In recent times, concerns of prolonged higher interest rates have begun to reverberate across the globe, leading to an upward trajectory in government-bond yields. Notably, the ten-year Treasury yields in the United States have surged to approximately 4.7%, marking their highest level since 2007. Simultaneously, the Bank of Japan has escalated its bond purchases to cap yields, while in Europe, on October 4th, the yield on ten-year German Bunds exceeded 3% for the first time in over a decade. Italy, one of the European Union’s most indebted member states, faces yields of nearly 5%—the highest since the euro zone’s sovereign-debt crisis in 2012. This situation raises concerns about Italy’s spending plans and their sustainability.
Over the past 15 months, the euro zone has grappled with surging inflation, prompting the European Central Bank (ECB) to increase interest rates by 4.5 percentage points. Despite this battle against inflation, public spending in several major European countries has continued to expand significantly, initially aimed at aiding citizens’ recovery from lockdowns and energy crises. However, as these shocks have diminished, budget deficits remain substantial. France anticipates a budget shortfall of nearly 5% of GDP this year, followed by 4.4% in the next. Italy, on the other hand, plans to maintain a deficit of 5.3% this year and 4.3% in 2024, despite expecting an injection of nearly €70 billion ($74 billion) from the EU’s common pandemic-recovery fund.
Italy’s precarious fiscal position is compounded by its sluggish economic growth, projected to remain below 1% this year, and its colossal debt burden, with net public debt reaching 144% of GDP in 2022. Excessive deficits and soaring interest rates could render Italy’s debt unmanageable, posing a severe threat.
Investors are well aware of these risks, leading to a premium for lending to Italy compared to lending to Germany. When Italy’s government unveiled its budget plans on September 27th, the yield-spread duly increased. Unless spending is reined in, Italy’s leadership under Giorgia Meloni is on a collision course with the European Commission, the central bank, and investors. Ideally, Italy would adhere to the EU’s fiscal rules designed to safeguard its public finances. However, these rules are viewed as unrealistic, with expectations of Italy achieving a debt-to-GDP target of 60% over a specified time frame being deemed impractical. Despite efforts to overhaul these rules, conservative northern EU countries remain reluctant to compromise, resulting in a standstill.
Even with improved regulations, enforcing them presents another challenge. Past experience indicates that national governments often sidestep Brussels’ rules to avoid upsetting their constituents. Consequently, Italy remains vulnerable to discipline from investors and the ECB. The central bank’s role is now more transparent than during the depths of the euro zone’s debt crisis, with commitments to purchase government debt if spreads become uncontrollable. However, the ECB’s focus is primarily on preventing unwarranted spread increases rather than directly managing interest rates—an issue confronting Italy. Furthermore, having been an active buyer of government bonds during the pandemic, the ECB is soon to decide on reducing its holdings, potentially diminishing demand for Italian bonds.
The stage is set for further market turbulence. While Ms. Meloni’s government may choose to rein in spending proactively, it is more likely that external pressures, such as nervous investors and rising borrowing costs, will eventually compel corrective action. A reckoning with reality seems inevitable; the only question is how dramatic the situation must become before significant changes are made.