Investors’ worries about Italy are justified

With summer over, Italy is back at the forefront of the news – this time not as a holiday destination but in its other capacity, as chief source of market worries. The way things are going, the worries are only just beginning.

Credit default swaps on Italian five-year debt have shot up lately, as confrontation about the budget deficit between the Italian government and the European Commission deepens.

Two-year bond yields jumped to three-month highs last week, after an Italian government official said, quoted by Reuters, that a 2019 budget deficit of more than 3% of gross domestic product could be justified by the need to invest in infrastructure.

It’s hard to argue against investing in infrastructure, and this is the way Italy’s populist government is framing the public debate: the big, bad EU blocking Italy’s efforts to boost investment in the safety of its roads, bridges and railways.

But Italy’s public debt already stands at more than 131% of GDP and it is advancing by €1, 379.69 per second; its GDP is only expanding by €1, 141.14 per second.

In case you’re wondering where I got this data, there’s this cool website I stumbled upon that measures the debt of all the EU’s countries – you can check out Italy’s figures here. If you want to dig deeper into the methodology, you can find it at this link.

It is said that the best way to deal with fear is to confront it. A recent research paper published by the IMF does just that, looking at three scenarios in which Italy’s debt would be hit and their consequences.

The three scenarios are: a shock equivalent to a 10% decline in the value of government debt, a bank bail-in, and a bank bailout.

In the case of a government bond price decline or a bank bail-in, wealthy households will absorb most of the financial shock, the paper concludes.

This is because households at the top 20% of the wealth distribution hold almost 70% of financial wealth, of which a lot is made of banks’ stocks and bonds.

The less wealthy households’ financial assets are largely held in bank deposits, which are insured up to €100,000 under EU rules — so a bond or bail-in shock would not affect them as badly as it would hit the rich households.

By contrast, a bailout – where the burden is borne by all taxpayers – would compensate bondholders, of which a disproportionate number are concentrated in the wealthier ranks of society.

Wealth distribution in Italy.

Who owns what in Italy? Source: IMF research

“The degree of domestic absorption in a bank bail-in is much lower than in a bailout, in which the government in effect transfers resources to foreigners and thus bears the brunt of the loss in value,” the research paper’s author, Daniel Garcia-Macia, writes.

“These costs will need to be passed on to the domestic taxpayer, and thus across the broader parts of the income and wealth distribution, given the heavy reliance on labour income and consumption taxes as opposed to wealth taxes.”

In case of trouble with Italy’s debt, what will the government do? It will probably try to take from the few, not from the many. Therefore, in the absence of bond purchases by the European Central Bank, a bail-in, rather than a bailout, would be on the cards. By international standards, Italy is a rich country. Still, perhaps not rich enough.