That reversal is coming. While it has been painful and is yet incomplete, the credit crunch has promoted a financial purging and healing process that has been even more rapid than we expected ten months ago when we last estimated system-wide credit losses. Household deleveraging and rising wealth have substantially restored balance sheet health and, coupled with increasing income, have given consumers more wherewithal and confidence to borrow again. For its part, Corporate America will likely soon start accumulating inventories and boosting capex, perhaps sooner than expected. We expect that the combination of rising household and corporate credit demands and massive Treasury borrowing needs will put significant upward pressure on real yields in 2010-11.
Credit availability improving. There is no mistaking the improvement in credit availability. While the credit crunch is not completely over, the credit headwinds to growth are abating. For example, high-yield issuers have brought $43 billion to market year-to-date, compared with $11 billion for the same period last year. And the winding down of the Term Asset-Backed Securities Lending Facility (TALF) is a good sign that the ABS market can function on its own, with the final tranche of loans collateralized by eligible newly issued and legacy ABS scheduled to be accepted on March 31, 2010.
To be sure, despite these improvements, banks remain relatively reluctant to lend, and access to credit for households and small businesses is still somewhat impaired. The Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in January, but at a slower pace. While that seems ominous, it's pace that matters for growth. Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating. We find that every 10-point drop in the proportion of banks tightening standards recently allows a 1pp increase in bank lending growth. Moreover, the net percentage of loan officers willing to lend to consumers moved into positive territory for the first time in 2.5 years, and to a four-year high. Finally, the NFIB small business canvass showed that credit was slightly easier to obtain in February for the first time since the recession began.
New era for households does not mean no borrowing. American consumers have begun what looks like a long process of deleveraging their balance sheets and rebuilding saving, aimed at restoring a more sustainable balance between household debt and the ability to carry it. One measure of sustainability is the debt service ratio - household payments of interest and principal on debt in relation to disposable income. By that metric, courtesy in part of lower interest rates and our expectations for a further recovery in income, consumers are already about halfway through the process. We believe that 11-12% is a sustainable debt-service ratio, consistent with debt/income of 80-100%; the former metric is halfway there, while the latter has some way to go.
Correspondingly, it's a new era for American consumers, one of rising thrift and moderate growth in consumer spending. Consumer deleveraging likely will continue into at least the summer as debt paydowns and write-downs exceed new originations. Soon after that, we think consumer borrowing - including consumer credit and mortgages - will begin to grow, although much more slowly than income. Indeed, consumer credit turned up in January after declining for 15 of the previous 17 months; it's too soon to argue that those data represent a turn higher, but they hint at stability. In our view, even stability in consumer borrowing following the unprecedented bust of the past two years will change the supply-demand balance in credit markets.
Corporate financing inflection point arrives. In contrast with the languid turn in consumer borrowing, corporate borrowing likely will turn up much more quickly for three reasons. First, corporate balance sheets were not the problem in this recession; by and large, debt/EBITA has been subdued. Of course, the ratio rose in recession, but it is quickly falling as earnings bounce back. Second, corporate access to funds in the aggregate has improved faster than for consumers. Finally, and most fundamentally, corporate external financing needs are likely to turn positive soon as companies turn from inventory liquidation to accumulation, as capital spending begins to recover, and as the growth in corporate cash flow inevitably slows. The combination of these developments is likely to boost corporate credit demands, perhaps sooner than expected.
Treasury financing update. We expect that the Treasury will issue $2.4 trillion in coupon securities in the current fiscal year. The budget deficit will likely be slightly lower this year than last, and overall Treasury financing needs more so (as most TARP outlays and recent repayments have been moved off budget). But the duration of Treasury issuance this year will be much higher than last, driven by the Treasury's effort to reverse the significant shortening in the average maturity of the debt seen in 2008 and 2009, when huge increases in T-bill issuance funded much of the initial spike in the budget deficit. While the debt managers said at the February refunding that coupon sizes have peaked and could be reduced later in the year, at current record levels, net coupon issuance remains enormous at each mid-month and end-of-month settlement of biweekly auctions, and this is being offset by sizable net bill paydowns. Even if supply is pared a bit in coming months, gross coupon issuance is likely to be nearly a third bigger in fiscal 2010 than it was in fiscal 2009, when it was already a record by a very wide margin.
