Strategy & economics
Bond vigilantes at the gates in Italy
Italy’s highly indebted government is a major concern for investors. Bond vigilantes are circling and they will ultimately decide whether Italy faces another debt crisis.
Unstructured Learning Time
The 2019 budget target was unveiled on 27 September 2019, with the government defying the advice of Giovanni Tria, Italy's Minister of Economy and Finance. Tria had recommended a deficit of 1.6% of GDP; however, the target has been set at 2.4% of GDP.
Italy is now on a collision course with the European Commission, which will assess all member states' budget plans from 15 October.
Why is the Italian budget so important?
In the past, Italian governments have been careful not to let government spending get out of hand. Since 2007, the government's primary balance (budget deficit excluding interest payments) only went into deficit in 2009 (0.3% of GDP), before bouncing back to surplus the following year (chart 1).
To put this into perspective, in 2009, the US ran a primary deficit of 9% of GDP, while many other countries also ran large deficits including the UK (8.3%), Spain (9.3%) and France (4.6%). Italy's management of its finances during the era of both the global financial crisis and the sovereign debt crisis is a remarkable achievement.
As Italy has run a primary surplus in 10 out of the past 11 years, clearly the problem is the interest on its existing stock of debt which when taken into account, means the government is running an overall budget deficit.
However, although past governments kept a tight rein on Italy’s finances through the global financial crisis and sovereign debt crisis, a populist coalition government is now in charge. The new leaders appear intent on cutting taxes, increasing public spending and unwinding some of the structural reforms implemented in recent years.
That said, the small expansion of policy (0.8% of GDP) announced in the 2019 budget is by no means a disaster. Full implementation of the government’s manifesto promises would have caused the debt and deficit numbers to balloon within a few years.
Nevertheless, as the third largest economy in the eurozone, investor concerns about the ability of the Italian government to repay its debt risk damaging the whole region’s stability. Italy is simply too big for the EU to bail out.
Investors demand a premium to buy Italian debt
Investors are therefore demanding higher interest payments on their Italian debt, in other words, yields on Italian debt are elevated (and they have been, ever since the coalition government came to power). Investors’ fears about the 2019 budget target, which is higher than the European Commission would like to see, has pushed yields even higher.
The rise in government bond yields has triggered concerns over the sustainability of Italy's public finances. The argument goes that higher bond yields will quickly make Italian debt unsustainable.
Too soon to panic
In the near term, however, we think there is no need to panic. Firstly, the government only plans to loosen fiscal policy slightly in 2019, and within the tolerance of markets. Moreover, the yield on offer in Italy will be difficult for investors to ignore, especially when European investors may have few places remaining to generate a decent income.
A sense of calm is likely to return; however, the elephant is still in the room. Italy's government has not suddenly become a coalition of liberal fiscal conservatives. The political pantomime will probably repeat itself this time next year when setting the 2020 budget. Meanwhile, Italy will remain vulnerable to any hit to growth, be it cyclical or a shock.
In the long term though, an ageing population means trend growth is likely to be lower, which will make it difficult to keep public borrowing under control. To keep public finances sustainable, Italy will have to make up for the fall-off in real growth by either running higher inflation, lowering interest costs, or running a larger primary surplus. The first two options are almost impossible without control of its own monetary policy, while the third is a non-starter from a political perspective.
The bond vigilantes may not be knocking at the door just yet, but they are certainly at the gates.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
 A budget deficit occurs when a government spends more than it receives in revenues. Deficits are financed by borrowing, and continued borrowing leads to an accumulation of debt.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.