THE TAPERING OF THE QE: RISKS AND POSSIBLE FALLOUTS FOR ITALY (2nd part)
This second part of the article wants to enact the worst-case scenario for Italy: the likelihood of a default in light of a reduction of stimulus program by ECB. At first, the conditions of the Eurozone seem pretty stable and the macroeconomic outlook, even considering political risk, is far from 2010. Populist parties have been sidelined during the last elections in France and UK. In Germany, a stream of positive economic data is accompanied by political uncertainty over Chancellor Merkel’s ability to form a coalition government: however, the turmoil is unlikely to have serious repercussions. Spain is regaining focus, notwithstanding the political stand-off between the Central government and Catalan authorities. Greece is no longer in dire straits and is slowly recovering: the Hellenic country has just held its first bond sale since 2014. Growth has gained steam in most of European countries over the last 2 years. In sum, the Eurozone economic recovery proceeds at a good pace, thanks to ECB asset-purchase program that has shored up financial and banking system and due to the implementation of internal reforms in several countries. As a sign of a stable macroeconomic outlook, global-wise the VIX-index for 30’s day market expectations- has just hit all-time lows. Nevertheless, elements of instability still exist, although financial crises are far from being predictable.
Many accomplished scholars and economists have put forward the hypothesis that tapering of the QE in the Eurozone could spark off a ripple effect in the global economy. As stated many times by the president of the ECB Mario Draghi, the “great unwind” of monetary stimulus is about to set off. The slowdown in monetary stimulus has already started in the US and Canada, where interest rates are slowly rising and the central banks have begun the run down of their balance sheets. Since the monetary stimulus alongside fiscal expansionary policy-after a brief period of contractionary measures- have moved the economy to an unprecedented territory of very low growth, subdued inflation and high asset prices, the fallout of a normalization is far from being estimated properly.
In this situation, Italy remains the potential candidate for the next financial crisis in the Eurozone. It is a country close to hold election, where populist party are in a close run-race in the polls with Renzi’s Partito Democratico. It would not be surprising whether the populist 5 Star Movement won the majority or the outcome of the elections ended up in a political stand-off. In addition, Italy’s economy is underperforming and continues to bear the burden of a huge debt, with a flawed banking system unable to deleverage which blocks money-lending and inhibits the recovery. Rome has thus far managed to tolerate high-debt levels thanks to the aggressive ECB asset-purchase program and the consequent flattening of the bonds’ yield-curve.
However, the insulation from risks is no longer guaranteed as the great unwind of QE looms large. At that time Italy could find itself at a crucial juncture, with elections and tapering taking place simultaneously. As a consequence, market and investors could sense the situation of uncertainty and instability, incorporating and reflecting their unfavorable expectations of Italy’s economy.
The first risk is that the end of QE could threaten the slow pace of economic growth of Italy. Indeed, the most likely rise in BTP yields could jeopardize the efforts that Rome has done so far to gain momentum, raising the cost of debt and the fiscal sustainability of the nation-system as a whole. In the gloomiest scenario, Italy would end up hitting its debt tolerance ceilings, where market interest rates would begin to rise quite suddenly, in this way forcing the country to painful adjustment that would endanger growth. This grim outlook would be consistent with the findings of Rogoff and Reinhart: high debt-to-GDP ratio are associated with lower growth outcomes and subsequent studies have thus come out with a 90% debt-to-GDP ratio and 3% level of deficit to describe a degree of debt consistent with a steady growth.
However, Italy’s government debt-to-GDP stands at 132%, far above the 90%. As previously highlighted, expansionary monetary policies implemented by ECB have had beneficial effects on the interest rate of sovereign debt. In this way, the sheer scale of Italy’s debt, alongside interests piling up on it, have been kept in check thanks to the favorable conditions in terms of inflation rate expectations and risk-premium requested by the investors. Nevertheless, tapering could rise again the expected return requested by the market on BPT, with yields set to shoot up.
Additionally, as far as inflation rate differential is concerned, Italy could be caught unaware by a euro currency rally after a tapering in the QE. Indeed, current strong cycle of economic performance could be jeopardized by an appreciating euro exchange rate. Thus, a strengthened currency would endanger export-oriented industries and put at risk the global supply chains of Italy’s exports. As a result, growth could be slowed down, causing a domino effect on Italy’s debt obligations: yields on BTP could surge, given that the investors would ask for higher returns, concerned by a slow pace of the economic cycle and by rising prices and their effects on real interest rate. The high sensitivity of export-oriented Italy’s sector to boom-bust cycle of economy and exchange rate could thus severely take its toll on BTP risk-premium.
Plus, according to several IMF researchers, an increase in Italian sovereign risks could have a significant impact on domestic banks and private credit conditions. The fallacies in the banking system-the high number of NPL in many balance sheets- could be worsened by a dramatic surge in BTP risk premium, since Italian banks hold large amounts of government bonds. In addition, the high number of BTP in their portfolio could take its toll on banks’ ratings and, consequently, to perceived risk profile and funding costs. The study carried out by Zoli highlights how banks with high pile of NPLs and low capital ratio on average are correlated with high level of sensitivity with regards to changes in sovereign spreads. Thus, a continuous commitment to strengthen banks’ capital buffer aimed at reducing impaired assets is a necessary step to shield Italian banks from the great unwind of ECB.