Supply-demand balance points to higher yields. Treasury yields have remained low partly as there has been little competition from private borrowers. Competition is coming, even in a moderate recovery. With growing concerns about the sustainability of US fiscal policy, we think that shift will promote significant increases in real yields this year.
The Treasury curve saw a decent flattening move in quiet trading over the past week, with 2s-30s hitting its lowest level since late January, as a continued run of improved economic data after a soft patch over the prior few weeks pressured the short end while the longer end was boosted by strong demand at the 10-year and 30-year auctions and perceived near-term value among some investors as peak long zero yields rose above 5%. Curve flattening was also supported by substantial renewed pressure on overnight financing rates Friday after some moderation much of the week from the prior week's run up, and there was also some market speculation that the Fed could soften its extremely dovish policy language in Tuesday's FOMC statement. We expect the "extended period" language to be modified soon but probably not as early as the coming week's meeting. Even so, the move towards the exit has already begun in a meaningful way as the ramping back up of SFP issuance that is draining bank reserves and sharply boosting Treasury supply is already adding to upward pressure on the overnight repo and effective fed funds rates. We continue to expect reserve draining to accelerate over the summer, when we look for term deposits and large-scale reverse repos to add to the ongoing liquidity draining being conducted by the Treasury on the Fed's behalf through the SFP program. In preparation for this next stage, the New York Fed moved over the past week to add major money market funds as counterparties for repo operations, as the primary dealer system by itself probably doesn't have the balance sheet capacity for the ultimate volume of reverse repos the Fed will need to implement. The economic data calendar over the past week was quite light, but what was released added to the prior week's run of solid numbers to further suggest that the economy held up better than feared early in the year during severe weather disruptions and some paybacks from late 2009 tax incentive-driven boosts. A much narrower-than-expected trade deficit in January and surprisingly strong underlying retail sales in February, with a partial offset from lower inventory numbers - a positive for future growth - led us to boost our 1Q GDP estimate to +2.5% from +2.0%, partly reversing a persistent run of downgrades in February from our initial 1Q GDP tracking estimate of +3.0%. We still think that 1Q growth was meaningfully depressed by the severe weather and other temporary paybacks and production consolidations, and we look for a snapback in 2Q with an acceleration to +4% GDP growth. Meanwhile, any concerns about how well the market would absorb the latest run of heavy long-end supply were not realized yet, as all three of the week's auctions, 3-year, 10-year and 30-year, saw very strong demand, allowing the long end in particular to recover significantly Thursday afternoon and Friday after being weighed down by pre-supply pressures for nearly a week starting soon after the employment report release. We continue to think that a major shift in the supply/demand balance in the credit markets after an unprecedented run of private sector debt reduction in 2009 offset record Treasury issuance will substantially boost long-end real yields over the coming year (see The Coming Rebound in Private Credit Demands by Richard Berner, March 12, 2010), but at least for this week there clearly remained ample demand to absorb the still surging Treasury coupon supply even at current abnormally low real yield levels.
