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Erber, Georg
Article — Published Version Italy's fiscal crisis
Intereconomics
Suggested Citation: Erber, Georg (2011) : Italy's fiscal crisis, Intereconomics, ISSN 1613-964X, Springer, Heidelberg, Vol. 46, Iss. 6, pp. 332-339, http://dx.doi.org/10.1007/s10272-011-0397-0
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Georg Erber* Italy’s Fiscal Crisis
Italy is presently one of the most vulnerable economies in the eurozone. Over the past twenty years it has failed to adapt to increasing global competition and its public fi nances have deteriorated dramatically. Even with huge fi scal support from the other members of the eurozone, Italy’s perspectives look rather bleak. How did this situation come about? Did Italy’s EMU membership make things worse?
Italy’s fi nancial stability is being increasingly challenged ian government.2 The Italian government under Silvio Ber- by the global fi nancial markets. Standard & Poor’s (S&P) lusconi was quite reluctant to address these weaknesses, downgraded Italy’s rating to A/A-1 from A+/A-1+ in Sep- which are the outcome of long-term structural weakness- tember 2011 and said Italy’s economic growth pros- es of the Italian economy. Now that Mario Monti’s new pects were getting weaker. This maintains Italy’s rating government has taken offi ce we shall have to wait and see at the level of investment grade, but the junk bond sta- whether, and how soon, this will change. Under the cur- tus threshold is getting closer. The future outlook is still rent circumstances of a crisis of confi dence in the fi scal negative according to S&P, raising expectations that fur- stability of numerous eurozone countries, these weak- ther downgrades may occur in the near future. After S&P nesses have become a severe liability. Structural reforms downgraded Italy, Moody’s and Fitch followed in October. to bring government expenditures into line with the lower Moody’s lowered its Italian sovereign bond rating by three growth perspectives are still in their infancy. Furthermore notches to A2 on 5 October 2011 for the fi rst time since there has been stiff resistance in the Italian population to 1993. Fitch followed suit on 7 October 2011, lowering the the austerity measures taken by the Italian government. Italian short- and long-term ratings to A+ with negative Again, we shall have to wait and see if the new govern- outlooks on both of them. The downgrade of Italy’s sover- ment has suffi cient public support. Without public sup- eign rating was followed by a downgrade of major Italian port for stabilising the government budget and bringing fi nancial institutions, since they are major holders of Ital- the high public defi cits down to a sustainable level, at- ian government bonds. The downgrading leads to higher tempts to get the country’s public fi nances under control fi nancing costs for both the government and the com- in the face of rapidly waning trust in the Italian fi nancial mercial banks in Italy. This creates a vicious circle which system will lead sooner or later to a debt trap. Rising mar- could become much more painful in the near future. ket interest rates for the burgeoning public debt – about two trillion euros – will make refi nancing via private capital One cause for the downgrade mentioned by S&P was that markets less and less feasible. The deteriorating market the fi nancial reforms proposed by the former Italian gov- sentiment for Italy, indicated by the country’s credit de- ernment of Silvio Berlusconi provided no expectation of fault swap (CDS) rate through August 2011, is shown in a major adjustment to the current weaknesses. The key Figure 1. Similar to Greece, Italy might end up in a sover- elements for Italy’s recent S&P downgrade are: eign default situation. This would ultimately put the fi nan- cial stability of the entire euro area at risk. • “Weakening real and nominal growth prospects. • What we view as signifi cant political impediments to The Core Debt Problem: Lower Growth but not Low- growth-enhancing reforms. ered Public Expenditures • High gross and net general government debt. • Limited commitment to expenditure cuts under the However, in addition to these weaknesses, the rapid in- current medium term fi scal programme.”1 crease of the Italian state’s indebtedness has rendered the country’s fi scal position unsustainable since the early The underlying factor for the current downgrade is the 1990s. Italy’s public debt is currently at its highest level weakness of Italy’s long-term growth perspectives, which have up to now not been addressed properly by the Ital- 1 Standard & Poor’s: Republic of Italy, Ratings Direct – Global Credit Portal, Message from 19 September 2011, London. 2 R. Sanderson: S&P downgrades seven Italian banks, in: Financial * German Institute for Economic Research, Berlin, Germany. Times, Message from 21 September 2011.
