Greece vs Italy – The Sovereign Debt Crisis
The European Sovereign Debt Crisis has centered around 5 nations – Portugal, Ireland, Italy, Greece and Spain giving this grouping of economies an unfortunate but somewhat deserving acronym – PIIGS. Greece and Italy are the two economies from this group that have attracted the largest amount of international attention in the past year. Greece because it has the most unfavourable percentage of government debt to GDP ratio at approximately 159% (2011-12 forecast) and Italy because it has the largest government debt in Europe and is the 3rd largest government bond market in the world. There are several fundamental differences between their debt situation. Examination of these differences allows us to analyse and predict the way forward for the beleaguered Italian government.
The two main points to consider are scale and recovery. In terms of sheer scale Italy’s 2.5 trillion dollar debt dwarfs the $470 billion Greek debt. While Italy’s debt exceeds the GDP of all but 2 nations of Europe (Germany and France), there are 10 countries in Europe with a GDP (nominal) higher than that of Greece. Greece has been developing fundamental faults in its economy since 1974, when it first became a democracy. To appease the socialist leaning populace, several populist schemes (beyond the capacity of the government exchequer) were introduced. The excess spending over the past 3 and a half decades was hidden by successive governments till 2009-10 when George Papendrou’s government unleashed a storm on European financial markets with revelations of government debt levels crossing the 120% threshold. The credibility of European Union regulators was badly damaged. In contrast the Italy economy has been developing cracks in its steady growth story only over the last decade. Lack of reforms and political will coupled with fierce competition from growing neighbours Germany and France put more pressure on the Italian economy. Silvio Berlusconi’s stranglehold on the economy further damaged the economy. Fundamentally however the Italian growth story remains intact. Milan and its neighbouring districts are still amongst the richest regions in the world while the Italian auto industry continues to dominate the segments that it targets. The point of essence is the rot in the system. While bureaucracy and poor political leadership have stalled Italy’s growth, the Greek story is entirely in tatters. As economists examine the history books of spectacular Greek growth in the 1990s through 2000, more and more are concluding that the growth was based more on the investment multiplier fueled by spending (spending that was sourced directly from borrowing). The Greek economy has its areas of strength, tourism and shipping being their primary industries, contributing more than 15% of the Gross Domestic Product, but the economy is over-dependent upon them and in times of recession, these are the first industries to be affected. Greece is ranked above 100 in terms of the ‘Ease of doing Business’ Ranking, a statistic that does not bode well for long term investors in the country.
Looking at the long term prospects of the two nations it is easy to see that Italy is fundamentally superior. It is a highly modernised and liberal economy with GDP contributions being spread across several sectors. With a change in the political leadership and a shake-up of the bureaucratic structure, Italy, with its massive coastline, strong geographical presence, solid industrial base and a new found vigour, the Italian economy may one day challenge the prosperous Germany. Investors recognise this.
In Greece, several factors converged to bring about the present situation. As it had been borrowing easy money since the entry to the European Union, its debt burden was massive. If the debt burden is $450 billion dollars then even at a conservative interest rate of 4% p.a. the Greek economy was paying interest equal to 6% of the GDP. This factor coupled with the international recession hit the Greek economy hard. Shipping suffered while tourism saw a massive slump. In this backdrop the Prime Minister announced the debt levels. Instantly the interest rates soared. Beyond a particular point no government can afford to buy debt. The dynamics of the financial system post millennium have leaned towards short term financing. With extensive debt up for roll over, the Greek economy was not yet insolvent, just illiquid. However as bond yields were/are so high, the Greek economy could not borrow from the open market. A direct default would have plunged the delicately poised international markets in a depression. Keeping this in mind the European Union closed ranks and produced a majestic rescue package. This rescue package however was simply meant to be a liquidity back-stop, to reassure investors that the financial might of the EU would ensure that their debts would be paid back. Ideally investors would have been reassured and would have held on to their debt, or rolled it over at the reasonable rates. However deeper examination of the Greek situation made many realise that the economy was beyond repair and long term prospects looked bleak. Prominent economists, analysts and even The Economist stated that a default was the only way forward for the Greek economy. Credit rating agencies were on a constant watch of the situation and would downgrade the debt with alarming frequency. Debt started being transferred from private investors to European governments. The scale of Greek debt and the fear of extensive contagion made a Greece bailout package possible. A large extent of the debt (more than 70%) had been held by foreign investors. This is also defined as ‘flighty capital’, money that would vanish at the first risk of default. Rescue packages and external aid was essential to reassure these influential investors.
Now we shall compare the Italian situation with the Greece debt crisis.
The first difference is scale. Italian debt is huge – $2.5 trillion, of which $1.1 trillion (44%) is held by foreign investors. Traditionally national investors would hold government debt at a greater risk of default than foreign investors. International investors roam the globe for the best returns at a minimum risk and are swift in withdrawing. With the scale of debt that faces Italy, it is not possible to design a rescue package sufficiently large enough to convince investors to stay put. Bailouts are politically unpopular, rescues of undisciplined financial entities with tax-payer money is not what voters wish from their representatives. First there were the rounds of banker bailouts, wherein highly paid bankers retained their jobs even as workers across other industries were adversely affected, and then followed the bailout of the Greek economy. Known for sun, sand and leisure, hard working Europeans may have secretly envied the Greeks. Yet their lazy and unethical work culture came startlingly into the limelight in 2009 even as the more prosperous governments, Germany and France had to reluctantly open up their purse strings to the economy that had built up its prosperity on borrowed money. Similar packages were given to Portugal and Ireland. Political sentiment against bailouts run so high that a Finnish party recently came to power with the promise of voting against more bailouts. In this context, it is politically impossible to pass another bailout package for Italy, which has also come under international ridicule for voting to power, year after year, the irrepressible Silvio Berlusconi, known more for his exploits outside his Presidential office than inside it.
If Italy is to issue a 10 year bond today, it would be paying $143.75 billion a year in interest burden alone. Therefore after the interest rates cross a certain threshold it is difficult for the government to roll over its debts. Yet the Italian economy remains fundamentally sound. 2 year bond yields are at 6.9% as compared to 28% for the Greek economy while 10 year bond yields are still within some control at 5.76%. Our analysis tells us that in the Italian case, it has to be the government that calms down markets. No external forces can play a role. The Italian government has to take a tough stand, cut spending and restore faith in investors. They can learn from the Spanish economy that was able to successfully cut spending and pushed through key reforms. While the 56% domestic debt holders do act as a buffer, every 1% increase in bond rates may increase the interest burden by anywhere between $5 billion to $25 billion. Because of the scale of debt, the effect of smaller increases in interest rates is substantially larger.
Politics will play a key role. Thats what differs Greece from Italy. Domestic politics did not have so much of a role in Greece as the role of external aid and the vast mountain of debt. The situation was deemed to be beyond repair by many. In Italy however effective political leadership and a solid promise of reforms, backed by practical plans may yet save the day. A united move to cut the deficit, coordinated by all political parties will restore faith in investors.Nowhere, and in no other financial debt crisis, has the role of domestic politics been so important. If Italian politicians get their act together, the bond yields will subside, the crisis shall pass and crisis-enabled reforms will push the economy to greater heights. If they should fail however, the consequences will disastrous.Opinions welcome. Readers may send in their views and opinions to Manan Vyas at the following e-mail address: firstname.lastname@example.org