On the week, moderate losses at the shorter end and small gains at the long end resulted in a significant curve flattening, with 2s-30s moving 7bp lower to 367bp, a low since January 27 after having risen to a two-week high of 380bp Tuesday. The 2-year yield rose 6bp to 0.96%, 5-year 7bp to 2.42%, 7-year 5bp to 3.15% and 10-year 2bp to 3.71%, while the 30-year yield dipped 1bp to 4.63%. TIPS outperformed on the week even as commodity prices came under a bit of pressure as worries rose about the possibility of more near-term moves by China to restrain liquidity after a batch of stronger-than-expected February data reports. The 5-year TIPS yield rose 2bp to 0.21%, 10-year fell 2bp to 1.45% and 30-year fell 2bp to 2.13%. TIPS inflation expectations saw a significant pullback in February as worries about Greece mounted, but as that situation has calmed down, breakevens have started to reverse higher, with the benchmark 10-year inflation breakeven hitting a three-week high of 2.26% after a 4bp rise the past week. Supply pressures contributed to poor relative performance by Treasuries versus other rates markets through the first part of the week, but this partly reversed as the long end of the Treasury market rallied once the 30-year auction was out of the way. Swap spreads ended up mixed on the week, with the benchmark 10-year spread widening by 0.25bp to 4.75bp after reaching a record low close of 2.75bp on Wednesday, but the benchmark 2-year spread fell another 0.5bp to 20.75bp, a low since 2003. Mortgages saw a big run of outperformance versus Treasuries in the week through Wednesday, partially reversing Thursday and Friday. Over the first couple of weeks of March, though there have been some dislocations along the coupon stack as investors have tried to adjust from buyouts of delinquent mortgages from MBS, current coupon MBS yields have been quite stable, holding near 4.33% even as the 5-year Treasury yield has risen 13bp. Mortgage yields haven't moved far from this level since mid-January actually, which has kept 30-year conventional mortgage rates close to 5% the past couple of months, only about a quarter-point above the record-low weekly average of 4.71%. We're expecting another month of weak home sales results in February, but the extension and expansion of the homebuyers' tax credit on top of these low rates and depressed home prices have left housing affordability at unprecedented levels heading into the key spring selling season, and the mortgage applications survey this week suggested that home purchases may be starting to pick up after the recent severe payback from sales pulled forward ahead of the initially scheduled expiration of the tax credit.
The rising financing rate pressures that drew significant market attention the prior week were easing somewhat most of the past week, but they resumed in a significant way Friday afternoon, and our desk expects this to extend into next week. The overnight Treasury general collateral repo rate averaged 0.14% much of the week, including the first part of the day Friday after increases the prior week to a high of 0.19% on March 5. But upward pressure became increasingly evident Friday afternoon, with rates backing up to near 0.30% in the late afternoon. Effective fed funds was also moving back up, averaging 0.16% Friday through the late afternoon after having dipped to 0.14% Tuesday and Wednesday from the recent high of 0.17% on March 5. Ongoing heavy increases in Treasury supply - another US$25 billion in new SFP bills were issued Thursday on top of another US$4 billion at the regular weekly bill settlement, and there will be another US$60 billion of net coupon issuance when this week's auctions settle Monday - continue to sharply boost available Treasury collateral in the repo market. On top of this, the GSEs are deploying a big chunk of their cash to buy delinquent mortgages out of their MBS pools. Fannie Mae's initial purchases will be spread out over a few months, but Freddie Mac's purchases were done in one fell swoop, with settlement on Monday.
Risk markets barely moved any day of the past week, extending a recent sluggish trend, but for stocks mostly minor day-to-day moves recently have been largely on the positive side and added up to a decent rally. The S&P 500 gained 1.0% over the past week to its best level of the year after a 7% rally the past month. The best-performing sectors in the past week were financials and technology and over the past month financials, industrials and healthcare. Energy, materials and financials were generally the highest-beta sectors earlier in the year, but recent upside in the dollar and rising concerns about tightening in China have restrained commodity prices somewhat recently. Credit also moved very little in the past week but lagged stocks by not managing to put together a run of minor rallies. The investment grade CDX index tightened 2bp Monday to 83bp and then stayed there all week. This is the best level since mid-January but wider than the tight close for the year of 76bp on January 11 and only slightly better than the 85bp close to 2009 while the S&P 500 is now up 3.1% year to date. High yield performance was similarly muted, with the index tightening 5bp to 515bp Monday and then only slightly extending the upside through the rest of the week. Similar to IG, the best close so far in 2010 for the HY CDX index was 468bp on January 11 and the latest week's levels were only slightly better than the 518bp close to 2009. Another area moving to its best levels of the year the past week was muni bond credit protection. As Greece, to a significant extent, faded as a major market worry, prior knock-on fears about state finances also eased, with the 5-year MCDX index trading about 12bp tighter late in the week near 138bp, a low since January 8 after widening out to as high as 180bp on February 4.