To make matters worse, the likelihood of a populist government-their support is hovering around 45%- and the remote chance that Italy leaves Eurozone and common currency could drive the country toward the path of default. As for the latter, the populist 5 Star Movement (M5S) has often put forward the idea of abandoning the euro currency to reboot the economy by launching a competitively devalued new lira. Aside the fact that a devaluation of a currency has a positive effect in case of a high-rate inflation differential accumulated to commercial partners of Euro area (with fixed exchange rate), however a forced leave of the common currency area is likely to cripple Italy’s economy. Many studies and reports have in fact highlighted how Italy would default on its debt obligations-since the risk premium would skyrocket and would be thus denominated in foreign currency. Aside legal and judiciary consequences of an Ital-exit, a partial “monetization” of debt to pay back investors and households, as suggested by many sovranisti (literally sovereignists), would see the country to slip into hyper-inflation with a strong devaluated national currency. Additionally, cash flows for those who hold Italian debt would be transformed, negatively affecting their investments, savings and returns: a new currency is likely to provoke an inflation overshooting that could definitely harm their positions.
Nevertheless, in populists’ view-Lega Nord as well as many other far-left and right sovranisti-the chance to drop out of the Euro and default on the debt is a sine qua non to start over a “new era of prosperity for Italy”. In light of the difficult negotiations between UK and EU for Brexit, it is likely that, if Italy left the Eurozone, would be required to settle its debts instantly-an amount which stands at 25% of nominal GDP, according to several researches. In the unlikely event that this scenario takes place, it would trigger a domino effect. Italy’s default on debt would spill over into every other Europe’s country sharing part of its debt: thus, the deferred losses on ECB’s balance sheet would be propagated to every EU members and would take years to recover. A study of Oxford Analytics has estimated a 0.4% of GDP wiped off due to Ital-exit, global-wise. Not to mention that Italian debt is mostly held by Italian investors-banks, households, financial brokers, mutual funds: a forced leave would consequently have negative repercussions on Italy’s GDP, with a credit crunch, a tightening in the households’ saving rate and a systemic default.
To sum up, even though it is hard to predict the real consequences of tapering QE on Italy’s economy, it is quite reasonable to highlight the main trends that such an event presents.
Italy remains the 8th largest economy in the world. Over the last few years growth in the country has picked up speed. Since 2011, after the political crisis, Italy has started to settle its public finances: however, Italy’s debt remains at all-time high (133%) and it’s the second highest behind just Greece. Rome is currently spending 4% of GDP to pay interests on its debt load, the second highest in the Eurozone. Additionally, deficit to GDP ratio, a measure that accounts for the sustainability of debt and interests paid on it with regards to GDP, hovers around 2,4%. In the Eurozone, the deficit-to-GDP ceiling is 3%, and over the last years European commission has started infringement procedures three times against Italy. As the paper has showed, these numbers have remained constant over the recent years: thanks to the aggressive asset-purchase program of ECB, the sovereign risk premium on Italian bonds has decreased and the yield curve has flattened. Thus, the cost of debt obligations followed suit.
The paper has tried to demonstrate how most-indebted countries’ debt sustainability in the Eurozone has fed off of unconventional monetary policy alongside forward guidance carried out by ECB. This debt sustainability was built upon the growth/interest rate differential between BTP and German-bunds. Over the last decade, the risk premium incorporated into the debt obligation as well as inflation differential has levelled off at Germany level. Thus, Italy has recently mitigated financing concerns over its indebtedness. Nevertheless, the risks remain.
Since Italy is part of a currency union and its monetary policy credibility was outsourced to ECB, the outcomes of slowdown in QE program would take their toll on sovereign risk premium requested by investors on Italy’s debt obligations rather than on currency, as first-generation model of currency crisis predicts. However, elements of similarity remain. As Rogoff and Reinhardt suggests, fiscal imbalances due to high level of debt burden and high level of deficit-to-GDP ratio are linked to fiscal policy and its sustainability. Aside exchange rate regimes, Italy’s next financial crisis could be related to a typical sovereign-default crisis framework. As the paper has tried to demonstrate, the perceived country risk in terms of economic, political and legal outlook is the main rationale that could help to predict the effects of QE’s scaling back on Italy’s economy. Thus, a sudden rise in the BTP spread due to the perceived fiscal unsustainability of Italy’s debt position would be the result of a political unstable outlook in the long-run: namely, the failure by the next government to fulfill the obligations toward its debtors, not just through the repayment of the interests but foremost for the unwillingness to implement the reforms to continue toward the path of growth. Italy could thus reach its level of “debt intolerance”, where the risk of its default begins to increase even at debt levels that were quite manageable in the past. This situation could be triggered by the short-term political pressure on Italy’s policymakers to push forward public expenditure-driven agenda which could walk the country’s debt out on a limb. Plus, Italy’s banking sector could be hit hard by a distress in the sovereign debt. As noted by Rogoff and Reinhart and Correa and Sapriza, banking crises are closely interconnected with sovereign debt crises: simply put, the role of banks as the primary financial brokers in the economic system could imply that an issue at the banking-sector level could severely affect aggregate macroeconomic conditions and consequently bring about a worsening in the fiscal position of Italy.
To conclude, this unwillingness to solve the macroeconomic-structural and policy distortions- in terms of job markets, electoral law, banking sector, bureaucratic inefficiencies-, in turn, could cause a sudden shift in market expectations and confidence: in this sense, a crisis could see a high-rate of capital flight alongside credit frictions and banking crisis, while the government could decide to default on its sovereign debt, given the high-risk premium requested by investors and the inability to pay off.