Intereconomics 2011 | 6 332 Fiscal Policy
Figure 1 statements4, they were ignored by the German chancel- Credit Default Swap Rates for Italy lor Helmut Kohl and the fi nance minister Theo Waigel. In- Aug. 2006 – Aug. 2011. stead Waigel pushed to establish the Stability and Growth Pact to prevent future eurozone states from drifting into 500 fi scally unsustainable positions and having to be bailed 450 out by the other member countries.5 From the beginning, 400 however, the Maastricht criteria were not taken seriously 350 by most European politicians. Even Germany had to re- sort to tricks to match the three per cent debt criteria in 300 1997. So it comes as no surprise that other countries used 250 fi nancial engineering to hide parts of their fi scal defi cits 200 from the offi cial statistics collected and published by Eu- 150 rostat.6
100 This includes Italy, which has never been in line with the 50 Maastricht Treaty’s debt-to-GDP criterion since being ad- 0 mitted to the eurozone in 1997. Italy was able to reduce its 07 8 9 9 09 0 0 10 11 . . 07 08 . 10 g. 10 v. g. ov ay ov. eb ay 10u o ay 11 debt burden only due to lower refi nancing costs when the Aug. Nov.06 06Feb. May07 07Aug N Feb. M0 Aug. Nov.08 08Feb. May Aug. N09 F M A N Feb. M11 Au interest rates of Italian government bonds plummeted to Source: Bloomberg. a level which had previously only been common to Ger- many (see Figure 2). This huge benefi t in interest rate sav- ings was used to expand the total amount of government bonds so that the underlying debt burden increased. In- since WWI. Italy crossed the 100 per cent debt-to-GDP- stead of paying double-digit interest rates as it had before ratio threshold in 1992 and has never managed since to 1997, Italy could expand its debt without facing higher fi - bring the ratio below this threshold.3 nancing costs due to the interest rate savings which cut fi nancing costs by more than half compared to the previ- The opening of Eastern Europe as a newly accessible ous levels. low-cost labour market put those countries at the south- ern periphery of the future eurozone under massive cost Only since the onset of the global fi nancial crisis has the pressure. Previously, Italy and other Mediterranean coun- interest rate spread between German and Italian gov- tries were regarded among European companies as low- ernment bonds started to diverge again. The temporary cost destinations for European investment. This location- decline of Italy’s debt-to-GDP ratio after 1997 concealed al advantage shifted after German unifi cation and the col- the fact that the actual amount of outstanding debt was lapse of the Soviet Union. With the eastward enlargement increasing; the reduced fi nancing costs for becoming a of the EU, the problems became even more pronounced member of the eurozone and the immediate interest rate for Italy. Nowadays Bulgaria and Rumania are the lowest convergence to the lower German interest rate levels cost destinations in the EU area. To stay competitive un- overcompensated for this effect. Italy could simply shrink der this global shift, Italy would have had to have adjusted its debt-to-GDP ratio by refi nancing its older debt at sig- its economy accordingly. This, however, never happened. nifi cantly lower fi nancing costs. Instead, hope was placed in the belief that the New Econ- omy growth regime might offer new opportunities for Manipulation of the European System of National higher growth without lowering the income level in Italy. Accounts
If the Maastricht Treaty’s debt ceiling of 60 per cent had Faced with the problem that it could not meet the Maas- been taken seriously by the EU institutions, Italy would tricht debt criterion in 1997, Italy pressed the EU Commis- never have been admitted into the eurozone. When rep- resentatives from the German Bundesbank, such as the former president Hans Tietmeyer, started to make such 4 Welt-Online: Tietmeyer wünscht Rom in der EWU – Bekräftigung zur Einhaltung der Euro-Kriterien – Duisenberg zum “Banker of the Year” gewählt, Online-Message of 4 March 1997. 5 Article 125 of the Treaties of the European Union, the so-called no- bailout clause. 3 S.A. Abbas, N. Belhocine, A. ElGanainy, M. Horton: A His- 6 G. Erber: Staatsverschuldung und Financial Engineering, in: DIW- torical Public Debt Database, IMF Working Paper WP/10/245, Interna- Wochenbericht 36/2011, 7 September 2011, German Institute for Eco- tional Monetary Fund, Washington DC, November 2010. nomic Research, Berlin, pp. 11-19.
