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Roubini Global Economics - Italy Should Restructure Its Public Debt Now
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Italy Should Restructure Its Public Debt
Now
By Nouriel Roubini
Nov 28, 2011 10:00:00 AM | Last Updated
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Italy’s public debt is rapidly becoming unsustainable as the country has a large and rising primary gap.
Now is the time to restructure its debt in an orderly manner, rather than delay and make a futile bid to
escape the inevitable default. The latter would only lead to the restructuring being disorderly.
The new technocratic government, led by the capable Mario Monti, unfortunately faces the same
constraints and problems as its discredited predecessor: Spreads are rising and policies imposed by
the markets, EU and ECB—fiscal austerity and structural reforms—are doomed to further weaken
growth in the short run and make the debt even more unsustainable.
Rather than wasting precious official resources (which currently aren’t even sufficient to backstop Italy
for the next three years) to prevent the unavoidable, such resources should be used to make the debt
restructuring orderly via a coercive but market-oriented exchange offer that provides both a par and a
discount bond with no collateral guarantees.
Even an orderly debt restructuring—that deals with Italy’s stock problems—would not resolve its flow
problems (i.e. the lack of growth/outright recession, the lack of competitiveness and the large current
account deficit). To resolve the latter needs a real depreciation that may require the eventual exit of
Italy and other member states from the eurozone (EZ).
It is increasingly clear that Italy’s public debt is becoming unsustainable and should be restructured
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immediately. Making the same mistake that was made in the case of Greece and wasting another year to
try to prevent the inevitable default and restructuring will mean the latter will be disorderly rather than
ECONOMIC RESEARCH
1. Italy Should Restructure Its Public Debt Now
orderly. The EZ’s apparent desire to eliminate private sector involvement (PSI) from the design of the new
ECONOMIC RESEARCH
European Stability Mechanism (ESM) on the basis that restructuring will never occur again is pig-headed:
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The markets now realize that it isn’t only Greece’s debt dynamics that are unsustainable. With public debt
CRITICAL ISSUE
at 120%, real interest rates close to 5% and growth at 0%, Italy would need a primary surplus of 5% of
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GDP rather than the current 0.5% expected for 2011 to stabilize its debt at this high level; i.e. the primary
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gap is currently about 4.% of GDP. Moreover, soon, real rates may be higher (if market and economic
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conditions worsen) and growth negative, making the primary gap larger and debt dynamics even more
unsustainable.
Moving to a 5% primary surplus—the bitter medicine that the ECB and Germany are now imposing on
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Italy and the other PIIGS—will make the Italian recession (like that in Greece) a depression, as raising
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taxes and cutting spending and transfer payments reduces aggregate demand and disposable income.
ECONOMIC RESEARCH
Even the much-vaunted structural reforms will make the recession worse for a while: You need to loosen
labor market laws to allow the firing of hundreds of thousands of public and private employees; you need
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to shut down thousands of loss-making firms; and you need to move labor and capital from declining
ECONOMIC RESEARCH
sectors to new emerging sectors in which you have a new comparative advantage. Furthermore, what are
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these phantom emerging sectors, given that Italy can’t have a nominal and real depreciation to restore its
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competitiveness and create new comparative advantages?
Thus, while the new technocratic government headed by the well-respected Mario Monti is much more
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STRATEGY
credible than the discredited Berlusconi regime, the basic macro and financial constraints have not
changed: Italy’s debt is becoming unsustainable and policies to reduce it will worsen the recession and
make the debt even more unsustainable. That is why markets have essentially ignored the good news of
Monti’s arrival and pushed Italian spreads to even higher and more unsustainable levels. Against this
background, Berlusconi is still scheming and is ready to pull the rug from under Monti as soon as it is
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Roubini Global Economics - Italy Should Restructure Its Public Debt Now
politically, judicially and electorally convenient for him to do so. The new government, assembled in a fit
of undemocratic desperation without the effective support of the two major center-left and center-right
coalitions (as it comprises only technocrats and doesn’t have any senior ministers representing the major
parties), has unfortunately been born wounded and weakened.
