Default risks in the US and Italy
July 17, 2011 11:58 am
by Gavyn Davies
Martin Wolf said to me last week: “I am off for a holiday. By the time I return, two G7 governments may have defaulted on their debt.” I think he was only joking, but the past week has certainly been dominated by fears of sovereign debt defaults, with the US and Italy now in the front line.
They are two very different kettles of fish. The US problems, at least in the near term, are largely self-inflicted as a result of the game of chicken being played by politicians in Washington. In Italy, on the other hand, the perceived risk of default stems from the fundamental problems which the economy is facing as a result its own “lost decade” of growth, exacerbated by the failure of the Eurozone to solve its peripheral debt crisis. Italy’s problems seem much more intractable than those in the US.
Although fears of default in the US and Italy have been vying for the headlines in the last few days, the markets have sharply distinguished between the two cases. Government bond yields in Italy have rocketed to the highest levels seen since the Euro was launched in 1999. Meanwhile, yields on US government debt have been falling sharply, reaching the lowest levels seen this year, despite the ending of QE 2 on 30 June:
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It is clear, then, that the markets perceive a very real risk of default in the case of Italy, whereas they perceive almost no risk at all in the case of the US. Why is this?
In Italy’s case, it is difficult to specify the precise reason why there has been such a sharp deterioration in the situation in recent weeks. True, there have been doubts over the passage of the budget, but this was nothing out of the ordinary for Italian politics. Furthermore, economic growth has been disappointing, and there has undoubtedly been contagion from the Greek saga. But none of this is really very new.
A more plausible explanation is that Italian public debt has been an accident waiting to happen. This is not because recent budgetary policy has been irresponsible. Italy has a primary budget surplus, which is scheduled to reach 3 per cent of GDP in 2014 under the new budget plans. Instead, it is because Italy has become trapped by two intractable problems – a high public debt ratio of around 120 per cent of GDP, which is a legacy from earlier decades; and a chronically weak rate of GDP growth, due to its increasingly uncompetitive production sector. Italian real GDP growth since the nation joined the euro has averaged only 0.6 per cent per annum, and it shows no signs of improving.
A very high debt ratio, together with low real GDP growth and a low inflation rate set by the ECB, is potentially a toxic mix. All it takes is a relatively minor increase in interest rates, maintained over the medium term, for budgetary arithmetic to turn very sour. At current bond yields of around 5.7 per cent, the debt ratio (according to Goldman Sachs) will fall to under 100 per cent of GDP by 2026. However, if bond yields rise to 6.7 per cent, the debt ratio will not fall at all. And at 7.5 per cent bond yields, it rises in perpetuity.
Because markets know that this is the case, bond yields have suddenly risen sharply, even though much of the Italian government debt is financed with long dated bonds. This helps, by spreading refinancing risk across a number of years. But because markets are forward looking, it does not help enough. And, because higher bond yields will tighten financial conditions in Italy, they will reduce growth prospects further, setting in train a vicious circle.
Note that ultimately the markets are worried about the Italian sovereign defaulting on its bonds because Italy has no central bank which would be able, in extremis, to prevent default by creating lira. If that were the case, the markets would instead by worried, again in extremis, about inflation rather than sovereign default. This, after all, is why Italian bond yields were so high for several decades prior to the mid 1990s.
But in present circumstances, Italy is more likely to be heading towards deflation than inflation, so bond yields would probably not be as sensitive to inflation risk as they are to default risk. A case in point is the UK, where the currency has been devalued, inflation has risen, but bond yields have so far remained low. The government’s fiscal tightening has clearly helped to maintain confidence, but so has the absence of any default risk, given that the UK has an independent central bank.
Another case in point is the US. Yes, the debt ratio is high at almost 100 per cent of GDP, and there is no credible medium term plan to bring it down. But the immediate fear of default is the result of a political stand-off between the two parties in Washington, and nothing much else. Provided that there is a last minute outbreak of sanity, and the debt ceiling is raised, a US sovereign debt crisis still seems to be very improbable, at least for now. In fact, as Paul Krugman has been emphasising, the economy is continuing to weaken, and inflation may have peaked. This explains why bond yields have simply refused to rise in the manner predicted by some pessimists in the markets. The Fed has ended QE2, but this has made no difference.
Comparisons between the US and Italy are therefore misleading. Up to the present time, the sovereign debt crisis has been ring-fenced to those economies which have no independent central bank. It is a crisis of default risk, and not one of inflation risk. If that were ever to change, the crisis would take a much more sinister turn.
