Default Versus Italexit What Is Driving Italian Risk Spreads Today?

Default versus Italexit What is driving Italian risk spreads today?

Abstract A comparison of yields on Italian government bonds denominated in euro and in US dollar suggests that re-denomination risk has become an important driving force behind the increase in risk spreads on Italian assets after the formation of the new government. The correlation pattern between the spreads on euro, and those on US dollar denominated debt instruments, switched after the 2018 elections. Before these elections, the two spreads moved almost exactly 1:1. Since the elections, and even more after the formation of the new government, euro denominated debt instruments trade at a higher spread to German bonds (of the same maturity) than dollar denominated ones (relative to US Treasuries). Given that US$ denominated bonds should not be affected by redenomination risk, this suggests that the fear of ‘Italexit’ is a factor in the higher spreads. Moreover, the pattern of daily correlation between USD and euro bonds is midway between the pre-election one, and the one prevailing during the EMS crisis of the 1990s (1993-1995), when Italy did have its own national currency. This suggests that re-denomination risk accounts for perhaps one half of the increased spread. During the ‘euro crisis’ of 2011/2, by contrast, redenomination risk seems to have been absent, since during that crisis period euro and USD denominated spreads moved 1:1.

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Contents

Introduction ...... 1 1. Euro versus US dollar risk spreads ...... 1 2. How to measure re-denomination risk? ...... 2 3. Changing patterns before and after the new government ...... 4 4. Concluding remarks ...... 6 References ...... 7 References (from Gros (2014) ...... 7

List of Figures

Figure 1 Spreads on USD and EUR denominated bonds ...... 2 Figure 2 Risk premia compared before the formation of the new government ...... 4 Figure 3 Risk premia compared after the formation of the new government ...... 5 Figure 4. ‘Foreign currency’ and ‘domestic currency’ risk premia compared ...... 5

Introduction Spreads on Italian government bonds have increased considerably after the election of March 2018; and in particular after the formation of the new government based on a coalition of two Eurosceptic parties. There are two, not necessarily alternative reasons for this increase in the spread. Redenomination: One of the governing parities, the Lega, had a ‘no euro’ sign on its headquarters for years. Moreover, one component of the new government, the Europe minister, but originally proposed as finance minister, had in the past supported a plan for Italy to exit the euro (see Gros (2018). Fiscal sustainability: The ‘coalition contract’ which formed the basis for the government foresaw a reduction in taxation (via a flat tax) and an increase in expenditure (via a citizen income) with a total impact on the deficit which has been estimated variously at up to 6 % of GDP (Cotarelli (2018)). A priori it is difficult to distinguish between these two sources of risk. For foreign investors it does not make a difference whether the value of the bonds they are holding is diminished because the government defaults, or because the country exits the euro and repays the bond in a devalued new currency (as foreseen in the ‘Savona Plan’ (Gros 2018). However, there exists a way to obtain some indication of the relative importance of these two sources of investor concern. Most Italian government debt is in euro, but there are also some bonds outstanding which are denominated in US dollars. These bonds should be much less affected by re-denomination risk. This note exploits the information content from these USD denominated bonds. This paper starts by providing a brief description of the bond yields to be used. It then documents that the correlation pattern between risk spreads on USD and euro denominated bonds changed around the March 2018 elections. The post-election pattern is then compared with that one could observe during the 2011/2 crisis and during the 1993-5 crisis (when the country had its own currency.

1. Euro versus US dollar risk spreads There are two US dollar denominated Italian government bonds outstanding. One matures in 2023 (Republic of ITALY 6.875 09/27/2023 Govt), which implies a residual maturity of about 5 years from mid-2018. The other one matures in 2033 (Republic of ITALY 5.375 06/15/2033 Govt). Bloomberg provides the risk spread for these bonds (relative to Treasuries). These USD spreads were then compared to the spread on euro denominated BTPs of similar maturity, e.g BTPS 4.75 08/01/2023 Govt. In the following I concentrate on the2023 bonds because the 5 year maturity is more liquid than the 15 years one.

