Bond Yields on UK, Italian and German Debt
Firstly, there is a significant difference between Greece and Italy. Greece was fundamentally bankrupt. It's budget deficit, and public sector debt was too large for it to cope. A debt restructuring was inevitable.
Italy's fiscal deficit is lower than many other countries.
It seems bizarre a country with a primary budget surplus can be facing a liquidity crisis that Italy is.
Reasons for Italian CrisisRecession. Austerity packages (spending cuts) and fears about the prospects of the Eurozone have precipitated a fall in consumer spending and economic growth in Italy. It is forecast Italy will remain in recession in 2012 and 2013. This negative growth will lead to a fall in tax revenues and higher government spending on unemployment benefits. Markets don't want to buy Italian debt because of fears over lack of economic growth will make it very difficult to reduce their debt to GDP ratio.
Poor Growth Record
Due to a combination of political instability, corruption and poor productivity growth, Italy has developed a poor track record of economic growth in past two decades.
Long Term Debt.
Though Italy's budget deficit (annual deficit) is quite low, public sector debt is over 110% of GDP, which is giving cause for concern. The problem is that it is quite difficult to reduce this debt / GDP ratio given - how much they spend on interest payments, and the poor prospects for GDP Growth.
The long term debt problem is not helped by Italy's ageing population. This will reduce income tax revenues and require greater commitment to state pensions over the next few years. Italy has one of the lowest birth rates in the world.
Since joining the Euro, Italy has seen its relative competitiveness decline. Labour costs have risen 40% compared to Germany; this has contributed to a 70% fall in direct investment since 2007. Like Greece and Portugal, Italy can't devalue so it is left with uncompetitive exports. This uncompetitiveness leads to lower economic growth and more pressure on debt/GDP ratio.
No Lender of Last Resort
Italy is not bankrupt, but it may experience a liquidity crisis (it may be unable to 'roll over its debt' i.e. sell enough bonds to meet current budget requirements in short term). This liquidity shortage should be quite a small risk. But, because there is no lender of last resort for Italy (i.e. ECB will not buy Italian bonds to roll over debt) Markets find Italian debt much less appealing. If there was a guaranteed lender of last resort, Italian bond yields would be much lower. People would have much more confidence in holding Italian debt. However, because there are fears over liquidity shortages this has pushed up bond yields; this increase in bond yields has increased the cost of servicing Italy's debt
Italy suffers from:
- Having wrong exchange rate. They have lost competitiveness and can't devalue leading to lower growth
- Monetary policy is too tight for Italian economy.
- There is no lender of last resort.
- EU austerity measures (spending cuts) are forcing Italy back into recession leading to a predicted slump in tax revenues. This is making markets nervous about future prospects for Italy.
- There seem no practical solutions to returning to strong growth. Again the only medicine seems to be 'spending cuts' and internal devaluation. But, this will be a long drawn out process.
- Political instability. Lack of strong cohesive government makes markets more nervous to hold Italian debt.
- Share decline in competitiveness
- Would benefit from devaluation, but in Euro can't
- Are experiencing high unemployment and economic stagnation
- Must regret being in the Euro.