The BTP-Bund spread: public debt, banks, financial intermediaries, financial markets and the economy in Italy

by Fabiano Colombini

 

Abstract: This paper analyses the BTP-Bund spread evolution by focussing on the  impact it has on public debt, banks, financial intermediaries, financial markets and the Italian economy  during the period January-to-October 2018.

In this regard, the BTP-Bund spread represents the difference between the yield of Italian bonds and that of German  bonds on the respective 10-year maturities. The spread level undergoes fluctuations almost daily, which concretely indicates the risk inherent in the issuer and, therefore, the higher or lower level of the cost of new issues of public securities on the basis of the higher or lower level of the spread.

The debt-to-GDP ratio, which is higher than 130 percent, simultaneously expresses an intrinsic weakness of the Italian economy regarding new production capacity wealth. This is a crucial result of low economic growth which increases the public debt level. This result can be ascribed to the economic policies pursued by Italian governments that have been negligent as to removing structural barriers, as well as dealing with serious financial crises since 2007 up to the present.

The structural factors that impact negatively on economic growth in Italy are tax evasion, corruption, excessive bureaucracy, an aging population, an imbalance between north and south, and protracted judicial processes. The negative impact of the latter factor is estimated at around one percent of the GDP in a year period.

In this context, the spread is an indirect measure of the ability of a state to repay the credit it received and, therefore, its insolvency risk. The spread is also a measure of investor confidence in the securities the state issued. A higher spread results in lower investor confidence in respect of public securities placed on the market and, as a consequence, higher spread increases the interest rates applied on public issues in the time frame taken into consideration. This, overall, has a negative impact on the total cost of debt.

This indicates the importance of elaborating fiscal policies and economic policies that pursue control over the spread trend, which should be considered a variable that cannot move without due supervision.

The increase in the spread and the consequent negative impact on the balance sheet asset values, and on the  share values, imply asset losses for all investors in public securities, as well as for investors in the capital of banks and other financial intermediaries. The downgrade by rating agencies, at the same time, caused significant drops in asset values. Evidently, the high level of public debt is a serious problem that has been lingering for many years and weighs heavily on the Italian economy. Although there are remedies for the problem, the will to impose and bring them forward seems to be lacking.

Despite a scenario of progressively increasing rates and yields, the increase and the instability in the performance of the 10-year  BTP-Bund spread has caused negative repercussions on bank stability, which is essentially expressed by fluctuations in asset values, higher collection costs, and continued negative impact on the expansion of loans and public securities.

Economic growth can be achieved by means of a strong push towards public and private investments through banks’ and financial intermediaries’ financial support and that of the financial markets.

The importance of strengthening  banking, insurance, mutual funds and financial markets has to be emphasised. Instability and increases in the spread that have occurred since the Conte government’s establishment do not provide good assumptions, but rather tend to complicate the situation, with risks leading to large-scale financial crises and economic recession in Italy.

Summary: 1. Introduction – 2. Spread and public debt – 3. Spread and banks – 4. Spread, financial intermediaries, financial markets and the economy – 5. Conclusions

1. The BTP-Bund spread represents the difference between the yield of Italian bonds and that of German  bonds on the respective 10-year maturities. The spread level indicates the risk inherent in the issuer and, therefore, the higher or lower level of the cost of new issues of public securities on the basis of the higher or lower level of the spread. Therefore, the spread constitutes the financial markets’ risk perception vis-à-vis that of individual states.

In this study, the spread considers differences in Italian BTP yields compared to German Bund yields across their respective 10-year maturities.

Why is the German Bund used as a reference or benchmark? This is because in the euro area the German economy is the strongest, and therefore presents balanced public finances. It is worth pointing out that the German Bund is considered risk-free because the issuer is very solid, whereas the Italian BTP carries a higher risk level because the spread is higher.

Italy dynamically highlights an upward or downward spread compared to Germany and considers how the financial markets perceive the economic and financial conditions to be worsening or improving. In the current year, 2018, the spread exhibits a considerable increase in the transition from the Gentiloni government to  the Conte government [1]. The uncertainty about fiscal measures and relations to European institutions have contributed to increases in the risk premium on Italian government bonds [2]. Thus, as is reported in Figure 1, the spread shows increases after the appointment of the new government on 1 June 2018, and also in the preceding months.