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Going back to fundamentals, even if austerity and reforms were to eventually restore Italy’s debt
sustainability, the loss of market credibility and the time that it will take to restore it require a lender of last
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resort (LOLR) to provide support and prevent sovereign spreads from exploding. Italy’s financing needs
for the next 12 months alone are not just the €400 billion of maturing debt and the expected flow deficits;
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at this point, most investors long in Italian securities would dump their entire holdings of Italian debt to the
sucker—ECB or European Financial Stability Facility (EFSF) or IMF or whoever else—that would be
willing to buy that debt at current yields as such yields (and capital losses) could become much higher if
that official support eventually dribbles down. So now, the entire stock of €1.9 trillion of Italian debt will
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soon be offered by the investors holding it if an LOLR is on the other side of this game. The IMF loans
(purportedly €600 billion) now circulating in news reports will also repeat the mistake of the Greek
program: By subordinating the existing debt to official lenders, the likelihood of PSI is increased and
recovery value is decreased, elevating yields and precipitating a flight to the exit.
So, using precious official resources to prevent the unavoidable is a huge mistake that will finance the exit
of those lucky enough to have claims maturing now and/or lucky enough to dump their claims on the
official sector. And since the official sector is effectively senior as provider of debtor-in-possession (DIP)
financing, the spreads on the remaining private claims will become—as in Greece—higher as such claims
become more junior in the presence of official financing.
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And not enough official money exists to backstop Italy (and soon Spain and possibly Belgium) for the next
three years: You would need €2 billion-3 trillion of real hard money, not the fake money of the two unableto-fly turkeys, the levered EFSF and EFSF SPIV. Even the current attempt to ramp up such resources
with IMF, BRICs, sovereign wealth funds and other international resources is bound to fail if the EZ core is
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unwilling to ramp up its own contributions—a much larger EFSF or ESM closer to €1 trillion—and if the
ECB is unwilling to play the role of an unlimited and unsterilized LOLR. Thus, recent press reports that
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the IMF is readying a €400 billion-600 billion program to backstop Italy for the next 12-18 months are, so
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far, hot air as the EZ (meaning Germany, the rest of the core and the ECB) is unwilling to provide
additional financial resources. And if Italy remains stuck in an uncompetitive recession and is unable to
regain market access in the next 12 months (a highly likely scenario), even if such large official resources
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were to be mobilized, they would be wasted by financing the exit of investors and thus postponing an
inevitable debt restructuring that would then be more likely to be disorderly.
Italy’s public debt thus must be reduced now—on a net present value (NPV) basis—to at least 90% from
the current 120%, or roughly a 25% haircut. Avoiding a formal default, this can be done with an exchange
offer with two options: A par bond (lengthening maturing bonds by 20-30 years) with a low enough
coupon, whose NPV debt reduction is equal to 25%; or a discount bond that has a face-value reduction of
25%. Both options should be made available—without the burdensome Brady-style collateral guarantees
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that landed Greece with even more debt: The par bond option may be more attractive for banks or
insurance companies that hold to maturity and don’t mark-to-market. Holdout problems can be fully dealt
with through a credible commitment not to pay such holdouts if they do hold out; and if that triggers the
CDS, so be it: Those who bought such protection/hedging should not be shafted—as they have been in
Greece—under the excuse of a technically “voluntary” debt exchange that is actually very coercive.
