Italian spreads, the "elephant in the room" of ECB normalisation

Since the end of 2021, we have seen a sharp widening of Italian spreads in the context of the normalisation of the ECB's monetary policy, high debt and slowing growth. The Eurosystem has been by far the largest buyer of Italian public debt in recent years and the forthcoming end to the ECB's massive asset purchase policies once again raises the question of the sustainability of Italian public debt. However, the ECB cannot afford a new “eurozone crisis”.

In recent years, the Eurosystem has been – by far – the biggest buyer of Italian debt. Indeed, the ECB has implemented two massive purchase programs of government securities in recent years:

• has the PSPP (Public Sector Purchase Programme), which started in March 2015 and has continued until now except for a 10-month break in 2019,
  
• the PEPP (Pandemic Emergency Purchase Programme) announced in March 2020 and which ended in March 2022.
  

In the end, in April 2022 the Bank of Italy and the ECB jointly held €723 bn of Italian public debt under the PSPP and the PEPP. These asset purchases have profoundly changed the ownership structure of BTPs since the share of non-residents has fallen from around 40% when the PSPP was launched to around 25% in 2022. The amounts of Italian debt held by Italian banks are remained relatively stable in value over the 2015- 2022 period and the other domestic players (insurance companies, households, etc.) have rather reduced their holdings of BTPs. In reality, it is the Eurosystem that has absorbed the increase in Italian public debt. Moreover, it even does more than absorb it because since December 2019, for example, the stock of Italian public debt has increased by €213 billion and the Eurosystem has bought €292 billion of it… In the meantime, nonresidents were net sellers for around €100bn. For 2022, the Italian Treasury has forecast €400 bn in gross issuance and €56 bn in net issuance (after respectively €480 bn and €107 bn in 2021), which represents amounts "absorbable" by domestic players but maybe not under any conditions. The termination of the PEPP in March 2022 and the very likely termination of the PSPP very early in Q3 (probably at the very beginning of July) raises the question of the future of the financing conditions of the Italian State in the absence of the ECB asset purchase programs. Moreover, the successive announcements related to the reduction or termination of the PEPP or the PSPP triggered a sharp widening of Italian spreads. At the beginning of June, the 10-year yield spread between Italy and Germany exceeded 200 basis points.

Let’s start with three remarks on the evolution of Italian public debt:

• The Italian debt to GDP ratio has certainly increased by 15 percentage points with the covid crisis, going from 134.1% in Q4 2019 to 150.8% in Q4 2021 but it should be mentioned that it peaked to 159.3% at the start of 2021 and that it has been falling since. Much more than the budget deficits, it was the sharp variations in nominal GDP that caused the debt-to-GDP ratio to rise and then fall sharply. Over 2021, the strong growth in nominal GDP, resulting from both rapid growth and an acceleration in inflation, has contributed to the decline in the debt-to-GDP ratio. When interest rates remain low, high inflation can facilitate deleveraging.
  
• The implicit rate applied to Italian debt stands at 2.45% in 2022, which is a very slight increase compared to the historical low observed in 2020 at 2.38%.
  
• The average debt maturity has increased since 2014 and more particularly since 2020. It now stands at more than 7.5 years. The transmission of the rate hike will therefore take time to affect the stock of debt.
  

In an article¹ entitled "The impact of the rise in interest rates on the interest charge", the Italian Observatory of Public Accounts estimates that a rise of 1 percentage point, lasting and uniform on the long part of the curve, implies an increase of €3 billion in interest expense over 12 months and of €12 billion over one year at a 5- year horizon. In addition, the last Economic and Financial Document for 2022 assumed a rise in 10-year rates, but much less than that which has taken place since the start of the year. Indeed, in the DEF, 10-year rates were expected to average 1.8% in 2022.

The current situation is very different in this regard because the terms of trade for the United States
improved significantly during the energy crisis of 2021/2022, unlike what happened in the 1970s.
The
reason for this is that the United States has recently become a net exporter of natural gas and petroleum products. The sharp rise in natural gas prices has thus greatly improved the terms of trade for the United States, unlike what happened for Europe and Japan. While the energy crisis of the 1970s had been negative for the US dollar, the energy crisis of 2021/2022 is positive for the US dollar. This is one of the main causes of the appreciation of the US dollar in recent quarters.

Even if the rules of the Stability and Growth Pact are suspended again in 2023 and the European Commission has waived any procedure for excessive deficit, the Draghi government has adopted a prudent management of public finances in a less favorable environment of lower growth and higher interest rates² . The energy decree issued in March 2022 and the decrees of May to deal with the rise in energy prices provide an illustration of this. They plan to finance measures of tax credits for companies, bonuses for households and rebates on fuel prices through a 25% levy on windfall profits made by energy companies. Draghi justified this choice by the fact that “this redistributive intervention makes it possible to avoid additional borrowing and to keep public accounts under control”.

In its article IV published in mid-May, the IMF considers that Italy must put in place a gradual strategy to reduce debt over the medium term by stimulating productivity and growth and increasing non-interest expenditure by 1 to 2 percentage points slower than nominal GDP.