Figure 1: Spread BTP-Bund trend (January 2018-October 2018)

Source: Data from website – Investing.com.

As Table 1 below reports, in the period from January to April 2018 the spread showed the highest value of around 163 points in January, while in the period from June to October 2018 the spread reached the value of 340 points in October. In the evolution of the country’s policy and government, by October 2018 the spread increased to more than double the rate of January 2018.

Table1: Spread BTP-Bund. Descriptive statistics 

Gentiloni Government		Conte Government
MEAN	134,2432	MEAN	256,8744
MAX	162	MAX	340
ST. DEV.	11,25376	ST. DEV.	30,29907

Source: Data from website – Investing.com.

Regardless of the outlook for the various changes considered below, the deterioration per se implies a rise in interest expenditure on new issues of government bonds, which escalates the public expenses and, therefore, negatively affects the rise in public debt that still weighs down Italian citizens, and especially also affects future generations.

One has to note that a high level of public debt greatly reduces the room for manoeuvring fiscal policies for anti-cyclical purposes.

The debt-to-GDP ratio, which is higher than 130 percent [3], simultaneously expresses an intrinsic weakness of the Italian economy regarding new production capacity wealth. This is a crucial result of low economic growth which increases the public debt level. This result can be ascribed to the economic policies pursued by Italian governments that have been negligent as to removing structural barriers, as well as dealing with serious financial crises since 2007 up to the present [4].

The structural factors that impact negatively on economic growth in Italy are tax evasion, corruption, excessive bureaucracy, an aging population, an imbalance between north and south, and protracted judicial processes. The negative impact of the latter factor is estimated at around one percent of the GDP annually [5].

Frequent occasions of slow justice over a long time and without any corrections, have proven to be truly important and significant in terms of the reduced ability to increase Italy’s wealth. Equally important is the macroscopic figure of tax evasion estimated at around 130 billion euro annually, which positions Italy very unfavourably in the context of European countries. Extended over time, these factors deplete public administration resources, thus exacerbating public debt [6].

In the period from 2001 to 2007, Italy showed a decline in productivity, measured in terms of the GDP per hour worked, equal to -0.01 per cent annually. This positions the country last in the ranking of industrialised countries’ productivity. Between 2010 and 2016, Italy’s productivity increased by +0.14 percent per year, thus achieving the worst result after Greece [7].

Italy stands out as a model of low technological innovation combined with inefficiency and uncertainty in justice.

The structural factors mentioned above represent serious obstacles to economic growth. Ignoring them, or leaving them unaltered, will create serious problems for Italy in the European and international context.

In this regard, the spread is an indirect measure of the ability of a state to repay the credit it received and, therefore, of its insolvency risk. The spread is also a measure of investor confidence in the securities the state issued. A higher spread results in lower investor confidence in respect of public securities placed on the market and, as a consequence, higher spread increases the interest rates applied on public issues in the time frame taken into consideration. This, overall, has a negative impact on the total cost of debt. Here, again, we find ourselves considering the case of increased public spending and related public indebtedness.

This indicates the importance of elaborating fiscal policies and economic policies that pursue control over the spread trend, which should be considered a variable that cannot move without due supervision.

The Austrian Government of Chancellor Sebastian Kurz, for example, has proceeded to reduce the deficit on GDP to almost zero level as it considered lowering and even zeroing the deficit on GDP, as well as a structural correction towards the recovery of areas of freedom in conducting fiscal policy, to be important.

This circumstance emphasises that in the European and international context, reducing the GDP deficit gap is a compelling pursuit to be actualised through economic policies and individual economies.

2. The level of the spread between the yields of the public securities of a single country and the yields of public securities of Germany reflects the economic and financial conditions of a single country, and so expresses the indications and investors’ judgment on the state’s ability to repay its debt. Economy, finance, economic and fiscal policies of the individual country thus enter into the full evaluation and consideration of the investors which are composed of domestic and foreign investors, as shown in Figure 2, the Italian debt placed indicates a  68 percent distribution to residents and 32  percent to non-residents [8], allowing for oscillations and changes in preferences from one period to another.

