• Richard Walker

Accessing the TPI is fine, but sooner or later you run out of somebody else’s money...

Updated: Jul 27

Executive Summary

  • On September 25th Italy will elect its 67th government since the second world war

  • This comes at a time of soaring Inflation in Europe and elsewhere

  • Italian BTPs touched a yield of 4.3% in the middle of June

  • The ECB released its ‘anti-fragmentation’ tool last week, designed to prevent widening of sovereign debt spreads

  • The ECB also raised rates by 50bps, 25bps more than forecast

  • Italy has a very large debt to GDP ratio and a large amount of bonds maturing in the near term (around €1Trn of bonds to refinance from 2022 to 2025).

The State of play in Italy

The split of Mario Draghi’s coalition government has triggered elections in Italy. The crisis was sparked by the Five Star Movement, which has been critical of Italy’s military support for Ukraine. Subsequently Matteo Salvini’s League and Silvio Berlusconi’s Forza pulled out of the coalition, leading to Mario Draghi’s resignation.


The elections on September 25th will see Italy return its 67th government since World War II. This snap election is the first that Italy has held in the autumn months - usually the time for putting together the budget for the coming year.


These elections are also the first to be fought with a slimmed-down Italian Parliament. Following a referendum in 2020 the number of MPs in the Parliament will be reduced from 630 to 400 in the Chamber of Deputies, and from 315 to 200 in the Senate.


Figure 1 - Countries ranked by Debt to GDP

Italy is servicing a very large debt, at over 150% of GDP Italy has the sixth largest sovereign debt relative to the size of its economy according to World Population Review (see figure 1 above). Not only is this debt large relative to the size of the economy, but a large amount of BTPs need to be refinanced in the next couple of years.


The chart below shows the comparison of the debt maturity ladder between Italy and the UK (figures converted to Sterling for comparison). As can be seen Italy has a large amount of debt that needs to be refinanced in the near term. Around €1Trn between now and 2025. (Maturity data and much other useful infomation can be sourced from the UK's DMO and Italy's MEF).

Figure 2 - Italian Debt Maturing by year (Green). Compared to the UK Debt Maturity (Red)

The ultra-low policy rates of the past decade-and-a-half have encouraged many governments to increase borrowing. With rate hikes now happening in Europe and the US to counter inflation, the costs of refinancing look set to increase.


The wider European context

The Italian elections come at a time of high and increasing inflation in Europe and in other parts of the world. In response to inflationary pressures the ECB has chosen to raise rates by 50bps, 25bps more than many commentators expected.

At the same time it announced details of its TPI - Transmission Protection Instrument. This is designed to prevent widening of Eurozone borrowing costs and “spread contagion”, the risk that a run on an individual countries debt sparks panic and a run on others. The goal is that TPI “will ensure that the monetary policy stance is transmitted smoothly across all euro area countries”.


Figure 3 - BTP (Orange) and Bund (Purple) Yields along with BTP/Bund Spread (Green)

The market has thus far reacted cautiously to Drag’s resignation and the announcement of the TPI. BTP/Bund spreads have widened to 241bps from 183bps at the start of this month. But these are still below levels seen at the beginning of the Covid 19 pandemic where they were briefly above 300bps.

Italy’s access to European aid

Mario Draghi's coalition had managed to secure access to around €200Bn in aid from the European Union, largely from the Covid recovery fund. This is contingent in adhering to a reform and investment program agreed between Rome and the European Commission. Thus far Italy has received a €25Bn advance and a first tranche of €21Bn linked to initial reforms in 2021. A second payment of €21Bn has been requested by Italy, this is currently being assessed by the European Commission. There are a set of reform milestones inlace to be met by December 31st 2022 in order to gain access to a third tranche of approximately €19Bn.


TPI to the rescue

The total aid earmarked for Italy in 2022 is therefore around €86Bn, but with over €1Trn of debt to refinance before 2025 the aid provided by the Covid recovery fund will be insufficient. Hence the urgent need for an instrument such as the TPI.


As with the recovery fund the TPI is not without strict conditions. Four eligibility criteria must be met:

  • Compliance with the EU’s "fiscal framework”

  • No “severe” macroeconomic imbalances

  • Sustainable public finances

  • “Sound and sustainable” macroeconomic policies; this includes compliance with the commitments under the EU recovery fund.

A key test will therefore be the issuing of the third tranche in December 2022. Will the incoming government continue to commit to reform? Will the European authorities cut Italy some slack and continue to make aid payments to Italy as well as fund BTP purchases under the TPI even if Italy doesn’t strictly comply?


Thus far the market seems to be answering both questions with a qualified and measured ‘yes’. For sure BTP/Bund spreads have widened, and as figure 4 below shows the 5yr CDS on BTPs has risen. But (thus far anyway) they have not spiked.


Figure 4 - Italian 5Yr CDS Spreads

Dutch clogs and Italian loafers

But the stakes are high, the sums required are vast. Much will depend on the commitment to reform of Italy’s new government post September. Much will also depend on the reaction of the frugal European countries - Austria, The Netherlands and Germany to these reforms. These countries have problems of their own and will not react favourably to fiscal profligacy on their borders.

Conclusions

  • The yield on the Italian 10-year BTP eased to 3.3% from the one month-high of 3.7% seen on July 21, mirroring the retreat for German Bund yields as energy security concerns and weak economic data heightened fears of a sharp economic slowdown.

  • Investors also continue to assess the risk on Italian debt amid the country’s political crisis and the effect that the TPI may have on averting fragmentation in the Eurozone.

  • Italy will hold snap elections on September after Prime Minister Draghi’s resignation marked an end to the national coalition that governed for 17 months.

  • Potential interruptions to ongoing reforms could jeopardize the access to EUR 200 billion of EU recovery funds, as well as eligibility for TPI relief. The spread between the 10-year BTP and Bund rose above 240bps, reflecting the perception of Italian debt risk.

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