peers.
As for the latter, the legal risk measured by the International Property Rights index, on a scale 0 (less protection) to 10 (highest protection), Italy ranks 6th. Even so, the legal system enforcing them it is considered below European standards and the total tax rate (as a % of commercial profits) averages at 48% (in 2005 was around 76%). Plus, in the labor market job growth and flexicurity are hampered by systemic deficiencies, and unemployment stands at its all-time high for youth. In addition, Italy has a long story of organized crime: this represents a pocket of vulnerability that accounts for 7% of GDP, off-the-books or via money-laundering in legal activities and public contracts competition.
Overall, Italy’s risk accounts for the (in)ability of government to meet its debt obligations. In this sense, the credit risk of the borrower captures the likelihood of default and determines the premium-or return spread- over the risk-free rate. For country risk, rating agencies and professional services provide investors with real-time ratings, assigning specific-risk premium to countries for both foreign currency and local currency borrowings: the lower the credit rating, the higher the probability of default (and/or lower recovery rate) so the larger is the YTM spread over the risk-free rate. While S&P and Fitch currently rate Italy sovereign risk BAA with outlook stable, Moody’s assesses it as Baa2 with negative outlook. Additionally, investors and lenders look at sovereign CDS (Credit Default Swaps). CDS is an insurance against the risk of default on a bond or bond-like security: it accounts for the risk associated with fixed-income assets. Over the last decade, CDS market has provided updated, market-driven estimates of default risk: Italy CDS 5YR stands at 118, while on average European CDS Markit is around €49. Thus, when evaluating risk and when incorporating it into their decision-making, investors and rating agencies carefully take into account every possible scenario, adjusting their expected cash flow in the probability of adverse event and consequently modifying the required return on their investment.
To conclude this first introduction, in the period considered above, the high-debt-to-GDP-ratio of Italy has put enormous pressure not only on sovereign bond yields and sovereign spreads, increasing investors’ risk appetite and consequently country’s risk, but it has also had a cascade effect on Italian banks’ CDS, lending rates and credit growth cycle.
After presenting an overview on Italy’s country risk and on the mechanisms and procedures that affect the measurement of sovereign risk, this part plans to evaluate the effectiveness of unconventional monetary programs adopted by ECB since 2013 on Italy’s economy as a whole. With a specific focus on its perceived sovereign risk. Drawing on several studies and formal economic models presented in these reports, the paper wants to investigate whether and to what extent ECB’s forward guidance policy- ECB press conferences and communication strategy- affected the Italian spread vis-a-vis Germany. In order to do so, it is necessary to briefly go over the timeline and the instruments at disposition of ECB in implementing its “bazooka”. Unconventional monetary policy was introduced while other kind of policies have already been in place. Indeed, existing policies consisted of SMP-Securities Market Program- and above all OMT-Outright Monetary Transactions. Both the programs consisted in a sovereign debt “purchase that began its operations in August 2012, shortly after Draghi’s poignant point of doing “whatever it takes to save the Euro”: the main aim of the purchase of bonds in the secondary market (ECB, by the books, cannot purchase directly from government) was to “ensure depth and liquidity in those market segments which are dysfunctional (…and) to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.” Namely, to alleviate the stress on bank lending channels and keep money flowing in the banking and financial systems of the most affected economies. Notwithstanding the opposition of Germany, SMP and OMT eased Italian and Spanish sovereign debt yields and gave a break to Greek, Irish and Portuguese debt. Nevertheless, ECB set off the “real” QE with the announcement of the Public Sector Purchase Program (PSPP) in January 2015 as a main component of the Expanded Asset Purchases Program (EAPP). As stated by ECB “the QE included liquidity facility extensions and a massive expansion of its asset purchase programs- allocated to different assets (covered-bond, asset-backed securities, PSPP, sovereign debt securities)”.