According to the IMF, a budgetary adjustment, which would start in 2023, would make it possible to achieve a primary surplus of 2% of GDP by 2030. In the longer term, maintaining this weak growth in expenditure and a primary surplus of 2% would leave enough space for priority investments (climate, energy, education, digitalization, innovation), even after taking into account the anticipated increase in pension expenditure, and would reduce the debt-to-GDP ratio to 135% by 2030. Sustained debt reduction could be considered thereafter. In the event of a crisis scenario, the IMF recommends not starting fiscal consolidation until the emergency phase has passed in order to avoid a pro-cyclical tightening.

For the simulation of the trajectory of the debt-to-GDP ratio, we considered three scenario here : 

• a central scenario based on the European Commission's forecasts, with a gradual reduction in the primary deficit which returns to 0 in 2025, growth of 2.4% in 2022 and 1.9% in 2023, which would remain above potential after, and an increase in the implicit rate of the debt to 3% in 2022 then 3.5% thereafter. In this scenario, the debt-to-GDP ratio would stabilize around 146% by 2025.
• a negative scenario where growth would be weaker than expected, rates increase stronger and primary deficit maintained at 2%, the debt would increase to 155% of GDP by 2025.
• a more favorable scenario with slightly more sustained growth in 2024 and 2025, a return to a primary surplus in 2025 and a moderate rate hike, the Debt/GDP ratio would return to 145% in 2025.

In recent weeks, the members of the ECB Executive Board have expressed the need to curb high inflation by bringing the deposit rate, which is currently at - 0.50%, towards the neutral rate, which is estimated by economists of the ECB towards 1.50% (the uncertainty of the estimate is very high). It is the anticipation of this "normalisation" that has driven German long-term yields up sharply since the end of 2021... and the rise in German yields, which serve as a benchmark for the eurozone, has led - in a context of debt high, as we have just seen – to a repricing of the Italian government's credit risk. Indeed, there is a substantial risk that bond markets becomes more defiant towards Italian debt, which would materialize in a widening of spreads as German yields rise. However, the very unpleasant experience of the eurozone crisis over the 2011/2013 period (7 consecutive quarters of GDP contraction) means that the ECB most likely wants to avoid a spike in Italian rates.

Several members of the Executive Board, including Christine Lagarde, mentioned the reflections carried out on the development of a specific tool “so that monetary policy is transmitted properly and that unjustified fragmentation is avoided”. Avoiding fragmentation is even a “central element of the normal conduct of monetary policy in the euro zone” according to Fabio Panetta. New purchases of securities targeted at peripheral countries could thus take place, but there would be a form of contradiction with the end of the PSPP planned for the very beginning of Q3, and supposed to precede the first increase in key rates... The situation would be even perfectly atypical because the other major central banks which are raising their key rates are simultaneously reducing the size of their balance sheets (Fed, BoE, RBNZ, RBA, Riksbank). Indeed, it should be remembered that the purchases of the PSPP and the PEPP were financed by the creation of central bank money and that the deposit rate applies precisely to this money held by commercial banks: rate hikes could prove costly for the Eurosystem if the latter purchases securities financed by monetary creation while raising rates. One idea to circumvent this problem would be to "sterilize" purchases as was initially done during the SMP program launched in 2010, i.e. the Eurosystem would borrow on the markets amounts equivalent to peripheral debt securities purchased. Another solution, more politically complicated, would be to reduce the debt holdings of the “core” countries of the euro zone more quickly than expected to allow peripheral debt to be purchased at constant excess reserves. But the most difficult question for the ECB is probably to know at what level of rate or at what level of spread it should intervene... In a speech in February 2022, Isabel Schnabel compared the spreads of the time to the levels that they had experienced in the years leading up to the pandemic. Therefore, we can recall that following the announcement of the League – 5 stars coalition in 2018, the Italian 10-year spread had risen to 325 basis points without this causing the ECB to abandon its plan to reduce the PSPP program (at the time, German yields were not much lower than they are today) but the political context and the balance of power in Europe were very different. More recently, in March 2020, the ECB insisted on the “flexibility” of the PEPP and on deviating from the capital key rule when the Italian 10-year spread reached 250 basis points. This was an opportunity to express his desire to avoid the "over-accident" and to add a new eurozone crisis to the covid crisis. We can therefore imagine that it is towards these levels that the ECB would specify its plans for an anti-fragmentation mechanism.

The monetary normalisation of the ECB is a real test for Italian debt, as the Eurosystem has been the biggest buyer of BTP in recent years. However, in a context of high public debt, the ECB cannot afford to trigger a new “eurozone crisis” and should specify an anti-fragmentation mechanism if Italian spreads widen further. Especially since the prospect of general elections in the spring of 2023 will rekindle the political risk in a country where succeeding in constituting a majority of government is a difficult exercise.

• https://osservatoriocpi.unicatt.it/ocpi-pubblicazioni-l-impatto-di-un-rialzo-dei-tassi-sulla-spesa-per-interessi
• Relevant Factors influencing Public Debt developments in Italy, MEF, May 2022