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.
Comments
Post a Comment