There wasn't much economic data out the past week, but key releases extended the more positive recent trend that started with the run of key early data for February the prior week. In particular, upside in the trade balance and underlying retail sales led us to boost our 1Q GDP forecast to +2.5% from +2.0%. We boosted our forecast for final sales more, to +2.6% from +1.9%, but there was some offset on overall GDP from unexpected further declines in January wholesale and retail inventories. Economy-wide inventory/sales ratios, however, are at or near record lows across major sectors after a huge inventory correction over the past year, so any 1Q downside in inventories should be made up going forward, as inventory destocking will need to swing to modest accumulation going forward to stabilize I/S ratios. Although the current quarter growth outlook looks a little better now, we still think that activity was meaningfully depressed by the East Coast snow storms and some tax credit paybacks, and we continue to look for a snapback to near +4% GDP growth in 2Q.
The trade deficit narrowed to US$37.3 billion in January from US$39.9 billion in December, with exports (-0.3%) and imports (-1.7%) weakening a bit after huge rebounds in the last eight months of 2009 following the collapse in global trade seen from mid-2008 into last spring. Both exports and imports of autos pulled back somewhat after spiking around 75% in the second half of last year. In addition, on the export side, capital goods were softer in line with aircraft industry data (after unusually strong aircraft exports in December) and factory shipments numbers. Capital goods imports were also down, as were imports of consumer goods, in line with some moderation in growth in inbound cargo shipments at the key West Coast ports after a major prior rebound. Based on these results, we now see net exports being neutral for 1Q GDP growth instead of subtracting 0.5pp. While the January trade gap improvement was driven by a pullback in imports, a much more positive export-led further narrowing should support GDP growth in the coming quarters. We look for net exports to add about a half-point to GDP growth in the year starting in 2Q, supported by a big divergence between quite strong emerging markets growth boosting exports against somewhat sluggish US domestic demand restraining import growth.
The outlook for consumption is also better after a stronger-than-expected retail sales report. Retail sales rose 0.3% in February, as a 2.0% pullback in auto sales partly offset a 0.8% surge ex autos. In line with the surprisingly robust chain store sales reports despite the bad weather, general merchandise (+1.0%), clothing (+0.6%), sport, books and music (+1.2%) and electronics and appliance stores (+3.7%) posted big gains. The weather was probably actually a significant positive for grocery stores (+1.3%) and building materials (+0.5%) as consumers stocked up on supplies ahead of the blizzards. The key retail control grouping that feeds into GDP (sales ex autos, building materials and gas stations) surged 0.9% in February, but January (+0.6% versus +0.8%) was a bit lower. Incorporating these results, we boosted our forecast for 1Q consumption to +3.2% from +3.0%, which would be the best gain since 1Q07.
