Public Debt Sustainability

in Italy: Problems and

Proposals

SYstemic Risk TOmography:

Signals, Measurements, Transmission Channels, and Policy Interventions

Paolo Manasse, Università di Bologna Silvia Merler, Bruegel SYRTO Code Workshop Workshop on Systemic Risk Policy Issues for SYRTO July, 2 2014 - Frankfurt (Bundesbank-ECB-ESRB)

1. Public Debt in Italy: Some Facts

2. Is Public Debt «sustainable»?

3. If not, what can be done? Muddle through vs

Mutualisation vsUnilateral Rescheduling

4. Historical Experience?

5. Conclusions

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Austria 79.085

Belgium 99.829

Cyprus 121.534

Estonia 10.916

Finland 60.164

France 95.756

Germany 74.551

Greece 174.697

Ireland 123.668

Italy 134.509

Latvia 32.711

Luxembourg 24.125

Malta 72.542

Netherlands 75.030

Portugal 126.689

Slovak Republic 58.621

Slovenia 74.857

Spain 98.805 Paolo Manasse 3

Debt and nominal GDP:

Solvency issue (source: OECD)

Debt Com ing Due: 550b in 2014-19

Liquidity issue (source: Panizza,

2014)

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Debt Composition: good news (source MEF)

Rate: mostly fixed rate (vs

floating) Currency: Domestic (vs Foreign)

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Maturity: reasonably long

Short vs. medium and long-term

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Who Owns the Italian Debt? Source: MEF

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Public Debt in Banks’ Assets: Back to where it once belonged

(source BoI)

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Italian Banks -% total assets, holdings of securities issued by:

Italian Eurozone (exc. Italy)

Government Banks

other sectors

Government Banks

other sectors

1999 12.3% 2.2% 0.2% 0.2% 0.2% 0.1%

2001 8.5% 2.2% 0.5% 0.5% 0.2% 0.3%

2002 8.5% 2.4% 0.7% 0.2% 0.2% 0.4%

2003 7.6% 2.7% 0.9% 1.0% 0.4% 0.4%

2004 6.9% 2.6% 1.1% 1.0% 0.5% 0.4%

2005 5.8% 3.0% 1.0% 0.7% 0.4% 0.4%

2006 5.6% 2.8% 0.8% 0.7% 0.5% 0.5%

2007 4.9% 3.6% 0.9% 0.4% 0.6% 0.6%

2008 5.1% 5.3% 1.7% 0.3% 0.7% 0.8%

2009 6.0% 5.6% 1.6% 0.2% 0.7% 0.7%

2010 6.0% 5.6% 3.7% 0.2% 0.6% 0.7%

2011 7.7% 8.2% 3.6% 0.1% 0.4% 0.7%

2012 9.4% 8.7% 3.3% 0.1% 0.3% 0.5%

2013 10.5% 7.8% 3.4% 0.2% 0.4% 0.2% Paolo Manasse 10

Italian debt is almost entirely governed by Italian law

All short term debt is under Italian law (BOTs).

Longer maturities: more than 97% governed by local

law (Moody's, as Jan 2012). Remainder under U.S.

law (1.8%) and UK law (.2%).

Spain (98.8%), Belgium (99.8%), Germany (100%),

France (100%), and the Netherlands (100%),

Greece(prior to the Greek exchange) 92%

Sources: Boudreau et al. (2012); Moody’s (2012)

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Decreto Presidente Repubblica Dec.30, 2003, no 398,

art.3 «…Ministry can proceed in order to restructure

the national and external public debt, to the

reimbursement before maturity of bonds, to the

transformation of maturities..»

Creditor protection clauses : 96% of bonds due after

Feb 2012 have no contract terms (CAC after Jan.2013)

legal conditions favorable to debtor

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Trading Books: according to EU 2011 stress tests, 66%

Mark-to-Market , today estimated at 20-30%

Banking Books, according to EU 2011 stress tests 34%:

«Hold-to-maturity» Face Value, today estimated at 80-

70%

Potentially Limited impact on banks asset value

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2015 2016 2017 2018 2019

IMF Forecasts

Interest rate 0,039 0,041 0,042 0,043 0,044

GDP growth 0,01 0,013 0,012 0,01 0,01

Inflation 0,012 0,014 0,015 0,015 0,016

Primary Surplus 0,033 0,045 0,049 0,052 0,052

Scenario 1:

Debt/GDP stable 1,35 1,35 1,35 1,35 1,35

Scenario 2:

Debt/GDP Fisc compact 1,35 1,31 1,28 1,24 1,21

1.Primary Surplus 0,023 0,019 0,020 0,024 0,024

2. Primary Surplus 0,056 0,056 0,058 0,056

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a) Kick-the-can-down-the-road:

Large fiscal consolidation

Risks:

interest rates up

political backlash

possible debt runs

ECB’s OMT challanged

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Buy-backs (externally financed ?): expensive, debt price rises, creditors benefit more than debtor

Debt Swaps/Reprofiling (new senior debt): «voluntary» exchange, old creditors loose as old bond price drops, debtor gains

- Risks: financial repercussions on banks (590b) legal challange at ECJ, litigation costs trigger CDS (italian banks likely net purchaser of

protection) rating downgrade ECB collateral

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Debt-Equity Swaps (privatisation): solvency improves

only if

loss of control of privatized assets

large inefficiency of public sector

deep pocket investors

Risks: ineffective

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(b) Concerted Lending/Forgiveness/Mutualisation

Voluntary Exchange/Interest Standstill Euro-bonds Euro-bills Redemption Fund Red-Blue Bonds PADRE Problem: Politically difficult (No Mutualisation without representation) For a comparative summary and assessment of previous proposals : http://www.bruegel.org/publications/publication-detail/publication/733-paths-to-eurobonds/

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Costs of a Restructuring and Default

Borrowing costs and exclusion from capital markets

- depend on the size of creditor losses. An increase in haircuts by

20 percentage points is associated with 50 basis points higher

borrowing costs (next six years), and lower likelihood of re-

accessing capital markets.