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Figure 1 below provides a simple plot of the two spreads, the one in USD and the one in EUR, from the beginning of 2017, when the outcome and even the timing of the elections was highly uncertain. It is apparent that the two lines move together, falling up to May 2018, then increasing sharply, but by different amounts. The difference between these two risks spreads starts to widen gradually already before elections, but it increases suddenly after the start of the negotiations for the formation of the new government.

Figure 1 Spreads on USD and EUR denominated bonds

Spread Italy zu Govs EUR/USD Maturity 2033 350

300

250

200

150

100

USD 2033 EUR 2033

Source: Bloomberg This is a first piece of evidence that the market perception of the riskiness of USD and EUR denominated debt of the Italian government diverged.

2. How to measure re-denomination risk?

The risk premium on a USD denominated bond should depend only on the probability that the Italian government debt defaults on (the entirety) of its debt, without exiting the euro. EUR denominated bonds, by contrast, incorporate another risk, namely that the Italian government decides to take the country out of the euro, without defaulting formally on its debt, which would be repaid in ‘new Lira’. The legal argument used by those who advocate ‘Italexit’, is simple (see Gros (2018)): the euro is the currency of Italy. But every sovereign

THE EMS CRISIS OF THE 1990S: PARALLELS WITH THE PRESENT CRISIS?  3

country has the right to determine its own currency. The Italian government could thus declare a ‘new lira’ legal tender in substitution for the euro and decree that its existing euro denominated debt will be repaid in that currency. Since euro denominated debt is issued under national law this could be done. A simple redenomination should not affect USD denominated bonds, at least not directly. Moreover, USD denominated debt is usually issued under international, mostly Anglo- Saxon law, making re-denomination impossible. One could of course argue that the large devaluation which is likely to follow the introduction of a new lira would make it difficult for the Italian government to service USD denominated debt. But the implicit reduction in the debt burden through (surprise) re-denomination and devaluation should free resources to service the USD denominated debt, whose overall magnitude is not that large anyway. It follows that the difference between USD and euro denominated bonds should be determined in the first instance by the expectation of Italexit. Credit default swaps (CDS) rates cannot provide a good measure of redenomination risk since any change in the currency would be considered a ‘credit event’ and thus trigger payment. This why one would expect CDS spreads to trade like euro denominated bonds, rather than USD denominated ones. The new harmonised CACs which have been introduced since 2013 consider redenomination a ‘credit event’. It is thus not clear whether the introduction of a new currency would actually alleviate the debt burden of the government. The key issue would then be whether Italian courts would uphold CACs against the national government, which will be arguing that it was acting in the national interest. So far there is anyway little sign of a different risk premium on newly issued bonds (with CACs), compared to otherwise comparable bonds without these CACs. One can assume that in a ‘normal’ default, without euro exit, the haircut should be the same for all bonds, irrespective of the currency they are denominated in. This would imply that the main difference between EUR and USD denominated bonds is the risk of denomination. The spread on USD denominated bonds should give an indication of the risk of ‘normal’ default, whereas the difference between the two spreads should indicate the redenomination risk.

Formally one might write the risk premia in the following way: USD risk premium = PD*LGD + PEX*PDEX*LGEX EUR risk premium = PD*LGD + PEX*[Dev+PDEX*LGEX] With: PD = probability of default, LGD = loss given default PEX = probability of exit from euro, LGEX =loss given exit from euro and Dev = devaluation given exit from euro. The key point is that the difference between these two expected losses is only the term: PEX*Dev, i.e. the probability of exit times the devaluation in that case.

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3. Changing patterns before and after the new government

The change in the relationship between the two risk spreads can best be seen in two scatter plots, one before and the other after the new government (or rather before and after the coalition talks started). Each point represents the value of the spread on euro denominated bonds on the horizontal axis and the spread on USD denominated bonds on the vertical axis. A simple visual comparison of figures 2 and 3 shows clearly the different patterns.