The economic calendar is a lot busier in the coming week, with focus on Tuesday's FOMC meeting. There will probably be a somewhat more upbeat view on the economy in the statement, but we don't expect the key policy language to change just yet. In particular, we don't expect any alterations in the extremely dovish "exceptionally low levels of the federal funds rate for an extended period" language. We do believe, however, there is a reasonably high probability that the key wording in the statement will be adjusted at the next meeting on April 27-28, perhaps by retaining the "extended" phrase while dropping ‘exceptionally' - implying that monetary policy is likely to remain accommodative for quite a long time, but that accommodative does not necessarily mean a zero fed funds rate. We expect that a resumption of the run-up in inflation expectations seen in the second half of last year and early this year as the economy continues to show sustainable improvement, the unemployment rate continues to appear to have peaked in October, and job growth turns positive, will ultimately be the trigger for the next stage of Fed tightening. This will likely take the form of the ramping up of the term deposit program and reverse repos over the summer followed shortly by the beginning of rate hikes. Key data releases due out in the coming week include IP Monday, housing starts Tuesday, PPI Wednesday and CPI and leading indicators Thursday:
* We forecast a 0.2% decline in February industrial production. The employment report showed a sharp 0.9% decline in hours worked within the manufacturing sector. However, some of this decline appears to have been attributable to the impact of unusually severe winter storms that arrived right around the same time that the labor market survey was conducted. In past such instances, the Fed has always applied an adjustment to the hours data to account for the likelihood that factory activity was not as depressed during the rest of the month. However, we still look for headline IP to post its first outright decline since last June, driven, in part, by a drop in motor vehicle assemblies. Note that the latest assembly schedules point to a sharp rebound in auto output during March, which is likely to be reinforced by some upside in other sectors as weather conditions return to normal. Survey data also point to continued underlying strength in the factory sector. All of this points to a very sharp snapback in IP for the month of March.
* We look for a drop in February housing starts to a 500,000 unit annual rate. The February employment report showed that hours worked in the construction sector posted one of the sharpest declines seen during the past couple of decades. Thus, starts are expected to plunge 15% in February, largely as a result of the unusually severe weather experienced across parts of the nation. Both single and multi-family categories are likely to show some fall-off.
* We forecast a 0.1% decline in the headline producer price index in February and a 0.1% increase in the core. A partial pullback in wholesale gasoline prices following some hefty gains in prior months should lead to a fractional decline in the headline PPI for February. Meanwhile, the sharp increases in categories such as light trucks and drugs, which led to some elevation in the core PPI reading for January, are unlikely to be repeated this month. So, we look for the core to be near the underlying trend of +0.1% per month.
* We look for the headline consumer price index to tick up 0.1% in February and for the core to be flat. Gasoline prices flattened out in February, following some hefty increases in prior months. Moreover, while quotes for fruits and vegetables continue to soar in response to poor growing conditions in some parts of the nation, milk and bread prices have started to edge down. So, the food category is expected to post only a fractional increase this month. Meanwhile, the core is likely to be restrained by ongoing softness in the shelter category (which has a 40% weighting) and a more modest rise in medical care costs than in January. On a year-on-year basis, the core is likely to round down to +1.3%.
* The index of leading economic indicators should rise 0.2% in February, its eleventh straight gain extending - even after factoring in the more modest increases seen over the past couple of months - the best run since 1983. The main positives in February should be the yield curve and real money supply, while the manufacturing workweek (a weather impact) and stock prices are likely to represent significant offsetting negatives. We may need to update our estimate following release of the building permits data on Tuesday.
Summary and Conclusions
Fiscal concerns brought the so-called EMU periphery under the market spotlight. According to the conventional view, all the countries generally associated with this group (Italy, Spain, Portugal, Greece and Ireland) are characterised by a degree of fiscal profligacy, a poor record of implementing structural reforms, a lack of cost competitiveness and sizeable current account deficits - unlike core EMU countries. Thus, fiscal problems in the smaller peripherals are just a taste of things to come. What if Italy, the biggest of all, gets into difficulties?
With Italy's public debt amounting to around €1,750 billion or almost one-quarter of EMU public debt, the consequences for the euro area will be substantial. Is Italy the next in line after Greece and the small peripherals? There are grounds to challenge this consensus view, we think. True, Italy has its own long-standing deficiencies (see Italy Economics - Assessing the Damage, October 26, 2009), but it measures favourably with the ‘typical' peripheral country. We approach this issue from six different perspectives:
• First, Italy is not yet regarded as a core EMU country in all respects, but it is increasingly behaving like one from a fiscal standpoint. Contagion in the bond market has been more limited than in the rest of the EMU periphery, and debt affordability does not look set to deteriorate sharply.