The par bond option—with appropriate regulatory forbearance—would allow banks to pretend for a while
that no losses have occurred and thus give them more time to recapitalize. This is not because they
deserve such subsidies, but because a credit crunch, already underway, would be worsened by the
sudden need to deleverage further and faster. Some losses would imply that many Italian banks would
need to be recapitalized by the government as they don’t have access to equity financing; but such
recapitalization is already in the cards; only its size would have to be larger. And to reduce fiscal costs,
the senior secured and unsecured debt of such banks—as well as the junior debt—would have to be
treated; thus, the mistakes made in Ireland should not be repeated. To make the restructuring even more
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Roubini Global Economics - Italy Should Restructure Its Public Debt Now
orderly, official resources—that are coming anyhow—should be made available to recapitalize the
financial system. And since about 40% of the Italian public debt is held by non-residents, a debt
restructuring would imply some burden-sharing with Italy’s foreign creditors.
Some influential figures in Italy have suggested that the same reduction in the public debt could be
achieved with a capital levy—a wealth tax—as opposed to a debt restructuring. But debt restructuring is
superior to a wealth tax. To lower the debt ratio by 25% (to 90% of GDP from 120%) with such a tax, you
would need a capital levy of €450 billion (30% of GDP). Even if the payment of such a levy were to be
spread over 10 years, that would imply an increase in taxes equivalent to 3% of GDP for 10 years
running; the subsequent fall in disposable income would make the Italian recession a depression as
consumption would collapse. While private wealth in Italy is reportedly about €9 trillion[1] and the capital
levy is only 5% of wealth, the consumption effects would be massive as the capital levy is 30% of
GDP/income. To reduce such negative effects, one would have to tax disproportionately (or only) the
wealthy—the 10% of households that hold 50% of such wealth. But such a tax would need to be 10%
rather than 5% of the wealth of those taxed. Leaving aside the political economy of such a huge capital
levy and the associated risk of massive capital flight, a debt restructuring implies greater risk-sharing as
some of the burden is shared by foreign investors, who hold 40% of Italian debt. So the negative
consumption and growth effects are smaller in the debt restructuring option. And since Italy is running a
small primary surplus, a debt restructuring would be feasible even without significant official external
financing for Italy.
A debt restructuring is thus a better option than trying a Plan A that will fail and then cause a disorderly
restructuring or a default of larger magnitude down the line; although even a debt restructuring—dealing with
Italy’s stock problems—would not resolve its flow problems (i.e. the lack of growth/outright recession, the
lack of competitiveness and the large current account deficit). To resolve the latter needs a real depreciation
that—most likely—would require the eventual exit of Italy and other member states from the EZ. Exit can be
postponed for a while. Restructuring, instead, should be considered and implemented now. The alternative
is much worse.
[1] The €9 trillion figure may be overstated, complicating the prospects for redressing excessive public
debt with high private wealth. Italian household wealth has increased significantly in the past 10 years,
even though the economy has grown little or not at all. The main cause, given a high degree of home bias
in household asset allocation and a 65% concentration in real estate, most of it domestic as well, has
been the EZ integration-induced collapse in real interest rates, which is now reversing itself. The fall in
real rates boosted the value of the cash flows and assets in the Italian economy without a commensurate
increase in the (real) size of those cash flows or real returns on those assets (which would have shown up
in a rise in real potential and trend growth). The trajectory of real and nominal rates has now gone into
reverse; the rise in rates will reduce the value of those assets/cash flows; and indeed the Italian stock
market has sharply fallen in the past few years as real rates and sovereign spreads have risen.
Furthermore, most of the remaining 35% or €3 trillion of financial assets is invested in government bonds
directly, indirectly through bank deposits, or through funds and securities. Levying an asset tax will raise
the cost of capital for Italy; so either the cash-flow variant of the asset tax, 30% of GDP over 10 years,
hits household income and thereby consumption, hitting growth/activity here and now; or it hits
investment, reducing the long-run growth potential of the economy, which was already stagnant at a time
when the world was growing rapidly and even the EZ was growing reasonably well.
All this suggests that, eventually, both the debt and the real exchange rate will have to give, even though
Italy seems to start from a better flow position (fiscal and external) than Greece, and a comparable stock
position (after a restructuring of Greek public debt).
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