To be more precise, the programme consisted of an open-ended monthly asset purchase of €60 billion. Contrary to conventional monetary instruments, where the central keeps under close monitor the real interest rate managing the short-term nominal interest rate- thus affecting the yield curve and consequently credit channels transmission, asset prices and the exchange rate- ECB started leveraging on unconventional monetary policy when conventional monetary tools became limited in their usefulness. That is, when nominal interest rates were effectively bound by zero, the Eurozone was facing slow economic recovery, with high levels of unemployment and, above all, was going through a deflationary moment. With the aim of reversing this grim economic scenario, the ECB brought forth a new Public Sector Purchase Programme (PSPP) additional to the Asset-Backed Securities and Covered Bonds Purchase Programmes (ABSPP and CBPP3) originally launched in September 2014. In short, ECB would have purchased sovereign bonds from euro-area governments and securities from European institutions and national agencies with the precise scope of “a sustained adjustment in the path of inflation which is consistent with the aim of achieving inflation rates below, but close to, 2 percent over the medium term”. The sweeping change in the monetary policy of ECB in terms of tools was rolled out with a new communicative way to explain the strategy to the public. Indeed, the ECB implemented a proactive communication approach aimed to influence the financial decisions of the major economic players-households, businesses and investors- and to signal the market the commitment of central bank to do “whatever it takes” to avoid market disruptions and fluctuations in asset prices. This strategy came under the name of Forward guidance: aside new tools -large scale asset purchase through Open Market Operations, swaps agreements with other central banks, a widening in assets eligible as collateral to allow flexibility for banks to obtain loans, NIRP (negative interest rate policy) - the expanded communication of FG worked on short-term yields and long-term interest rates, increasing the overall effectiveness of the policy.
In order to gauge the efficacy of ECB unconventional operations on Italy’s spread and economic outlook, it is worth drawing on the econometric studies carried out by Falagiarda and Reitz and Falagiarda and Gregori. The main findings of the studies above mentioned can be summarized as follows.
First, the differential between perceived sovereign risk of Italy with regards to its German benchmark counterpart (German-Bund 10Y) has widened significantly since the introduction of the euro up to 2008, but then it has lowered steadily. Second, ECB unconventional monetary policy positively affected the euro area sovereign debt problems of Italy. That is, ECB communications about non-standard operations (FG) managed to reduce the sovereign solvency risk of Italy. Through an empirical investigation made up of an event-study and a time series analysis, the authors came to the conclusion that over the last 5 years, expansionary monetary policies implemented by ECB have had beneficial effects on the interest rate of sovereign debt. The latter is determined by real return made up of economic growth (GDP growth), inflation rate expectations and risk-premium requested by the investors. According to the authors’ robust findings, for Italy the last two variables have been stabilizing at Germany’s levels for 4 years. The main rationale behind this is related to the stabilizing price-levels environment brought about by the currency union: interest rate differential between Germany and Italy’s similar bearing-assets (sovereign debt) has descended since adoption of common currency. Plus, concerted monetary policies have levelled off inflation rates, without abrupt change in exchange rates to compensate for inflation differentials and, above all, without irresponsible monetary policy that could have led to high-inflation rate. In this way, Italy managed to increase its saving on interest expenses, that has averaged around €45 billion since 2012.
Third, it has to be said that fiscal responsible policy carried out by Italy’s government since 2012, especially in terms of a tightening in fiscal policy plus Fornero’s pension reform, worked together with ECB’s FG and were effective in shrinking the Italian spread vis-a-vis Germany.
Finally, FG operations announcing the Covered Bond Purchase Programme, the Securities Market Programme, and Outright Monetary Transactions are connected with a rapid and great lowering of the differential between Italian and German long-term bond yields as compared with other kinds of unconventional measures.
Overall, to conclude this first part, over the last five years the ECB unconventional policy measures have succeeded in downsizing the euro area sovereign debt crisis, in terms of a reduction in Italy’s sovereign risk. In addition, several policies implemented by Italy’s government have accounted for a better and more stable macroeconomic outlook. Accordingly, also general factors such as liquidity risk and international contagion effects, and country-specific features, such as fiscal positions and macroeconomic fundamentals ameliorated. Nevertheless, Italy’s economy does not have to rest on its’ laurels. ECB unconventional stimulus have allowed the country to buy time, however pockets of vulnerability still remain large. The country is near an election where a populist party enjoys considerable support to form a government, and the market could react adversely to this. Plus, Italy has an economy performing well below its potential, while its banking system is fragile. To make matters worse, structural issues that drag down economic performances have yet to be fixed, with a bloated and inefficient public sector and a huge debt burden. In conclusion, in Italy all is set for a potential next financial crisis of the Eurozone.
Read the second part here
Read the second part here