Figure 2: Italian public debt composition

Source: Banca d’Italia, Finanza pubblica: fabbisogno e debito, 2018.

An increase in the spread implies an increase in the cost of new issues of public securities, which increases public interest expenditure and, at the same time, overall debt. Increases in public spending and public debt tend to worsen public finances, creating assumptions towards recessionary pressures and, therefore, bringing quite the opposite of the economic growth objectives indicated in the Conte government budget proposal. The trend of spreads and its dynamism presuppose modalities of control.

A fundamental point should be emphasised: a very low spread level of close to zero would make encourage the use of international and domestic markets for the issuance and placement of public securities, as this would, from a European and international perspective, imply financing at the lowest rates.

A high level of public debt, expressed above the 130 percent of the debt-to-GDP ratio, as in the case of Italy, raises many questions and many doubts about the state’s ability to control the spread because the higher the debt, the larger the renewal needs. At the same time, it is important to consider the average maturity, as a longer average maturity implies more margins for adjustment.

It is necessary to underline that a high level of the debt-to-GDP ratio  implies an imbalance and a structural gap that can trigger financial instability through the spread increasing and, therefore, negative value oscillations in the public bonds. Simultaneously, negative oscillations in the portfolios of government securities in banks’ assets have a negative impact on prices, thus creating a vicious circle which repeats the mechanisms of the sovereign debt crisis that, until recently, has been plaguing Europe. This circumstance shows negative elements both for Italy and for Europe. Italy does not live just including geographical borders of the boot. Economic relations go far beyond national borders. To rekindle and resuscitate the sovereign debt crisis with all the related negative effects would be very risky for Italy, Europe and the euro.

Hence, Italy represents an example of structural weakness that generates increases in the spread dynamics, starting from the high level of the debt-to-GDP ratio, together with repeated imbalances in the budget that delivers a relatively high deficit-to-GDP ratio. At the same time, negative fluctuations in the values ​​of bank assets, as well as in the values ​​of bank shares and the ability to provide loans to customers, raise critical issues in the banking context that appear difficult to control.

The increase in the spread and the consequent negative impact on the balance sheet asset values, and on bank share values, imply asset losses for all investors in Italian public securities and in the capital of banks and other financial intermediaries. The downgrade by rating agencies caused significant drops in asset values. Evidently, the high level of public debt is a serious problem that has been lingering for many years and weighs heavily on the Italian economy. Although there are remedies for the problem, the will to impose and bring them forward seems to be lacking.

Regarding the downgrade by rating agencies expressed in October 2018, we need to note that Moody’s cut Italy’s sovereign debt rating to one notch above junk status because of concerns about government budget plans, but it found the outlook to be stable, while Standard & Poor’s affirmed Italy’s existing credit rating but lowered its outlook from stable to negative because of concerns about government’s policies on economic growth prospects.

3. Instability in the spread with a rising tendency, produces a weakening of the banks that can extend to the level of capitalisation. This engages a dangerous mechanism that leads to a reduction in loans to the economy and, therefore, reduces the foundations for economic development that largely extend from adequate financing of companies and, in particular, small and medium-sized enterprises.

The financial turbulence in the euro area has highlighted the strong link between the credit risks of states and banks. Thus, the subprime mortgage financial crisis of 2007 caused the transmission of credit risk from the banking system to the public system. This gave rise to increases at the level of public expenditure and primary deficits or in public spending alone, leaving the primary deficit unchanged and so limiting fiscal correction possibilities. The second hypothesis implies balanced public finances and maintaining such equilibrium, thus producing no impact on the credit risk of public securities. This contrasts with the first hypothesis which focusses on the state’s debt situation worsening, which introduces more or less serious deterioration factors and negatively impacts on the credit risk of public securities. The sovereign debt crisis caused the transfer of credit risk from the public system to the banking system to absorb value fluctuations arising in the context of government bonds due to still being present in the security portfolios of banks.

