Italy has been in the spotlight in recent weeks for having one of the worst COVID-19 outbreaks in the world. As the country is still fighting the pandemic, many have started worrying about its economic and financial implications.

The large size of Italy’s public debt stock – the third largest in the world – is fueling concerns that the government does not have room to support the economy during the COVID-induced crisis, without endangering the sustainability of the public debt.

The increase in government debt due to the COVID crisis

According to Banca d’Italia, Italy’s national central bank, the government debt was €2,409 billion, or about 136% of gross domestic product (GDP), at the end of 2019. ¹ The debt will increase considerably as a result of the COVID crisis over 2020. The government imposed a countrywide lockdown and ordered the closure of all non-essential businesses on March 8th and March 23rd respectively.

The lockdown, which is likely to last at least until the end of April, suppresses demand for goods and services, as consumers cannot go out and spend, and will result in lower revenues to be collected from transaction taxes for the government. At the same time, the closure of all non-essential businesses puts a break on production and reduces corporate and labor incomes. This will result in even lower revenues from income taxes.

In addition, the simultaneous collapse in demand and halt in production is destroying millions of jobs, increasing the pool of unemployed workers to whom the government pays an unemployment benefit. I estimate that the COVID-induced recession might result in about €42 billion less in tax revenues and about €11 billion more in expenditures on unemployment benefits, increasing the deficit by about €53 billion relative to a no-crisis scenario. ²

In addition to this “automatic” increase in the deficit, on March 17th the government approved a fiscal stimulus package to support the economy during the crisis³ . The Ministry of Finance estimates that these new discretionary fiscal measures will increase the deficit by an extra €20 billion (MEF, 2020). Finally, to estimate by how much the debt will increase in 2020, I also take into account the interest payments that the government needs to make on the existing debt stock.

AMECO, the database of the European Commission, forecasts interest payments to be about €59 billion in 2020. Taken together, these factors – the “automatic” increase in the deficit as a result of the crisis, the discretionary fiscal support package, and the interest payments on the debt stock – might increase the debt up to €2,524 billion by the end of 2020.

This will have a sizeable impact on the debt-to-GDP ratio. Using the forecast of Italy’s Finance Minister that GDP will contract by about 6% relative to 2019 (Reuters, 2020), I estimate that debt-to-GDP ratio will increase to about 152% of GDP by the end of 2020. ⁴

Implications for debt sustainability

Financial markets might struggle to absorb all the debt that the Italian government will have to issue this year. Besides the increase in the deficit discussed above, the government needs to repay an additional €255 billion of debt that matures this year (Osservatorio CPI, 2020). Since it is short of cash, the government will need to borrow again on capital markets to rollover this maturing debt. Overall, it might need to issue around €370 billion of new debt during the rest of 2020. ⁵

Fortunately, the European Central Bank (ECB) will help investors to absorb this mountain of debt. On March 18th, the ECB announced a new round of quantitative easing – dubbed the “Pandemic Emergency Purchase Programme” – through which it will purchase €750 billion worth of debt of eurozone countries secondary markets. This new round of quantitative easing is on top of previously approved measures.

However, not all of the funds of the ECB will be devoted to the purchase of Italian government debt. Osservatorio CPI (2020) estimates that the ECB might end up buying a total of about €215 billion of Italian government debt, during the remainder of 2020. ⁶ That is a huge amount, but it would still leave €155 billion of debt – a sum almost equal to half the GDP of Malaysia – to be absorbed by private investors.

In normal times, the government might not find it particularly challenging to sell €155 billion of debt to private investors. But these are not normal times. By various measures, uncertainty has increased to unprecedented levels. Fratzscher (2012) and other prominent economists have shown that investors tend to prefer “safe haven” and shy away from “risky” countries during uncertain times.

That seems to be the case also in the current context. According to EPFR, a popular data provider tracking trends in the investment fund industry, funds investing in Italian debt suffered outflows equal to about 2.5% of assets under management every week, on average, during the month of March Another factor that might increase the difficulty, for the Italian government, of placing €155 billion of debt on the markets is the competition from many other governments.

According to the International Monetary Fund, the other G7 economies (Canada, France, Germany, Japan, the United Kingdom and the United States) have announced fiscal support measures worth €3,417 billion. Most of that will be financed through the issuance of new debt, and it is on top of the debt that will be issued to cover the “automatic” increase in deficit resulting from the COVID crisis and to roll-over maturing debt.

Even if the markets will absorb all the Italian government debt to be issued in 2020, long-term sustainability might become a concern. Contrary to many other advanced economies, over the last three decades the Italian government has persistently collected more in tax revenues than it has spent on the economy. Yet, the debt-to-GDP ratio has increased from 102% in 1991 to 136% in 2019.

A contributing factor to that increase was the perverse dynamic of the Italian debt. Interest payments to be made on the debt stock were higher than the increase in nominal GDP, meaning that the debt-to-GDP ratio increased merely due to the rollover of debt. Data from AMECO show that this so-called “snowball effect” contributed to increase the debt-to-GDP ratio by about two and half percentage point of GDP, on average, for each year since 1996, when the data first became available.