July 17, 2011 11:58 am
by Gavyn Davies
Martin Wolf said to me last week: “I am off for a holiday. By the time I return, two G7 governments may have defaulted on their debt.” I think he was only joking, but the past week has certainly been dominated by fears of sovereign debt defaults, with the US and Italy now in the front line.
They are two very different kettles of fish. The US problems, at least in the near term, are largely self-inflicted as a result of the game of chicken being played by politicians in Washington. In Italy, on the other hand, the perceived risk of default stems from the fundamental problems which the economy is facing as a result its own “lost decade” of growth, exacerbated by the failure of the Eurozone to solve its peripheral debt crisis. Italy’s problems seem much more intractable than those in the US.
Although fears of default in the US and Italy have been vying for the headlines in the last few days, the markets have sharply distinguished between the two cases. Government bond yields in Italy have rocketed to the highest levels seen since the Euro was launched in 1999. Meanwhile, yields on US government debt have been falling sharply, reaching the lowest levels seen this year, despite the ending of QE 2 on 30 June:
It is clear, then, that the markets perceive a very real risk of default in the case of Italy, whereas they perceive almost no risk at all in the case of the US. Why is this?
In Italy’s case, it is difficult to specify the precise reason why there has been such a sharp deterioration in the situation in recent weeks. True, there have been doubts over the passage of the budget, but this was nothing out of the ordinary for Italian politics. Furthermore, economic growth has been disappointing, and there has undoubtedly been contagion from the Greek saga. But none of this is really very new.
A more plausible explanation is that Italian public debt has been an accident waiting to happen. This is not because recent budgetary policy has been irresponsible. Italy has a primary budget surplus, which is scheduled to reach 3 per cent of GDP in 2014 under the new budget plans. Instead, it is because Italy has become trapped by two intractable problems – a high public debt ratio of around 120 per cent of GDP, which is a legacy from earlier decades; and a chronically weak rate of GDP growth, due to its increasingly uncompetitive production sector. Italian real GDP growth since the nation joined the euro has averaged only 0.6 per cent per annum, and it shows no signs of improving.
A very high debt ratio, together with low real GDP growth and a low inflation rate set by the ECB, is potentially a toxic mix. All it takes is a relatively minor increase in interest rates, maintained over the medium term, for budgetary arithmetic to turn very sour. At current bond yields of around 5.7 per cent, the debt ratio (according to Goldman Sachs) will fall to under 100 per cent of GDP by 2026. However, if bond yields rise to 6.7 per cent, the debt ratio will not fall at all. And at 7.5 per cent bond yields, it rises in perpetuity.
Because markets know that this is the case, bond yields have suddenly risen sharply, even though much of the Italian government debt is financed with long dated bonds. This helps, by spreading refinancing risk across a number of years. But because markets are forward looking, it does not help enough. And, because higher bond yields will tighten financial conditions in Italy, they will reduce growth prospects further, setting in train a vicious circle.
Note that ultimately the markets are worried about the Italian sovereign defaulting on its bonds because Italy has no central bank which would be able, in extremis, to prevent default by creating lira. If that were the case, the markets would instead by worried, again in extremis, about inflation rather than sovereign default. This, after all, is why Italian bond yields were so high for several decades prior to the mid 1990s.
But in present circumstances, Italy is more likely to be heading towards deflation than inflation, so bond yields would probably not be as sensitive to inflation risk as they are to default risk. A case in point is the UK, where the currency has been devalued, inflation has risen, but bond yields have so far remained low. The government’s fiscal tightening has clearly helped to maintain confidence, but so has the absence of any default risk, given that the UK has an independent central bank.
Another case in point is the US. Yes, the debt ratio is high at almost 100 per cent of GDP, and there is no credible medium term plan to bring it down. But the immediate fear of default is the result of a political stand-off between the two parties in Washington, and nothing much else. Provided that there is a last minute outbreak of sanity, and the debt ceiling is raised, a US sovereign debt crisis still seems to be very improbable, at least for now. In fact, as Paul Krugman has been emphasising, the economy is continuing to weaken, and inflation may have peaked. This explains why bond yields have simply refused to rise in the manner predicted by some pessimists in the markets. The Fed has ended QE2, but this has made no difference.
Comparisons between the US and Italy are therefore misleading. Up to the present time, the sovereign debt crisis has been ring-fenced to those economies which have no independent central bank. It is a crisis of default risk, and not one of inflation risk. If that were ever to change, the crisis would take a much more sinister turn.
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