The increase in credit risk on public issuance is replicated in the market of credit default swaps (CDSs) showing its effect in the solvency of the states. Initially due to the subprime mortgage financial crisis, and later, more intensely, due to the sovereign debt crisis, the volumes of trading in derivatives under discussion showed an exponential growth in the economic choices of investors and in the strategies applied by the monetary authorities.

The measures that many states put in place to protect their banking systems and to overcome the economic recession increased the trade in CDSs. In particular, holders of government bonds poured into the market in question to purchase protection against a possible issuer default. In this regard, the crises manifested in Greece, Ireland, Portugal and Spain produced significant trade in the relevant CDSs.

Interestingly, although CDSs exist in almost all countries, many in emerging countries have characteristics that, given the lack of negotiation institutions, are intrinsically distinguished by high volatility. Given the circumstances, it is no coincidence that many parties have detected how the speculative attacks on CDSs provoke fluctuations in the relative prices and, consequently, have a considerable impact on the ability states subject to speculation have to finance at competitive rates.

Notably, CDSs usually imply worsening in state debts, generating increased spreads in sovereign debts perceived to be at greater risk and, as a consequence, the most exposed banks in these countries suffer losses in their financial instrument portfolios as their bonds, shares and derivatives.

Although there are many sales, the financial intermediaries represent the main holders of government securities. Therefore, the large sales that affect the government bonds of the countries most at risk subject the portfolio of financial instruments to heavy devaluation.

One can easily see that the hypothesis of imbalances in public finances through rescue plans, is affected by a return wave of credit risk initially transmitted by the banking system to the public system. This demonstrates the fact that if the sustainability assumptions of the credit risk the financial sectors generated are ignored, the process manifests diffusive and multiplicative features.

In such a context it is important to underline some points:

• Banks provide liquidity to the economy by broadly financing the private sector in various forms of loans to the economy; at the same time, they provide public sector financing to a large extent through purchasing public securities.
• Despite a scenario of progressively increasing rates and yields, the increase and the instability in the performance of the 10-year BTP-Bund spread has caused negative repercussions on bank stability, which is essentially expressed by fluctuations in asset values, higher collection costs, and continued negative impact on the expansion of loans and public securities.
• In the formulation of economic and fiscal policies it is for the reasons indicated above, necessary to consider and neutralise the negative impact on the spread.

The expansionary policies governments pursue should aim to avoid an increase in the spread due to the consequent negative impacts on banks and their ability to finance the economy by granting  loans to the private sector and buying securities to the public sector.

It also follows that the mere objective of increasing economic growth can be nullified by an increase in the spread and the related negative repercussions on  banks [9].

4. Economic growth can be achieved by means of a strong push towards public and private investments through banks’ and financial intermediaries’ financial support and that of the financial markets.

The importance of strengthening  banking, insurance, mutual funds and financial markets has to be emphasised. Instability and increases in the spread that have occurred since the Conte government’s establishment do not provide good assumptions, but rather tend to complicate the situation, with risks leading to large-scale financial crises and economic recession in Italy.

More generally, commercial banks  can offer public and private financing through loans to public and private companies, and through purchasing public and private securities; insurance companies can do so through purchasing public and private securities, or mutual funds contribute to financing through purchasing public and private securities, while financial markets contribute through placements and purchases of corporate bonds and shares.

The increase in the spread expresses negative repercussions in granting loans and in purchasing public and private securities at the initiative of banks, insurance companies, mutual funds and financial markets. Further, the increase introduces negative and weakening elements to the ability of banks, financial intermediaries and financial markets to finance the economy.

Hence, we reiterate the importance of elaborating and conceptualising political and economic issues that, for the reasons indicated above, do not negatively impact on the spread. Economic policies should tend to reduce the spread for cost advantages and business competitiveness.

The stability and lowering of the spread to levels close to zero should be a priority and not a secondary objective in a country’s economic and financial choices, due to the positive effects such spread will have on the cost of public funding, and on the cost of private financing. Further positive effects will be evident in grafting virtuous elements towards the process of economic growth that would be boosted by the lower cost of capital. Such lower cost is required for realising investments and production processes.

