Italy may find November is the cruelest month

It won’t take much to push highly indebted Italy into a debt crisis, as it is already flirting with bond yields close to unsustainable levels. The big risk is of a buyer’s strike, akin to the recent UK gilt market meltdown. What happens next month will be crucial for the nation’s economic future.
A lot of things have to come together harmoniously in November, including the creation of a new Italian government with an acceptable finance minister and the reconvening of Parliament. Immediately after that comes the annual budget that has to pass scrutiny with the European Commission before year-end. That process, always fraught, is likely to be even more fractious this year because of a wider budget deficit and an increase in borrowing. With €245 billion ($238 billion) of government bonds needing to be refinanced next year and €230 billion in 2024, there is very little room for error.
So far, newly elected Prime Minister Giorgia Meloni, head of the Brothers of Italy party and leader of a right-wing coalition, has been careful not to cause too many fiscal waves since winning the Sept. 25 election. Unfortunately it is not all plain sailing as European Central Bank board member Fabio Panetta, reportedly her first choice for finance minister, has declined the pportunity. Italian President Sergio Mattarella has few executive powers, but he does have to approve ministerial appointments; the finance minister is the key role, and a technocrat has usually been preferred to placate nerves in Brussels over fiscal rigor.
Moody’s Investors Service made clear in its Oct. 5 review of Italy’s Baa3 rating, already with a negative outlook, that attempts by the new coalition to redraft the National Recovery and Resilience Plan negotiated by outgoing Prime Minister Mario Draghi would increase the risks of a downgrade. That would leave Italy with a junk assessment.
Italian 10-year yields have more than quadrupled this year, climbing to 4.7%. But it is in shorter maturity debt that the pain of rising ECB official rates is really being felt.
Three-year yields, which were negative at the start of the year, are now above 3.5%; borrowing costs rise to more than 4% for debt maturing in five years and longer. The 10-year yield spread between Italy and German debt has widened to more than 250 basis points.
Unfortunately, Italy may find itself at its most vulnerable politically just when the ECB’s ammunition to defend the euro zone’s peripheral bond markets is at its lowest. The central bank is relying on recycling maturing debt acquired under its Pandemic Emergency Purchase Program from wealthier nations such as Germany, France and Netherlands to fund new purchases of Italian, Spanish, Portuguese and Greek debt.
In June and July, the ECB bought about €8.5 billion of Italian bonds, but the pace declined substantially toward the end of summer. So, in theory, there is some ammunition left. The central bank is understandably coy about how much firepower it keeps in reserve, but there’s a worryingly thin period looming in the final months of this year and the start of 2023. Following a large French redemption in October, there are few available maturities from donor countries available to roll into supporting Italian or other peripheral debt.
Austria has €10.5 billion maturing at the end of November and there is a €14 billion German repayment in mid-December, then the pace slows until March. Italy itself has large redemptions but that is of little benefit.
Moreover, what proportion of these maturing bonds is held in the main Asset Purchase Program, which are not eligible for cross-market reinvestment, is unclear. According to Bloomberg Intelligence strategist Huw Worthington, on average less than a quarter of the ECB’s holdings are in the pandemic QE facility. So there may be insufficient capacity to counter renewed selling of peripheral debt. Of course, there is also the ECB’s new anti-fragmentation weapon, the Transmission Protection Instrument, to fall back on. But details of how and when that might be employed remain vanishingly scarce.
With a quarter of a trillion euros of debt to refinance next year, it will cost Italy an extra €11 billion annually if yields stay this high as the average interest rate on its debt will treble. It is hard to know where or when the tipping point comes for Italy’s debt sustainability — but it is surely edging closer to the cliff edge.

—Bloomberg

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London