The road to Rome
EVER since Europe’s sovereign-debt saga began, euro-area policymakers have feared that the turmoil afflicting first Greece, and then Ireland and Portugal, would engulf larger economies. Most attention had focused on Spain, a country that remains in peril. This week, however, contagion spread to another and even more alarming place: Italy.
Starting on July 8th bond markets staged an unexpected buyers’ strike, driving yields on Italian debt to their highest levels in a decade. These violent moves were mirrored by sharp falls in the shares of Italian banks. Markets calmed in mid-week amid talk that the European Central Bank had started buying peripheral debt. But the psychological damage has been done. The possibility that Italy, the euro area’s third-largest economy and the world’s third-biggest issuer of government bonds, might be sucked into the debt crisis cannot now be denied.
But actually, in some ways the sudden involvement (albeit in a very limited way so far) of Italy in the crisis could be seen more as a reversion to a more normal state of affairs. Until 2010 Italian bonds were judged by the markets to be a more risky investment than Spanish bonds, as illustrated by the spreads over equivalent German bonds displayed in the first column in the table below. The substantially lower level of Spanish government debt (again, see below) was certainly the reason for this. And in fact, it wasn't until May of 2010 that yields on Spanish bonds surpassed those of Italian debt.
The perceived riskiness of the sovereign debt of any particular euro country is the product of multiple factors, the most significant of which are probably the size of the outstanding stock of government debt (which, at around 150% of GDP, is what has convinced most observers that Greece is now insolvent) and the size of the current budget deficit. Spain has recently had a larger budget deficit than Italy (about 9.2% of GDP compared to 4.6% for Italy in 2010), and has added about nine percentage points more to its stock of debt than Italy over the past few years, but Italy's stock of debt is still far, far higher.
Clearly investors have begun reevaluating the relative importance of these two factors when assessing the riskiness of sovereign euro debt. And in so doing, they may be starting to revert to the sentiment that the overall size of the stock of debt is just as important as the size of present budget deficits. So rather than be surprised at the recent reconsideration of the riskiness of Italian government debt, perhaps we should be surprised that it took so long.