Intereconomics 2011 | 6 333 Fiscal Policy
Figure 2 Long-term Interest Rates for Ten-year Government Bonds of Italy and Germany 16
14
12
10
8
6
4
2
0
r. 2002 . 2011 p Jul. 2007 an Jul. 1993 Apr. 1995Nov. 1995Jun. 1996 Jul. 2000 A Jun. 2003 Apr. 2009Nov. 2009 Feb. 1994 Sep. 1994 Jan. 1997 Aug. 1997 Mar. 1998 Oct. 1998 May 1999 Dec. 1999 Feb. 2001 Sep. 2001 Nov. 2002 Jan. 2004 Aug. 2004 Mar. 2005 Oct. 2005 May 2006 Dec. 2006 Feb. 2008 Sept. 2008 Jun. 2010 J Aug. 2011 Italy Germany Source: ECB.
sion and the other member states to focus on the three ciated signifi cantly, giving Italy a large currency profi t per cent defi cit-to-GDP criterion as the key indicator and on its borrowing. Italy did a currency swap to lock in the tendency in 1997 to reduce the debt-to-GDP ratio. its profi ts. The swap was off-market. In a normal swap, The Italian government of Silvio Berlusconi also took ma- you set the exchange rate at the time the swap is done jor steps to hide its fi scal defi cits from the public. (i.e. December 1996 – G.E.); Italy set the exchange rate at May 1995; this meant it gave up its currency gain. Italy pushed through national accounting standards for Not quite. Under the swap, Italy paid a rate of the dol- Eurostat’s debt and defi cit measurement in 1995, which lar minus 16.77%! Given that LIBOR rates were around offered a way to reduce the offi cial debt and defi cit num- 5.00%, this meant that Italy had accepted a bad ex- bers through fi nancial engineering.7 Eurostat initially re- change rate and received cash in return. The payments sisted these changes, and if this resistance had been were used to reduce the defi cit.”8 successful then moving debt from one year to another would not have changed the overall debt calculations, If this statement is correct, a look at the lira-yen exchange which would have made the window-dressing opera- rate development at this time (see Figure 3) shows that it tions employed by Italy and Greece ineffective. Ultimately, was an ideal time for this kind of carry trade and currency however, Eurostat was forced by the European Commis- swap operation. Quite unusually, the lira-yen exchange sion and the EcoFin Council to accept the changes in the rate dropped from about 16 lira per yen in November 1994 accounting framework. to reach its low at the end of April 1995. This was when Italy issued the 200 billion yen bonds. Over the following The means of Italy’s fi nancial trickery were currency months, the lira depreciated signifi cantly to reach a tem- swaps between Italian lira and Japanese yen arranged by porary peak of 13.4 lira per yen in December 1996, an ap- Morgan Stanley. preciation of 31% in just a few months. This was locked in by the currency swap of the Italian government with the “In May 1995, Italy had issued a 200 billion yen bond deferred purchase price arrangement. The question aris- ($1.6 billion). By December 1996, the yen had depre- es: did the Italian central bank engage in major currency interventions to make this highly profi table deal feasible?
7 G. Piga: Derivatives and Public Debt Management, Research Report delivered to the International Securities Market Association, Zurich 2001. 8 F. Partnow: Infectious Disease, Owl Books, New York 2004, p. 567.
Intereconomics 2011 | 6 334 Fiscal Policy
We also have to keep in mind that before the euro was Figure 3 introduced, the ECU system limited the bilateral exchange Lira-Yen Exchange Rate rate fl uctuations of ECU member state currencies. If the Aug. 1993 – Dec. 1998 200 billion yen were issued in May 1995, then the profi t 25 the Italian government made from the carry trade com- bined with the currency swap in December 1995 was a 20 little more than 791 million US dollars (using the yen-lira and lira-dollar exchange rates of December 1996). Even 15 shifting this amount to 1997 as pure revenue for the Italian government to lower the defi cit and debt ratios could not by itself explain the decline reported in the offi cial Euro- 10 stat statistics. 5 One possible explanation is that this might not have been the only transaction engaged in by the Italian government 0 Aug. Aug. Aug. Aug. Aug. Aug. to bring down its defi cit ratio. It is possible that the curren- 93 94 95 96 97 98 cy swap deal was combined with an interest rate swap, Lira Yen exchange rate Carry Trade betting on the expected lower interest rates in 1999 after Italy had been admitted into the eurozone (see Figure 2). Source: Oanda.
