- Modelling from Nomura shows Italy’s latest budget deficit is almost double the required limit to reduce its overall debt burden.
- Italian shares slumped and bond yields spiked overnight, as the new government refuses to cut its spending forecasts.
- The budget falls outside of EU rules on spending limits, and a showdown with top EU officials now looms later this month.
Asset classes across Europe got sold off overnight, as concerns grow about Italy’s mounting debt crisis.
And research from Nomura suggests it could be decades before Italy can rein in its government debt to a level that meets European Union rules.
The analysts noted that forecasting debt sustainability for a given country is an inexact science. For example, it requires an estimate of the output gap — the difference between an economy’s actual growth and its optimum potential.
“In short, it’s not something that can be easily calculated on the back of an envelope.”
However, they presented a model which acts as a useful guide for calculating the debt burden of a given country, based on the following three parameters.
1. The ratio between the headline budget deficit and GDP;
2. Nominal economic growth rate; and
3. The level of debt as a percentage of GDP.
By forecasting a constant rate for deficit-to-GDP and economic growth, one can calculate how long it will take to reduce overall debt-to-GDP levels.
Here’s what the resulting chart looks like (it looks complex, but we’ll explain):
The chart is based around the European Union’s Stability and Growth Pact, which states the member nations should aim for a debt-to-GDP ratio of 60%.
If it’s higher, then governments need to take measures to bring it back within the recommended range.
Italy’s debt-to-GDP is higher. How much higher? More than double the limit:
So based on Nomura’s model, Italy needs to bring its deficit down to 1.4% of GDP (left-hand axis in Chart 1).
Even then, it would take around 25 years (right-hand axis) for Italy to get back within the 60% range for overall debt-to-GDP, assuming a constant nominal growth rate of 2.5%.
Nomura said the 2.5% figure is based on IMF growth forecasts, along with the past 15 years of historical data for Italy’s economy.
The problem is, Italy’s latest budget will see the deficit rise to 2.4% of GDP, almost double the level in Nomura’s model. At that level, Italy’s debt-to-GDP ratio won’t get to the recommended limit for another 40 years.
And Italy said it doesn’t plan to start reducing the structural deficit until 2022.
The latest budget figures were met with warnings by the EU, who said the debt levels were in breach of EU spending rules.
But those statements were met by some fiery rhetoric from Italy’s deputy prime minister Matteo Salvini, who called those same officials “enemies of Europe”.
With both sides refusing to budge, a potential showdown looms later this month. In view of that, it’s perhaps not surprising that Italian stocks slumped by more than 2% overnight, while the country’s bond yields surged to a new four-year high.
The euro also fell sharply amid the chaos, with Italy’s debt crisis now shaping up next to trade war fears and rising US bond yields as one of the central challenges markets will have to navigate in the months ahead.