The Italian balancing act

  • Why it matters

    Why it matters

    The annual Jackson Hole Policy Conference takes place on Thursday.

  • Facts


    • The ECB currently purchases €60 billion in euro zone government bonds each month.
    • Italy’s predicted economic growth is significantly below the euro zone average, while its debt level is a steep 133 percent of GDP.
    • Foreign investors have sold more than 43 percent of their Italian bond inventories since the ECB bond-buying program began.
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The eyes of the Draghi. Source: Picture Alliance / AP

Jackson Hole, a plush resort town in the Rocky Mountains, is a world away from Rome. Yet Italy’s capital will be paying close attention to happenings in Wyoming, where the annual summit of the world’s monetary elite begins on Thursday. Officials in Rome are hoping the European Central Bank’s president, Mario Draghi, will keep his lips sealed about plans to end bond purchases and an ultra-relaxed monetary policy. But even if Mr. Draghi keeps mum, it’s all over but the scheduling.

When Mr. Draghi finally signals a halt to so-called quantitative easing, the loudest applause will happen in Germany, where leading officials have long wrung their hands over the potential impact on euro zone inflation and the currency’s stability. Bundesbank boss Jens Weidmann went so far as to say the bond-buying program verged on illegal financing of government debt.

On the other hand, one of the biggest losers will be Mr. Draghi’s home country, as the ECB’s bond purchases cast a lifeline to Italy’s deficit-riddled public coffers.

German economists Clemens Fuest and Marcel Fratzscher read the tea leaves on ECB monetary policy.

Analysts are warning about the fallout. “Italy’s long-term debt sustainability is more doubtful than that of other countries,” said Christian Schulz, an economist at Citigroup. Johannes Mayr, an economist with BayernLB, notes that Italy’s debt ratio is “especially high.” The country has one of the worst-performing economies in the euro zone, and its banks continue to reel from the effects of the financial crisis.

The problems now dogging a single EU member, it seems, are now big and serious enough to turn the central bank’s monetary policy into a tightrope walk.

The ECB began buying sovereign debt of euro zone countries in March 2015, with the aim of stimulating lending, the economy and ultimately, inflation. This year marks the official end of the program after purchases of a total €2.3 trillion ($2.72 trillion) in mainly government bonds. Investors expect that in January, the ECB will begin reducing its purchases from the current monthly rate of €60 billion, partly because the central bank would breach its self-imposed limits if continued unabated.

At 1.3 percent, euro zone inflation is still well below the ECB’s target of just under 2 percent. The risk of deflation, or steadily falling prices, has been averted.

The ECB forecasts the economy will grow 1.9 percent this year. However, the European Commission predicts growth of only 1 percent for Italy. And the country’s debt level is also extraordinarily high, at 133 percent of GDP. According to data from Banca d’Italia, the country’s central bank, Italy’s absolute debt reached a new record in June, at just under €2.3 trillion.

For Italians, the timing of the policy change is unfortunate as national elections are set for next spring. This means Euroskeptic parties will benefit from loose talk of a renewed financial crisis in Italy – even though the actual crisis seems to be over.

What troubles investors is the question of who will continue to buy Italian bonds when the ECB stops. According to calculations by Citigroup, foreign investors sold 43 percent of their euro zone bond inventories between March 2015 – the start of the bond-buying program – and March 2017. This amounts to more than €75 billion in bonds.

Banks are increasingly unloading Italian government bonds. In June, they sold €20 billion worth, a monthly record. “There has already been a flight out of Italian sovereign debt, which could trigger a domino effect for the rest of public debt,” warned Francesco Forte, a former Italian economics minister.

Because of the ECB purchases, annual returns or yields on Italian government bonds have been relatively low,  with 10-year bonds currently yielding 2 percent. But that includes a risk premium, or spread, of 1.6 percent above the yield of government bonds in Germany.

22 p29 Italian Government Bonds-01

This leads analysts to expect a sharp rise in risk premiums for Italy’s bonds. Commerzbank expects an increase to 2.25 percent from the current 1.6 percent for 10-year interest-bearing securities, while BayernLB and Citi predict 3 percent. Yields of 3.5 percent will be sweet enough to draw buyers to Italian government bonds again, said Mr. Schulz. But there’s a risk, he added, that “an increase in yield to that level could upset the market, in light of Italy’s debt sustainability.”

Officials in Italy are acutely aware of the situation. Once the ECB’s easy monetary policy comes to an end, “we will probably witness a continuous rise in interest rates, which will drive up (Italian) public debt even further and make investments less attractive,” said Renato Mason, general secretary of CGIA, the Italian small businesses association. Former Economics Minister Forte is also concerned, noting that if the bond purchases come to an end, “interest rates will go up, banks will scale back commercial lending, and the euro will rise even further, harming Italian exports.”

The ECB is expected to proceed with caution. “Phasing out the bond purchases can only succeed if the financial markets continue to have faith in Italy’s debt sustainability,” said Mr. Mayr of BayernLB. While the central bank probably won’t announce a fixed date, the central bankers will likely reduce monthly purchases to €40 billion from next year and continue doing so bit by bit.

And what if the situation escalates, and investors begin to panic? The ECB could fall back on its Outright Monetary Transactions (OMT) program, which it has never used. This would allow it to support bonds of, say, a euro zone country that’s having trouble securing financing in the markets – in return for a commitment to implement reforms. Technically, the OMT would help keep Italy in the euro zone, said Mr. Schulz. “The question is whether there is the necessary political will in Italy,” he added.

Andrea Cünnen covers the bond markets for Handelsblatt from Frankfurt. Regina Krieger is Handelsblatt’s Italy correspondent. 
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