Figure 2 Risk premia compared before the formation of the new government

Spread Italy zu Govs EUR and USD Maturity 2023 before new government 250

200 y = 0.8672x + 22.255 R² = 0.8238

150

100 SpreadDollar denominated bonds 50

0 0 50 100 150 200 250 Spread on euro denominated bonds

THE EMS CRISIS OF THE 1990S: PARALLELS WITH THE PRESENT CRISIS?  5

Figure 3 Risk premia compared after the formation of the new government

Spread Italy zu Govs EUR and USD Maturity 2023, after the elections 250

y = 0,5329x + 41,693 R² = 0,9524 200

150

100

Spreadon dollar denominatedbonds

0 0 50 100 150 200 250 300 350 400

Spread on euro de nominated bonds

The figures also show the correlation patterns. Before the elections the two spreads moved almost exactly 1:1, the dollar spread increased by 0.87 points for every point increase in the euro denominated spread. This changed some time after the elections. Starting around the date of the formation of the new government, dollar spreads increased only by 0.53 points for every increase the euro denominated spread. The difference is statistically significant as the two confidence bounds on the slope coefficient do not overlap. The correlation pattern between the spreads on euro, and those on US dollar denominated debt instruments, thus clearly changed after the elections. Finally, one can compare the correlation patter which emerged with the new government with those observed during two previous crisis episodes: the 2011/2 crisis and the 1993-5 EMS crisis. This is done in figure 4, drawn from Gros (2014), which shows the same variables as above (namely USD and ‘national currency’ denominated debt) for two previous crisis episodes: The left hand panel shows what happened during the height of the ‘euro crisis’ of 2011/2. The right hand panel shows what happened during the ‘ESM crisis’ of the mid- 1990s, when Italy still had its national currency.

Figure 4. ‘Foreign currency’ and ‘domestic currency’ risk premia compared

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7 7

6 6 y = 1,0167x + 0,1865 5 R² = 0,9368 5

4 4

3 3 y = 0,1571x + 0,2658 2 R² = 0,8317 2

1 maturity) same government,

USD denominated debt risk premium risk debt denominated USD 1 USD denominated debt (Italy minus US minus (Italy debt denominated USD 0 0 -1 1 3 5 7 -1 1 3 5 7 Euro denominated risk premium Lira minus German (DM) interest rate on public debt

The data from the 1990s (right hand panel) thus suggest that for financial markets the probability of a formal default on public debt was much lower than the probability that debt problems are solved via devaluation and inflation. By contrast during the (As mentioned above euro denominated debt instruments traded a higher spread to German bonds (of the same maturity) than dollar denominated ones (relative to US Treasuries). The correlation pattern between the spreads on euro, and those on US dollar denominated debt instruments, after the formation of the new government appears to be midway between the pre-election one, and the one prevailing during the ESM crisis of the 1990s (1993-1995), when Italy did have its own national currency. This suggests that re-denomination risk has returned, accounting for perhaps one half of the increased spread. During the ‘euro crisis’ of 2011/2, by contrast, redenomination risk seems *to have been absent, since during that crisis period euro and USD denominated spreads moved 1:1, i.e. during that period USD denominated bonds were judged to bear the same risk as EUR denominated bonds.

4. Concluding remarks This contribution has tried to disentangle two current sources of investor concerns resulting from the formation of the new Italian government: The risk that the country leaves the euro (Italexit, for example via plan outlined by one of the Ministers). The risk that increased deficit spending might make public finance unsustainable, leading to a default, possibly while remaining in the euro, like Greece. A comparison of yields on US dollar and euro denominated bonds suggests that both source are equally important. The overall conclusion one should draw from the increase in Italy’s spread in May/June 2018, is that playing with the idea of exiting the euro can be costly, even if public finances remain under control. It remains to be seen whether the ‘genie’ which was let out of the bottle by generic anti-euro party positions and precise plans for Italexit can be pushed back into the bottle.

THE EMS CRISIS OF THE 1990S: PARALLELS WITH THE PRESENT CRISIS?  7

References Gros, D. (2014) “The EMS Crisis of the 1990s Parallels with the present crisis?”, Centre for European Policy Studies (CEPS), Working Document No. 393 / March 2014. Gros, D. (2018) “How to exit the euro in nutshell- ‘Il piano Savona’” CEPS Commentary https://www.ceps.eu/publications/how-exit-euro-nutshell-il-piano-savona Cotarelli, C. (2018)

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