Increase and instability of the spread in the Italian BTP-German Bund across 10 years simultaneously show negative repercussions on financial market trends with reductions in the value of bonds and, especially, BTPs and in banking and financial equity. Additionally, they are also similar in creating obstacles on the basis of their capacity for new equity and even bond placements.

One has to recognise that the bond and equity placements attest to the industrial and financial firms’ abilities to find resources of medium, long and indefinite terms that are best suited to supporting investments in input and new technologies.

In this context, the negative repercussions of high spreads and spread instability appear to be broad and different in intensity. They tend to involve banks (usually the most affected), insurance companies (affected at different intensities), mutual funds (affected in performance and in value fluctuations), and financial markets (affected by financial instability).

5. In the EU, the European Central Bank’s pursuit of expansionary monetary policies has presented a frame and a general framework for all EU-membership countries. The advantages of accommodative monetary policy were, however, not reflected equally in the economies of individual countries.

Quite obviously, the weakest countries in terms of economic growth should address the problem of reducing structural barriers to economic development through reform and, at the same time, should carefully consider the level of the spread of national government bond yields compared to yields of German public securities.

By retaining the spread at high levels (for example in the case of Italy), mechanisms of higher cost of interest expenditure on public debt, higher cost of fund collection, higher interest rates on bank loans to companies, and higher cost in the placement of corporate bonds are maintained. As a result, more obstacles to economic development remain.

Therefore, the BTP-Bund spread is not a slightly weighted, minor variable, but a variable of crucial importance. It relates strongly to the damage fluctuations  in the spread increase due to its negative impact on banks’ asset values,  insurance companies’ and mutual funds’  holding public securities, and on  bank and financial share values. Therefore, the BTP-Bund spread greatly affects the performance of financial markets. This points to the importance of the spread for adjustments to and the impact on various variables and on the financial system as a whole.

The subprime mortgage financial crisis and, in particular, the sovereign debt crisis have brought to the attention the spread and the dangers inherent in the increase in the spread, which are due to the negative repercussions of a higher spread on public accounts, public debt, the financial system and the economic system.

The choices of the Italian government seem to ignore the recent history of financial crises with all the dangers that financial instability hold and that have resulted from the financial instability inherent in the crises and bankruptcies of banks and financial intermediaries, in the crises and failures of financial markets, and in the events of economic crises themselves.

Italy’s financial and economic problems derive from the structural factors explained above and that have been dragging on for many years. The challenges have certainly not been suitably addressed or resolved with measures of financial assistance; rather they have been exacerbated by increases in public spending and in public debt accompanied by increases in the spread, as well as by banking and financial instability already noticeable in the current phase.

  

[1] Regarding the relationship between politics and economy, see Capriglione F., Crisis of politics and economic process. The case of Italy, Open Review of Management, Banking and Finance, Volume 4, Issue 1, 2018.

[2] See Visco I., Address, ACRI, 2018 World Savings Day, Rome, 31 October 2018.

[3] See Banca d’Italia, Bollettino Economico, Aprile 2018.

[4] See Colombini F., Calabrò A., Crisi finanziarie. Banche e stati. L’insostenibilità del rischio di credito, Torino, Utet, 2011; Colombini F., Risk, regulation, supervision and crises in the European Banking Union, LEYR, vol. 4, part 2, 2015.

[5] See Banca d’Italia, Considerazioni finali del Governatore della Banca d’Italia, Roma, 31 maggio 2011, p. 12: “Nostre stime indicano che la perdita annua attribuibile ai difetti della nostra giustizia civile potrebbe giungere a un punto percentuale”.

[6] See Cottarelli C., I sette peccati capitali dell’economia italiana, Milano, Feltrinelli, 2018.

[7] See OCSE, Compendio degli indicatori di produttività, 2018.

[8] See Banca d’Italia, Finanza pubblica: fabbisogno e debito, 2018.

[9] See Blanchard O., Zettelmeyer J.,  The Italian Budget: A Case of Contractionary Fiscal Expansion?, Peterson Institute for International Economics, 2018.

Author

Fabiano Colombini is Full Professor of Economics of Financial Institutions and Markets at the Department of Economics and Management, Pisa University, Italy.