by Alvise Lennkh-Yunus, Executive Director, Sovereign & Public Sector

Given Italy’s (BBB+/Stable) public finance vulnerabilities – government debt-to-GDP of around 150%, annual gross financing needs close to 30% of GDP and a government deficit still above 5% of GDP – markets are rapidly repricing risks on Italian government bonds in the absence of full assurance around the ECB’s commitment to contain rates and/or spreads.

Italy’s reliance on the private sector is set to rise over the coming years as the government’s funding needs will remain elevated while the ECB winds down net asset purchases. This transition, which contrasts with the 2019-21 period, has important implications and needs to be managed carefully.

The ECB is committed to prevent fragmentation in the transmission of its monetary policy, hence the plan for a flexible reinvestment of principal repayments of securities under the pandemic-related programme (PEPP). However, many important details are not yet public.

The ECB’s self-imposed limit of not holding more than 33% of any outstanding bond issue (under the PSPP) could imply less capacity – or willingness – to reinvest maturing bonds of certain jurisdictions. In the case of Italy where the Eurosystem, via the Banca d’Italia, holds around 25-30% of outstanding debt, that additional flexibility could prove particularly valuable should the Italian Treasury face continued pressure on its financing costs given the country’s sizeable gross financing needs.

The ECB could use the reinvestments to purchase more securities of certain member states by shifting reinvestment across jurisdictions and time. The ECB could also accelerate reinvestment in securities of one member state prior to the maturing of debt securities of that specific jurisdiction.

Figure 2: Eurosystem holdings of debt securities, % of total, end-2021

NB: Does not include Estonia, Luxembourg.
Source: ECB, IMF, Scope Ratings

This could help smooth out spikes in yields during the shift in security holdings away from the Eurosystem balance sheet to the private sector’s. The key question, in our view, is how much market volatility we see until a new equilibrium is found, where risk premia again reflect country fundamentals in a normalised interest rate environment.

Even without reinvestment flexibility, debt securities corresponding to a deficit of about 2.5% of GDP could be absorbed by the Eurosystem via its reinvestments over the next years, or about EUR 50bn. Thus, assuming a fiscal deficit of 6.0% in 2022 and 4%-4.5%% in 2023, and deficits of around 2.5% for 2024-27, the volume of annual long-term issuances by the Italian Treasury absorbed by financial markets should remain in line with 2014 levels of EUR 272bn over the coming years, partially limiting pressures on financing costs for Italy. It will likely, however, be significantly above the volumes observed in recent years, resulting in higher funding costs.

Figure 2: 10-year Italian government bond yield and spread to German Bund

Source: Macrobond, Scope Ratings

The immediate impact of a parallel shift of the whole curve by 100bps is estimated by the government at around 0.5%-0.6% of GDP after three years. If yields were to stay at current elevated levels with the 10-year government bond yield at around 4%, this would correspond to a 300bps shift compared to the beginning of the year. A back-of-the-envelope calculation would thus imply an increase of interest payments of around 1.5% of GDP, or about EUR 25-30bn cumulatively after three years. This compares with total interest expenditures of EUR 60bn in 2021 and EUR 83.6bn back in 2012.

From a policy perspective, such an adverse scenario could probably be mitigated if the ECB clarified explicitly its commitment to use reinvestments flexibly across jurisdictions and time. Under more stressed scenarios, the ECB could also announce a new programme to prevent further interest rate fragmentation as some market participants are already calling for, or alternatively, revive an old programme, specifically the ECB’s Outright Monetary Transactions (OMT) programme.

Reaching a new interest rate equilibrium for Italy will thus require policy flexibility at the European level – as exemplified over the past 15 years via the establishment of OMT, the ESM (AAA/Stable) and the EU’s (AAA/Stable) NGEU – but also domestic political stability, including after next year’s general elections, and the implementation of reforms in line with those on which NGEU disbursements are conditioned on.

Given Italian citizens’ strong support for the euro, with 72% supporting the single currency per the latest Eurobarometer, we believe EU policymakers will use existing and, if needed, develop new instruments to ensure broad macro-economic stability across the EU. This is particularly the case for Italy, a founding EU member of systemic political and economic importance, which is a key argument underpinning our BBB+/Stable rating. Scope’s next scheduled review for Italy is 29 July.