Output and trade costs

- Drop in GDP of between 2 and 5 percent per year (depending

on duration, banking and currency crises). Bilateral trade flows

fall up to 7 percent for more than 10 years

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Financial Sector Implications:

-banking sector distress, causing bank failures and bank runs, such as in Russia in 1998.

FDI Flows and Private Sector Access to Credit:

- drop in FDI of up to 2 percent of GDP per year.

- Corporate external loan and bond issuances have dropped by up to 40 percent.

Negotiation Costs and Fees:

The expenses for financial and legal advisors can be substantial. During the 1980s, fees reached up to 2 percent of restructured volumes.

Problem: Italy’s case implies systemic risks

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- Now is good time to raise the issue of debt sustainability: markets are calm, maturity and currency composition are favorable, legal and accounting features likely to reduce litigation costs, risks of systemic banking crisis are not overwhelming, required haircuts and adverse economic consequences are reasonable

- Multilateral approach and reprofiling seems to minimize costs.

- The idea if ain’t broke don’t fix it» is myopic and potentially more risky. Maral hazard can be dealt via conditionality

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Delpla and Von Weizsacker (2010), subsequently changed

Mutualise debt of each member state equal to 60% of GDP with Blue

bonds. The remainder (Red bonds) still to be issued on a national basis

This split and the joint and several guarantees are designed to insulate banks from national sovereign risks, lower borrowing costs for some sovereigns, and reduce flight to safety

Any borrowing above the 60% of GDP threshold would be through the Red bond. Red Bonds are explicitly junior and hence at a (marginal) cost reflecting the country’s own creditworthiness, thus maintaining price signals and fiscal discipline incentives.

The proposal has been amended to clarify that the transition would be gradual, with guarantees and common bond financing phased in over a period of 3-4 years.

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Euronomics group (2011)

Create a form of common safe debt by pooling and tranching a balanced

portfolio of EZ sovereign debts.

The result would be a two-tier structure with a senior tranche (European

Safe Bond - ESBies) and a junior tranche (EJB).

Benefit (1): banks holding ESBies would no longer be exposed to national

sovereign risks, but to combined EZ risk;

Benefit (2): any flight to safety would be from the EJBs, the junior (risky)

bond, to the ESBies and not from one country to another

The core of the proposal requires no sovereign guarantees, so it faces

possibly limited hurdles to implementation, yet it can also be easily

reversed. However, it is a form of financial engineering, which may limit its

appeal to policymakers.

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German Council of Economic Experts (2011)

A Redemption Pact would transfer debt of a member state in excess of 60% of GDP into a European Debt Redemption Fund (ERF) for which all members would be jointly and severally liable.

The total debt covered would amount to some 27% of EZ GDP, with Germany, Italy, and Spain the largest participants.

In return, countries would agree to repay ERF the transferred debts within 25 years, with these obligations senior to remaining national debts and possibly backed up by collateral and dedicated tax revenues from each country.

During a roll-in phase of 3 to 4 years, participating countries would, by transferring obligations coming due up to their issued quota of guaranteed debt, be able to meet much of financing requirements. Any other debt would remain of national responsibility and be junior.

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Hellwig and Philippon (2011)

A variant to the Blue-Red proposal limited to short-term common debt (i.e.,

Eurobills), envisioned to be about 10% of GDP.

The proposal pools all short-term borrowings, backed up by joint and several

guarantees, and thus allows (some) member states to borrow some amounts at

lower interest rates—thereby improving their debt sustainability dynamics,

while at the same time providing a safe asset to banks—thereby reducing

financial stress.

The short maturity has the benefit of imposing some continuous discipline (as

guarantees need not be renewed). And while the proposal is easily scalable to

longer-term claims, it also has a built-in exit mechanism (as claims with

guarantees can be rolled off).

Because of its more limited nature, the proposal is thought to more easily

comply with European and national legal constraints.

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European Commission (2011) The EC version is called stability bonds. There are three options listed, which largely build on

abovementioned proposals and range from complete substitution of national debt by common bonds issued under a joint and several framework, to issuance of both common and national debts, and to a more modest option of bonds with just several guarantees.

Depending on the option chosen, changes to institutions, including EU-Treaties and financial markets, would be needed to minimize risks, especially moral hazard, ensure budgetary discipline, and keep costs low. Paolo Manasse 28

This project has received funding from the European Union’s

Seventh Framework Programme for research, technological

development and demonstration under grant agreement n° 320270

www.syrtoproject.eu

This document reflects only the author’s views.

The European Union is not liable for any use that may be made of the information contained therein.