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Warning from the Bank of Italy

Teaser: The Italian central bank recently published a report that barely pleased the government of Rome, though it is worth the read.

Since spring, it has been well-known that the new Italian government has been on its way with expansive fiscal proposals. The hefty increased budget deficit has at the same time brought the EU Commission in Brussels up in the red field. That part is old news, though my expectation is that the battle will continue with rather tough collisions during the next few months. The financial market has reacted negatively a couple of times by selling out of Italian government bonds, hence the interest rate has been sent significantly upwards.

On 23rd November, the Bank of Italy issued a report dealing with the damage to the Italian economy that is already measurable, as a consequence of the rising yield curve.

The government in Rome will increase the budget deficit next year to 2.4 pct. of GDP, though the rumours say that it might be scaled-down to 2 pct. The irony, however, is that the game has already cost the economy more than the 2 pct. of GDP. One minor burden is the EUR 9 billion in increased interest rate payments on the government debt in 2020. The steep drop in bonds prices has cost households EUR 85 billion just during the first six months of this year, and since then, the bond market suffered even more losses. In addition, the Bank of Italy estimates that corporate borrowing costs have risen by two percentage points alone from the first to the third quarter. A quick calculation will easily show that the total loss exceeds the government’s growth package for 2019, though it should be mentioned that the package contains a large degree of income redistribution.

I pay big attention to the central bank’s analysis of how fast, and what effect the higher yield already has had on the stability of the banking sector and life insurance companies. Graphic one shows the liquidity ratio for Italian banks where the segment called “larger banks” saw an increasing ratio during the first half of 2018. As shown, the coverage is far higher than the required 100 pct. among the smaller banks. But in the really important group representing the biggest banking groups, the liquidity coverage fell by 16 percentage points from 160 to 144 pct. in just six months. This is significant, and again, the speed is very worrying- which Bank of Italy says is caused by the bond prices.

The central bank has calculated that a parallel shift of one percentage point in the government debt yield curve will send the liquidity coverage down to 120 pct. for the big banking groups. This is equal to the move in the bond market in May, thus giving an impression of how easily the big banks can be exposed to stress.

Financial stress is also a risk to life insurance companies, which would hit many private savings extra tough. As graphic two shows, Italians increasingly saving via life insurance products. The proportion of private savings through this channel has gone up from 11 pct. in 2008 to 17.3 pct. this year (June). As comparison, it can be mentioned that during the same period, the household’s allocation of investments in listed shares remained unchanged at approximately two pct.

But a big concern is that Italian government bonds amount to around one third in the portfolios of insurance company investments. One can almost by intuition, imagine how quickly stress in the financial markets can find its way into the portfolios of insurance companies. To secure the customers’ savings, the requirement for capital coverage among insurance companies is of course particularly high, and currently there is no risk.

However, just the decline in the bond market in the second quarter reduced the capital ratio by 23 percentage points to 225. Again, it underlines the speed, and this development has prompted the central bank to deal with this risk in their report. One can find a special piece about the importance for the Italian economy if interest rates rise further, for example, the effect on private savings in the insurance companies.

The Italian economy has not yet gone under and ironically, a high government debt often means that the country’s private sector is wealthy, as it is the case in Italy too – for some people at least. The Italian household debt is therefore also among the lowest in the Eurozone. Italy has a stable surplus on the trade balance and the public foreign debt is practically zero. The fact that the government debt is financed domestically is one of the reasons why Italy always has landed on both feet regardless of how stormy the economic situation has been. But despite these positive elements in the equation, the risk of turbulence in the country’s financial system rises, and thus for the whole economy.

The interest burden for everyone in the country is rising, and the consolidated positive macroeconomic effect is largely wasted before the government plans are launched is one thing.

But the rate of how fast the sale of government bonds within the past six months converted into measurable challenges for Italy’s economy weighs considerably in my risk estimates.

I assess the risk scenario for Italy to be more serious than 12 months ago, and one example is that Italy is moving closer to the feared junk bond status. At Moody’s (the rating agency), Italy already has a credit rating equivalent to BBB-and the other major rating agency Standard & Poor’s has indicated that the same credit rating for Italy is likely to come – just one nudge away from junk bond status.

It illustrates very well how Italy balances on a knife-edge, risking the deterioration to a significantly worse financial situation. A government rescue of the life insurance would be a catastrophe, but a part of the disaster is already happening due the to reports like the household losses on government bonds and the higher financing costs for the corporate sector – I can only repeat my prior assessments, that the Italian economy is still heading towards more trouble and it’s just a question on how much, and it’s looking heavy this time.

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