An analysis of Italy’s relationship with the EU and how it has been affected by the new recovery fund programme, amidst the coronavirus pandemic, turbulent internal politics and deteriorating public finances.
During late February as Europe conducted its day to day business, Italy’s battle with coronavirus took centre stage in the headlines. It set a frightening precedent across Europe of the pandemic’s potential to cause extensive social, political and economic damage. It is notable that one of the EU’s most volatile members has also been one of the worst affected of the pandemic. During this time, even the most pro-European political figures in Italy were losing faith in Europe’s lack of financial support when the country needed it the most. According to a March survey conducted by an Italian consulting group Tencè on a sample of Italy’s population, 67% of respondents indicated Italy’s membership within the EU was a disadvantage, a sharp rise from 47% in November 2018 .
Key events such as the Greek debt crisis and more recently Brexit have contributed to a global image of the EU being a divided institution lacking in cooperation and solidarity amongst its members. This has mainly derived from conflicting views on governance between countries, with differing approaches towards democracy and public finances. Coronavirus created a scenario which would ultimately ‘make or break’ Italy’s relationship with the EU, but for the EU the stakes were much higher than that. Germany and other Northern European states needed to bridge the divide and help Italy or risk anti-European rhetoric taking over, potentially leading to another ‘Brexit-like’ event in Europe. Therefore, is the recovery fund programme sufficient to meet this goal, and why was monetary policy not enough?
How can we use markets to analyse Italy’s current situation?
One key way to measure the impact of certain events on European markets is through analysing different countries’ respective 10-year bond yields. Despite having a monetary union through the ECB, the EU’s lack of fiscal union has been traditionally seen as its biggest institutional flaw which means there is a disparity in different countries’ borrowing costs . A 10-year bond yield provides a benchmark for this cost. For example, on purchasing a 10-year Italian government bond, the investor would receive semi-annual coupon payments. If these payments are on schedule, subsequently reinvested and the bond is held to maturity, this will provide the investor with a return equal to the bond yield . The bond yield can also show the risk investors take on buying a government’s debt. This is due to yields being affected by supply and demand, as yields and bond prices change inversely to each other. If investors determine a government’s likelihood of bankruptcy to increase, (and they would be unable to meet their coupon payments), demand for the bond would fall. The bond price will subsequently fall, which will cause a rise in the yield.
Why are Italian bond yields so volatile?
In a similar fashion to Greece, Italy has gained notoriety in recent years for its poor handling of public finances which has created a high debt to GDP ratio. This has given Italy an undesirably high bond yield compared to other EU countries with lower relative debt levels, such as Germany.
Political tensions have also caused temporary spikes in bond yields in the past. For example, the unpredictable political behaviour of Salvini, leader of the League party has instilled fear in investors. If elected, his policies would likely cause Italy’s budget deficit to rise above EU limits. When this scenario became a potential reality as he tried to force a re-election last August, bond yields reacted accordingly .
Despite its growth rate only reaching 0.3% last year, what is often overlooked is how fundamental Italy’s contribution is to Eurozone GDP – accounting for approximately 15% . This has created a mutual need for the EU to maintain Italian membership, despite being forced to harbour the burden of their slowly deteriorating public finances.
What happened to Italian bond yields when the pandemic hit?
In early March, 10-year Italian government bond yields rallied above their pre-crisis level of less than 1%, hitting their highest level on 17th March at 2.4% . This is hardly surprising given the immense strain Italy’s coronavirus response put on its fiscal position, which would have likely caused a large initial sell off in bonds as investors doubted the government’s ability to maintain solvency throughout the crisis.
The case for Italian bonds worsened on the 29th April, when the credit rating agency Fitch cut Italy’s credit rating to BBB minus – one level above ‘junk’ status. Its justification included the prediction that total government borrowings are expected to rise to approximately 155% of GDP this year. As seen in the graph below, the 10-year nominal bond yield again rose into positive territory upon the news of this downgrade. This ultimately impacted Italy’s creditworthiness in the short term and their ability to effectively borrow and fund their crisis response .
How does this relate to the EU and why was monetary policy insufficient?
Although the ECB’s substantial Pandemic Emergency Purchase Programme (PEPP) helped reduce rising yields by directly purchasing Italian bonds, unlike Mario Draghi’s ‘whatever it takes’ strategy in 2012 Christine Lagarde did not hesitate to highlight the need for a separate fiscal response of a similar scale. In March, she frankly declared ‘The ECB has played its part, now it’s time for the governments’ . She created added tension with the Italian government when stating in an interview ‘We are not here to close spreads, this is not the function or the mission of the ECB’ . In this statement, she referred to the BTP-Bund spread, which is the difference between German and Italian 10 year bond yields. As Germany’s bond yields are seen as more stable, it typically shows the risk premium (extra interest) that an investor would receive on an Italian bond compared to a German one. In reaction to Lagarde’s comment, the 10-year BTP – Bund spread hit a 9-month high which is indicative of the dependency Italian bond yields have on retaining the ECB’s support.
What has the recovery fund programme promised – and what does it mean for bond yields?
In order to return to a yield of less than 1% in the longer term, it is evident that more was needed from the EU to satisfy the ‘whatever it takes’ criteria historically demanded by investors. Thus, when the recovery programme was agreed on July 20th this seemed to finally satisfy investors, as yields quickly declined and the euro rallied.
The EU plans to use financial markets by relying on investors to buy bonds and fund the package. By the end of 2021, borrowing in total will amount to €980bn – a huge sum within the Eurozone, matching the size of the Spanish bond market . The demand for these bonds is likely to be high, as the EU has a AAA rating, making them competitively priced against similarly rated German bonds . Italy and Spain are expected to be the largest recipient of funds from this plan, with Italy receiving €209bn from the fund including €80bn in grants . As debt is now mutualised this will help Italy in particular by not only reducing its debt exposure through grants and shared loans, but also by restoring investors’ faith in Italy’s government, likely reducing bond yields. This faith could be short lived depending on the future of Italy’s turbulent political environment, but for now it seems such measures are sufficient to sustain low yields.
The political significance of reaching this deal also positively impacted investor sentiment. The scale of this recovery fund spearheaded by Angela Merkel adds a level of stability to the future of the Eurozone. Yields hit an historic low at less than 1% demonstrating the immediate boost in attractiveness of Italian debt as a result of being ratified by Brussels . The greater level of cohesion in European bond markets is also evident in the spread falling below 1% as investors buy Italian bonds which they believe to be under-priced relative to German bonds . Portuguese and Spanish bond spreads with Germany are also smaller.
The recovery programme has long term implications with Italy firmly integrated in the EU’s strategy in tackling the pandemic and the economic recovery for decades to come. Prime Minister Giuseppe Conte stated that the stimulus package has given his government the responsibility to ‘change the face’ of the country, suggesting the EU’s renewed financial support particularly in the form of grants may provide a much-needed trigger to finally tame its budget deficit and restructure its economy . This is likely to be reinforced by the mandate within the programme requiring Italy to make economic reforms. Although it is impossible to predict a path for Italy’s bond yields, this deal is likely to curb any spikes caused by other sources of uncertainty such as Italian politics.
First year economics student at the University of Warwick