Italy weathers crisis better than peers

Having fought the temptation to prop up the economy with large discretionary spending during the recession due to high public debt, Italy appears ready to reap the benefits as public finances elsewhere worsen rapidly.

Analysts no longer lump Italy – once dubbed the "sick man of Europe" over its sluggish economy – with peripheral euro zone countries such as Portugal or Ireland, and some said its debt could perform better than many others in the medium-term.

"Over a 12-month period Italy can expect to outperform an index comprising all major euro zone issuers," said Alessandro Tentori, a strategist at BNP Paribas in London.

Italy benefits from relatively modest fiscal and current account gaps, stable credit ratings, a strong domestic saving base and the high liquidity of its €1.76 trillion (Dh8.78trn) debt.

Fiscal stimulus measures Italy adopted in 2009-2010 to address the crisis did not add to the deficit, the European Commission said. Euro zone countries spent on average 1.8 per cent of GDP.

State support for a relatively sound banking system only cost about 0.3 per cent of GDP, according to Standard & Poor's.

"Italy is a 'semi-core' country," said Natacha Valla at Goldman Sachs. "Its public finances deteriorated a lot less than the euro zone's average".

A public debt close to 116 per cent of GDP at end-2009 bars Italy from the club of fiscally virtuous "core" countries such as Germany, Finland or the Netherlands. It is also the main reason why its sovereign rating does not go above double-A.

But "with public debt rising sharply in many other European countries, Italy's historical competitive disadvantage is thinning", said Fabio Fois at Barclays Capital.

The EU Commission sees euro zone public debt at 84 per cent of GDP in 2010, an increase of 18 percentage points from 2007. Italy expects its debt to peak at 116.9 per cent of GDP this year, up 13.4 points from 2007.

Italy vs Spain

Italy's 2009 fiscal deficit stood at 5.3 per cent of GDP, less than half the Spanish budget gap, and is forecast to fall to 2.7 per cent of GDP by 2012. To match the EU threshold of a three per cent deficit-to-GDP ratio, Spain needs to cut its deficit by about eight percentage points by 2013.

But the real divide between the two countries lies in Italy's low private debt, which spares the country a painful deleveraging process and leaves a reservoir of households' savings.

"The government can borrow from the private sector and doesn't have to go and seek money out from overseas," said Citigroup strategist Steven Mansell. "That differentiates Italy from the periphery."

After boosting Spain's external deficit, debt-fuelled private demand has dried up, turning into a drag on growth. Debt of consumers and non-financial companies stood at 139 per cent of GDP in Italy in 2008 against Spain's 220 per cent, according to BNP Paribas.

Yields on Italian and Spanish 10-year benchmarks trade roughly in line at around 70 basis points above Germany. But some analysts said the premium Spain pays is slightly lower because Spanish banks used liquidity borrowed from the ECB to buy domestic bonds, a trade due to peter out as the central bank gradually drains the excess liquidity from the system.

"It's a slow-burn trade [but] I think Italy against Spain makes a lot of sense," said Mansell, who also considered Italy a better short-term bet than France.

France expects its debt to peak at 87.1 per cent of GDP in 2012 in a best-case scenario, nearly 20 percentage points above the 2008 level of 67.4 per cent.

The budget gap, seen this year roughly stable at eight per cent of GDP, is due to fall to three per cent of GDP only in 2013.

"If France does not contain its deficit and take the right course of action over the next few years, then you could certainly argue for less of a differentiation between France and Italy," said Charles Diebel, head of sovereign strategy at Nomura. French 10-year bonds currently offer a yield premium of about 30 basis points over German Bunds.

The Greek connection

The yield gap between 10-year Italian BTPs and German Bunds rose to about 160 basis points last year. It has since steadily come down, holding below 100 basis points in recent months, despite the outbreak of Greece's debt crisis which pushed the premium on Greek 10-year benchmarks above 450 basis points.

The Italian Treasury is in charge of managing outstanding notes worth about €1.48trn at end-March, giving it vast experience of tapping the markets.

"The way the Italian Treasury conducted bond auctions during the crisis has set an example others have followed," said Tentori at BNP Paribas. "By reopening off-the-run bonds that had lost liquidity, it has eased pressure on the benchmarks, whose yields are used to calculate spreads."

Despite attractive low rates at the short-end of the curve, Italy extended the average maturity of its debt to 7.07 years at end-2009 from 6.82 years at end-2008.

Its sheer size and the strict market-making obligations of the 20 banks that act as specialists for Italian debt ensure its high liquidity, a key feature for investors keen to always be able to quickly liquidate positions as well as build them.

Economists estimate that Italy will borrow €256-259 billion this year. (Reuters)

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