Italian financial market folly

Anyone doubting how seriously distorted the global credit markets have become as a result of central bank bond buying activity need look no further than the Italian government bond market. Courtesy of the European Central Bank’s (ECB) massive bond-buying program, a highly indebted Italian government can now borrow short-term at a zero interest rate and for 10 years at less than 1 percent. 

Never mind that the COVID-19 pandemic has put the Italian government debt on an unsustainable path and weakened its already shaky banking system. Never mind as well that stuck in a Euro straitjacket and mired in a deep economic recession, there is little prospect that Italy will mend its public finances anytime soon.

It would be a gross understatement to say that in the wake of the COVID-19 pandemic, Italy’s economy and public finances are now in a much worse state than they were in 2012, when the country experienced its sovereign debt crisis. Being at the European epicenter of the pandemic, Italy’s economy is now officially projected to decline by some 10 percent in 2020 or the largest amount by which it has declined in the last 90 years. That very deep economic recession in turn is wreaking havoc on the country’s already shaky public finances. 

According to the IMF’s latest estimates, even in the absence of a second wave of the pandemic, Italy’s budget deficit is set to balloon to 13 percent of GDP in 2020. That in turn has caused the country’s public debt-to-GDP ratio to skyrocket from 135 percent before the pandemic to 160 percent by the end of 2020, or to a level higher than that after World War II.

Italy’s public debt situation could get appreciably worse if Italy does not manage to get the second wave of the pandemic that it is now experiencing soon under control. It could also get worse if the Italian government is forced to bail out its shaky banking system, which will likely get inundated by a flood of non-performing loans in the wake of the pandemic. 

Italy’s past unfortunate experience with trying to reduce its budget deficit in the midst of an economic recession would suggest that it will be no more successful this time around in the grips of a very much deeper economic recession than it experienced in 2012. Stuck in a Euro straitjacket, which deprives the country of an independent monetary or exchange rate policy to cushion the economic blow of budget belt tightening, the country is likely to find again that budget austerity only deepens the economic recession. This likely means that as extraordinarily high as Italy’s public debt already is, it will keep rising for as far as the eye can see.

If the capital markets were functioning properly, Italian interest rates relative to those of its peers would be rising to reflect the country’s markedly worsening public finances. But this useful market signaling process is now being thwarted by the ECB’s massive purchases of Italian government bonds. 

No longer restricting itself under its quantitative easing program to buying member countries’ bonds in relation to their ECB capital contribution, the ECB is now buying a disproportionately large amount of Italian government bonds. Indeed, in recent months it is estimated that the ECB has been buying Italian government bonds in the secondary market in an amount that exceeds the country’s gross government financing needs. 

To be sure, the ECB’s large-scale purchases of Italian government bonds is helping to stave off an otherwise early Italian sovereign debt crisis. But it is doing so by encouraging investors to keep lending to a country that by any reasonable standard must be judged to have a very serious solvency problem. Unless we are to assume that the ECB will be prepared to buy more than EUR 500 billion of Italian government bonds a year from now to eternity, Italian government bond buyers will eventually have their day of reckoning.

Unfortunately, the Italian government bond market is but one example of how seriously distorted the global credit market has become as a result of the world’s major central banks’ extraordinarily easy monetary policies. Those policies have allowed credit to flow all too easily to highly troubled and deadbeat corporate and emerging market borrowers. This hardly bodes well for global financial market stability when the world’s major central banks eventually begin normalizing their ultra-unorthodox and easy monetary policies.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.