Underlying the uniqueness of the Italian situation in the current environment of global low interest rates, Italy was the only advanced economy to experience a detrimental snowball effect in 2019. The new debt that will be added in 2020 will contribute worsen this debt dynamic even further, unless the interest rate on the debt decreases substantially. ⁷

There is a risk that at some point the government might find it politically difficult to collect enough tax revenues to finance interest payments, which in large part are a transfer of wealth out of the country, as about 30% of the debt is currently owned by foreign investors (Banca d’Italia, 2020). European leaders are holding videoconferences to discuss potential policies to deal with the COVID-19 pandemic.

They know that ensuring financial stability in Italy is a precondition to ensure stability in Europe overall. A range of different proposals have been made. We should hope that Italy’s exceptional situation will be recognized – any new debt that significantly increases interest payments seriously risks undermining the sustainability of the government finances.

Zero-interest-rate and long-maturity loans could be provided either through an intergovernmental arrangement or through the European Stability Mechanism, a Fund established by Eurozone governments in 2012 to deal with financial crises. Alternatively, the issuance of COVID perpetual debt, jointly guaranteed by Eurozone governments and to be purchased by the ECB, as proposed by Giavazzi and Tabellini (2020), could ensure debt financing with negligible interest payments.

Lessons for emerging markets

Italy’s plight offers useful lessons for Malaysia and other emerging markets. Italy’s debt-to-GDP ratio increased from about 37% in 1970 to about 95% in 1990, while GDP was growing more than 3% on average (Mauro et al., 2013). By the beginning of the 1990s, interest payments had become so high that the government had essentially given up fiscal policy as a tool to cushion the economy during shocks.

When the country was struck by the global financial crisis of 2008-2009 – largely an exogenous external shock – not only could the government not support the economy, but financial markets also became nervous about the sustainability of the debt. This precipitated in a sovereign debt crisis in 2011-2012, from which the economy was still reeling before being hit by COVID-19 – another exogenous shock.

Now, with investors again concerned about the sustainability of public finances, the government is dependent on the goodwill of its European partners to support its tanking economy and avoid unnecessary economic and human damage. The good news for emerging markets is that, for the most part, they are still the master of their own fiscal policy. They should not accumulate debt during periods of high growth, as the Italian government did in the 1970s and 1980s. Debt should be issued with extreme moderation.

During the good times, debt issuance should be limited to the financing of productive investment and governments should build-up meaningful budget surpluses to be used to support the economy when a shock hits.

The current COVID crisis reminds us of an important lesson: when times are good, it is wise save for the rainy days. External capital might become unavailable when it is most needed. It is imperative for Emerging Markets to never find themselves unprepared.

References:

1. Ahir, H, N Bloom, and D Furceri, “World Uncertainty Index”, Stanford mimeo (2018).
2. AMECO. European Commission. Economic and Financial Affairs. Database. Consulted 6th April 2020.
3. Banca d’Italia. “Finanza pubblica: fabbisogno e debito.” Statistiche (2020): February 14th.
4. EPFR. “Fund Flows Database.” Emerging Portfolio Fund Research. Database. Consulted 6th April 2020.
5. Fratzscher, Marcel. “Capital flows, push versus pull factors and the global financial crisis.” Journal of International Economics 88.2 (2012): 341-356.
6. Giavazzi, Francesco and Guido Tabellini. “Covid Perpetual Eurobonds: Jointly guaranteed and supported by the ECB.” VoxEU (2020): March 24th.
7. IMF. “Policy Responses to Covid-19.” International Monetary Fund. Database. Consulted 6th April 2020. https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19
8. IMF. “World Economic Databases. October 2019 Edition” International Monetary Fund. Database. Consulted 6th April 2020. https://www.imf.org/external/pubs/ft/weo/2019/02/weodata/index.aspx
9. Mauro, Paolo, Rafael Romeu, Ariel Binder and Asad Zaman. “A Modern History of Fiscal Prudence and Profligacy,” IMF Working Paper No. 13/5, International Monetary Fund (2013).
10. MEF. “Protect health, support the economy, preserve employment levels and incomes.” Italian Ministry of Finance (2020): March 19th.
11. Osservatorio CPI. “L’impatto sul finanziamento del deficit pubblico italiano del Pandemic Emergency Purchase Programme (PEPP) della Banca Centrale Europea.” Osservatorio sui Conti Pubblici Italiani (2020): March 19th.
12. Reuters. “Italy’s EconMin sees 6% fall in 2020 GDP as ‘realistic’ estimate.” Business News (2020): April 1.

Prof. Gabriele Ciminelli joined ASB in 2019. Prior to that, he worked for the International Monetary Fund from 2016 to 2019, where he was Projects Officer at the Research Department. His professional background is complemented by working experiences at the European Bank for Reconstruction and Development, and the European Commission. Dr Ciminelli’s research interests span the fields of international finance and applied macroeconomics. He holds a Ph.D. in Economics from the Tinbergen Institute and the University of Amsterdam.

He can be contacted at gabriele.ciminelli@asb.edu.my.
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