• Second, courtesy of fiscal prudence during the crisis, and a relatively small overall and primary budget deficit, Italy has less work to do in terms of tightening fiscal policy than the ‘typical' EMU country. As in the other large euro area countries, fiscal consolidation will start next year - not this year.
• Third, this does not mean that Italy will not face higher debt servicing costs over the next couple of years - all EMU countries will. But courtesy of the long maturity of its debt, it will take several years for the cost of servicing the debt to rise meaningfully in Italy - longer than in most other EMU countries.
• Fourth, the long-term sustainability risk to Italy's public finances is medium, as pension reforms have helped to reduce the projected cost of an ageing population. We think that the market is underestimating the relevance of this factor, which is crucial from a sovereign solvency perspective.
• Fifth, Italy's competitiveness gap with core EMU countries is appreciable, but smaller than depicted by price-competitiveness indicators. Indeed, from a long-term perspective, Italy has protected its market share more successfully than it is generally assumed.
• Sixth, unlike in the small EMU peripherals, the current account deficit is manageable and no credit-fuelled housing and consumer boom-turned-bust has taken place recently. This means that there is no pressing need for the Italian private sector to deleverage considerably.
1. Is Italy a Peripheral EMU Country? Not really
The bond yield and CDS spread widening over the past few months are symptomatic of concerns about short-term debt rollover and long-term debt sustainability risks in many countries. Sovereign risk appears to be driving financial markets lately. Indeed, the question that seems to be on many an investor's mind, i.e., ‘after Greece, who's next?', has many potential candidates for an answer.
Predictably, and in some cases without much supporting evidence, these candidates are perceived to lie mostly within the so-called EMU periphery. However, without denying evident long-standing deficiencies in these countries, a closer look at the facts reveals that the EMU periphery is a very heterogeneous entity from both a broad economic and fiscal standpoint (see Portugal and the EMU Periphery, February 15, 2010).
In particular, the distinction between core and peripheral EMU countries is not clear-cut. Indeed, while Germany, France, the Netherlands and Austria, for example, feature in virtually all definitions of core EMU, the constituents of the periphery reflect, in some instances, dynamics dating back to the pre-EMU period - now no longer applicable (see the following sections). This is relevant because the size of these countries is remarkably different. To the extent that sovereign risk concerns in the market contribute to enforce fiscal discipline in one small country, then the direct consequences on the euro area economy would be limited. Conversely, fiscal tightening in one large country would depress euro area growth by a meaningful margin.
Take Greece, for example - which accounts for about 2.5% of euro area GDP. A downturn in this country would have contained repercussions on its European neighbours. The same applies to, say, Portugal (1.8%). At the other end of this range, a downturn in Spain (11.7%) or Italy (17%) - the biggest country among those generally considered to belong to the EMU periphery and the largest sovereign borrower in Europe - would exert meaningful negative effects on the euro area. This is not to say that world markets cannot be correlated on a daily basis, or that contagion effects cannot spread regardless of the fundamentals. Rather, it is an observation that size is important too - especially once the dust settles.
The good news is that Italy not only does not seem to be as fragile as the other peripherals from a fiscal standpoint; it also compares favourably to some of the core countries. That Italy is a new addition to the core of the EMU is perhaps an overstatement. But the fact remains that, in terms of both the economic policies that its government has put in place and how the market has reacted to these policies, Italy has weathered the fiscal storm relatively well. For example, at 5.1% of GDP on our forecast, its budget deficit will likely be one of the lowest in the euro area this year - together with Germany - in sharp contrast with France (8.1%). It may not yet fully belong to core EMU, but Italy is the core of the EMU periphery.
Contagion - Not That Much So Far
Recent market dynamics seem to confirm our view that Italy is somewhat ‘special' among the EMU peripherals. Indeed, although bond yields and CDS spreads have widened in Italy too, they have done so to a much lesser degree than in Greece, Portugal, Ireland or Spain, for example.
