Little time for Italy

Paolo Manasse, Giulio Trigilia

The Eurozone crisis now extends to Italy. Markets' pricing of credit default swaps shows that Italy’s troubles are home-baked and that matters are rapidly coming to a head. The risk of default has now become concentrated on the very short run. This suggests that Eurozone leaders may be rapidly punished by markets if they fail to take convincing steps this week.

Here’s a money-management quiz. Imagine that you lend some money, say €1.9 trillion, to a hypothetical country, let’s call it I + - + y. The nation’s vulnerabilities have long been known:

Stagnant total-factor productivity,

High debt and a penchant for fiscal deficits;

A level of tax compliance in line with that of the developing world;

A dual labour market penalising women and the young;

A lack of competition in services and product markets;

Small firms producing standardised goods and little innovation;

An inefficient and oppressive bureaucracy;

An expensive, corrupt, and inept political elite;

Powerful organised crime; and

An aging population.

Also imagine that within a few days the following important aggravating circumstances appear:

The government of I + - + y approves a long-waited fiscal consolidation plan, but it turns out that 4 out of 5 measures will either take place or generate savings in 2013-2014 – the period of general elections. Moreover the plan consists mainly (60%) of tax increases with no hints of badly needed privatisations or liberalisations.

The Economy Minister of I + - + y, the plan’s author, is publicly disowned by the Prime Minister whose media company is in the meantime sentenced to pay a €560 million fine over a corruption affair.

A close aide of the Economy Minister faces arrest over a serious corruption charge, while the Minister finds himself moving out of his aide’s luxury house where he’s been living when in I + - + y’s capital.

Now ask yourself: Would you keep rolling over this country’s bonds when they come up for redemption? Presumably not – an answer that is independent from an important aggravating circumstance.

The sub-optimal currency area

I + - + y is a member of a suboptimal currency area (SCA).1 It can neither devalue nor inflate its way out of its troubles (as it did many times in the past). Nor can it disentangle its fate from that of other SCA members – three of whom are already insolvent.

With the simple quiz out of the way, we wish to make three points.

Italy (yes, you guessed right) is not yet doomed;

Italy’s troubles are largely home-made; and

Time may be running out before the home cooking burns down the house.

Is Italy a lost bet?

In a recent Vox column (Manasse and Trigilia 2011a), we looked at the euro-wide component of 5-year credit-default-swaps spreads. We argued that the evidence indicates that markets are increasingly discriminating between safer and riskier European borrowers.

Using the same methodology, Figure 1 answers the following question: How much do Italy, Greece and Germany contribute to the overall euro spreads? The figure shows the Italian, Greek and German “factor loadings” in the euro-wide (principal) component of daily spreads, from June 2006 to 15 July 2011.

Figure 1.

Source: Authors' calculations using data from DataStream

These numbers measure the three countries’ contribution to the common risk. If a euro-component moves in line with the country’s spread, the country’s coefficient equals one, while if the country’s and the euro spreads are unrelated, the country’s coefficient falls to zero.

This is exactly what has happened in Greece during the past two months, but not to Italy (nor Germany). This suggests that Italy still is an anchor of the Eurozone. Both on the up and down side, Italy still affects spreads in the rest of the Eurozone. This means that the market believes that Italy is it not “lost”.

Is the European crisis to blame for Italian troubles?

The second important piece of evidence comes from Figure 2. This answers the question: How important is the euro-dimension in explaining Italy’s credit-default-swap premium?

The figure shows the percentage of Italy’s variance of spread that can be attributed to the euro-wide component. It shows that in the past two and a half years, with a reversion recently, the share attributable to the euro-component has become less and less important. It fell from 98% to 40% in April 2011, bouncing back since then to about 60% in the past weeks.

The message here is that the market is increasingly judging Italy on its own merits. Blaming speculation against and contagion from Europe is not only pathetic, it is wrong.

Figure 2.

Source: Authors' calculations using data from DataStream

How much time is left?

The final question our methodology can address is the ultimate one – the one that should be foremost in the minds of Eurozone leaders meeting this week. What is the perceived risk of Italian sovereign debt at different time horizons?

Working this out requires easily available data and a couple of assumptions. Italian credit-default-swaps spreads indicate that the market believes there is a chance that Italy will default. But how large is the probability at different time horizons? Assuming that the market believes that, in case of default, creditors will suffer a fixed 40% haircut, we can calculate the hazard rate of default (i.e. the instantaneous probability) at different maturities, from 1 to 10 years.

For example, if we saw a very high hazard rate on a CDS contract that will mature this year, but low hazard rate on a CDS contract that will mature next year, the message is clear; markets think the danger is imminent, but if we struggle through, the danger dwindles next year.

So what did we find? The results (borrowed from our on-going research Manasse and Trigilia 2011b) are illustrated in Figure 3, but interpreting this figure requires a bit of background. From the premium paid to insure against a default in a one-year CDS contract and the premium paid to get insurance for a two-year contract, we can recover the probability the market assigns to a default occurring 2 years from today – conditional on the default not having occurred before.2

We calculated hazard rates for each CDS maturities ranging from 1 to 10 years for each day from 21 Dec 2007 to 15 July 2011. This is an awful lot of numbers, so we summarise them with a “slope” estimate; this gauges whether the hazard rate is increasing for longer maturities (a positive slope), or decreasing (negative slope). In this sense, a single number shows whether the default risk is stacked higher in the short run than it is in the long run. The slope coefficients are plotted in Figure 3.

Figure 3.

Source: Authors' calculations using data from DataStream

What do the numbers mean?

Noting that “trouble” is typically associated with a negative coefficient, indicating the markets perceive that risks are concentrated at the shortest horizon, the figure delivers some bad news. The last couple of weeks have seen the slope turn negative and sharply so. This indicates that market participants now view the highest risks in the short term.

The verdict on Italy has not come yet, but the jury is out and perceives that risks are concentrated in the very short run. Italian leaders Mr Berlusconi and Mr Tremonti should take note – as should the European leaders meeting this week.

References

Manasse, Paolo and Giulio Trigilia (2011a), “The Fear of Contagion in Europe”, VoxEU.org, 6 July.

Manasse, Paolo and Giulio Trigilia (2011b), “Contagion in Europe”, mimeo, University of Bologna and University of Warwick.

1 SCA membership is marked by little labour mobility, widespread price and wage rigidities, asymmetric “shocks” in competitiveness and productivity growth, no centralised fiscal policy, and inadequate institutions and financial supervision