Another possibility is that the size of Italy’s GDP reported to Eurostat was heavily distorted upwards. It is well-known that Italy includes an estimate of its shadow economy to 22% of the national GDP. In 2009, this would have been signifi cantly mark up its offi cial GDP numbers, producing more than 334 billion euros. This is a huge amount with an upward bias which lowers the Italian debt and defi cit which one could manipulate the national accounts data. ratios.9 Dell’Anno and Schneider estimate the size of the Since the relationship between the formal and informal Italian shadow economy as 26% of GDP in 1994/95, which economies varies over time, it would have been possible increased to 27.3% in 1997/98. If similarly high values were to generate any number needed by the Italian Statistical used to increase the offi cial GDP statistics, this could have Offi ce in order to conform with the debt und defi cit cri- lowered the debt- and defi cit-to-GDP ratios signifi cantly. teria. Combined with fi nancial engineering, there is likely More recent research challenges the high estimates pre- no reliable measure of fi scal debt control by an outside sented by Dell’Anno and Schneider. If the Italian shadow institution. Thus there is essentially no reliable database economy were indeed much smaller, Italy’s debt and defi - against which the current measures undertaken by the cit ratios would be much higher than reported in the offi cial Italian government can be checked. statistics.10 Increasing the size of the shadow economy and raising the GDP numbers would have had a major impact By taking huge defi cits of -7.4% in 1995 and -7.0% in on the calculations for entering the eurozone. Questions re- 1996, the Italian government probably obtained huge garding the huge 4-5% drop in Italy’s defi cit-to-GDP ratio in upfront payments in 1997 and 1998 to reduce its defi - the years 1997 and 1998 remain unanswered.11 cits to -2.7% and -2.8%, respectively. This made the debt and defi cit reduction trends look quite impres- An A.T. Kearney12 study on the shadow economy in Eu- sive to an uninformed outsider. The Italian government rope estimates the size of the Italian shadow economy at could claim that it had taken major steps to reduce its defi cit and debt to be able to enter the eurozone. But
9 R. Dell’Anno, F. Schneider: The Shadow Economy of Italy and alas, this was just an outcome of window dressing via other OECD Countries: What do we know?, in: European Journal of fi nancial engineering. Once Italy had been admitted into Political Economy, Vol. 21, No. 3, September 2005, pp. 598-642. the eurozone, it was rewarded with the huge interest rate 10 H.-G. Petersen, U. Thiessen, P. Wohlleben: Shadow Economy, Tax Evasion, and Transfer Fraud – Defi nition, Measurement, and Data reductions shown in Figure 2. This presented Italy with Problems, in: International Economic Journal, Vol. 24, No. 4, 2010, the opportunity to further reduce its debt through lower pp. 421-441. interest rate payments while at the same time expanding 11 R. Basile, B. Chiarini, E. Marzano: Can we Rely upon Fiscal Policy Estimates in Countries with Unreported Production of 15 Per the debt volume. Cent (or more) of GDP?, CESIfo Working Paper No. 3521, Munich, July 2011. When the cheating to fulfi l the Maastricht criteria was 12 A.T. Kearney: The Shadow Economy in Europe, 2010 – Using elec- tronic payment systems to combat the shadow economy, A.T. Kear- revealed to the public in 2001, Eurostat changed the ac- ney, in Cooperation with F. Schneider and VISA Corp, 2010. counting rules to block such methods of artifi cially reduc-
Intereconomics 2011 | 6 335 Fiscal Policy
ing the debt and defi cit burden.13 However, neither the EU Figure 4 Commission nor the European Council took any steps to Italy’s Defi cit-to-GDP Ratio remove Italy and Greece – which had also managed to 1995-2010 14 enter the eurozone via fi nancial engineering – from the 5 6 97 02 eurozone. 0.0 199 199 19 1998 1999 2000 2001 20 2003 2004 2005 2006 2007 2008 2009 2010