Italy's 10-year bond yield spread against Germany is still wide relative to its post-EMU average (15-25bp). But this is not because the yield on Italian bonds has risen sharply. Since the onset of the financial crisis in July 2007, the yield on 10-year bonds in Germany has declined by 150bp to 3.16%, while it has come down by 75bp or so in Italy.
These dynamics go beyond economic considerations. The main catalyst behind the spread widening is not country-specific. All else being equal, when there is lower risk appetite and higher volatility - as is still the case - a shift towards safer or more liquid assets tends to take place. This drives down the yield of the benchmark.
What's more, the risk of facing a ‘buyer's strike' on the Italian bond market seems lower than in other EMU peripherals. Indeed, the so-called ‘home bias' effect seems to be more of a factor in Italy. This effect refers to a typical pattern in financial markets: in case of adverse news - which could potentially push interest rates higher - foreign holders tend to hold on to the debt to a lesser degree than domestic holders. While the former might liquidate the bonds more easily when prices fall, the latter might wait for longer (to the extent that they are not convinced that the country will default) - after all, higher interest rates would boost their incomes.
As is well known, one country that benefits from the ‘home bias' effect is Japan - where the vast majority of the public debt is held by residents. In the EMU, Italy stands out relative to the other peripheral and core countries for its high share of public debt held domestically. Indeed, residents hold about 60% of the Italian government debt. This compares to one-quarter for Portugal and Ireland, one-third for Greece and about 40% for Spain. In Germany and France too, the share of public debt held domestically is lower than in Italy. What's more, issuance is going rather well in Italy, with the government having already covered almost 20% of the estimated 2010 funding needs (on our forecast).
Italy Behaves More Like a Core Country in Some Respects ...
So, barring an unlikely U-turn in fiscal policy, Italy does not look particularly vulnerable to the contagion from the situation in Greece that affected other peripherals. However, there is a more fundamental reason for this: debt affordability, i.e., the ability of a country to contract a large amount of debt at an affordable cost. On this measure, Italy - together with Portugal - really is different from the ‘typical' EMU peripheral country.
Looking at the sensitivity of interest rates to the debt trajectory, we see that debt affordability has hardly deteriorated in Italy from 2007 - and we expect it to worsen only by a small degree over the next two years despite rising public debt. What's more, the slope of the debt trajectory in Italy is similar to that of core EMU countries, reflecting its ability to contract a larger debt at an affordable cost.
... and Looks Like the Core of the Periphery
So, Italy may well be the core of the EMU periphery. However, the difference between the solid debt affordability of Italy from the shaky one of other peripherals (with the exception of Portugal, which truly looks like a core EMU country from this perspective) does not necessarily make Italy and, say, Germany alike. Indeed, the starting point in Italy (higher debt and interest) is different from that of core EMU countries (and less favourable).
Still, the steep debt affordability curves of Greece, Ireland and, to a lesser extent, Spain do indicate that, as the debt/GDP ratio rises, so does the cost of servicing the debt as a share of revenues (which gives an indication of a country's ability to cover interest expenses) - and quite quickly. Conversely, rising debt implies smaller increases in the cost of debt servicing in Italy. With debt and interest payments rising everywhere, Italy's position is an advantage.
2. Fiscal Tightening - Getting the Timing Right
This does not mean that Italy will not tighten its fiscal policy. We do expect a more stringent public purse not only in Italy, but also in Germany and France. However, unlike in Spain, Greece, Portugal and Ireland (where fiscal policy is already - or about to become - more restrictive), we think the expected tightening will not happen this year, but probably next year.
Both the Italian and French budget deficits will remain broadly unchanged in 2010, based on the respective budget laws. What's more, the German government has promised tax cuts this year and will likely cut spending to make room for these cuts, but not by much (see Germany Economics - Mending Europe's Largest Economy, September 28, 2009).
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