Italian Government Bond Yields 2008 - The Growing Risk Premium

One point which it may well be interesting to watch for as we move through 2008 is the way in which the eurosystem evolves under strain. One particular point of interest will be the emergence of a yield differential for the Spanish banking system, another will be the performance of the "spread" on Italian government debt.

With this in mind it is worth noting that the difference in yield between Italian 10-year bonds and the benchmark German bunds increased to the most in almost a decade earlier this week. The spread between German and Italian bonds widened to 52 basis points on Tuesday, the most since October 1998, when it was as much as 61 basis points.

The European Commission halved its 2008 growth forecast for Italy on Feb. 21, saying slumping confidence and rising prices may push the Italian economy to the brink of recession. The economy will grow 0.7 percent this year, the European Union's Brussels-based executive body said, revising down a November forecast of 1.4 percent growth.


The spread between the 10-year bund, the euro region's benchmark, and similar-maturity Greek bonds also widened to the most since 2001. Greek notes yielded 52 basis points more than similar-maturity bunds, 5 basis points more than Monday and the widest spread in almost seven years.


Italy's long-term foreign-currency debt is currently rated Aa2, the third-highest investment-grade rating, by Moody's Investors Service and two steps lower at A+ by Standard & Poor's. Greece is rated A1 by Moody's, its fifth-highest rating, and one ranking lower at A by S&P.

The UK Daily Telegraph had an article on this topic. They made the following reasonably valid points:

Investors sold Italian and Greek debt yesterday in signs of near panic liquidation, driving bond spreads to the highest level since creation of the single currency.The yields on Italian 10-year government bonds reached 52 basis points above German Bunds, approaching levels that risk setting off a self-reinforcing spiral of investor flight.

The wild moves on the euro-zone bond markets came as gold plummeted by $29 an ounce to $957 on automatic stop losses and forced selling by funds. Crude oil futures tumbled almost $3 a barrel in New York.

The Dow Jones index fell 226 points at one stage.

Mounting evidence that Italy is sliding into recession have raised fears of a ballooning fiscal deficit, putting the country’s debt trajectory on an unsustainable course. The collapse of Romano Prodi’s government has left Rome in limbo and raised doubts about the viability of economic reform.

The rating agencies have already downgraded Italian debt twice. A growing number of banks have advised clients to take “short” bets against Italian debt, including Goldman Sachs and BNP Paribas.

Simon Derrick, currency strategist at Bank of New York Mellon, said flow of funds data show that foreign investors have suddenly liquidated half the Italian and Greek governments bonds accumulated over the last four years.

He said the markets were starting to price in risk that these countries would be hit much harder than Germany by the strong euro and a cyclical downturn. Brussels has halved its growth forecast for Italy to 0.7pc this year.

Italy Q4 2007 GDP Data Not Released

The Italian National Statistics Office (ISTAT) is in the process of revisising its methodology for measuring movements in GDP and it's components. The procedures involved are fairly technical (and are explained by ISTAT here) and are intended to harmonise Italian GDP statistics (esepcially as regards the price deflator applied to international trade transactions) with those of other countries in the European Union following the adoption of European Council regulation EC 1392/2007 on 13 November 2007 (as described in this very tedious document here). The timing of this change would see to be quite fortuitous, but it does mean that we will have no Q4 2007 data until the next quarterly release (of Q1 2008 on 23 May) since ISTAT do not have the compatible data to hand. As I say, this is probably fortuitous, but we will now have to wait till May to know whether or not Italy actually fell into rcession in the last quarter (if it didn't have actual negative growth it must have been a pretty close shave, as the string of recent downward revisions indicate), and clearly with elections looming you can read this whatever way you want to.

So for the moment we are left watching and waiting and guessing. Istat did, however, release the 2007 growth rate base on the new methodology last Friday, and it came in at 1.5%, a level which was lower than previously forecast, As a result of applying the new methodology ISTAT also revised Italy's GDP growth in 2006 down to 1.8% from 1.9%, while the 2005 figure was revised up to 0.6% from 0.1%.

As was expected there was reasonably positive news on the fiscal front, and Italy's budget deficit declined to 1.9% of GDP last year from a downwardly-revised 3.4% of GDP in 2006. The figure marked the first time the deficit was below the European Union's ceiling of 3.0% of GDP since 2002, and was also below expectations. Finance Minister Padoa-Schioppa said the reduced budget deficit was satisfying, as was the increase in the primary surplus - the budget balance before counting interest payments on national debt - to 3.1% of GDP from 1.3% the year before.

Italy was committed to reducing the budget deficit to 2.8%, and last summer forecast a reduction to 2.4%. It has pledged to balance its budget by 2011, a year later than most euro-zone members.

On the other hand Italy's overall fiscal burden rose last year, to 43.3% of GDP, the highest level since 1997, from 42.1% the year before. Padoa-Schioppa called the increase "limited" and said it reflected increased receipts from a crackdown on tax evasion rather than higher tax levies in general. This latter point is debateable since there have been tax increases, and primary spending rose by 3.6% on the year.

With this growing structural burden in mind, and no reforms which substantially alter the underlying dynamic in sight, slowing growth following two reasonably strong years obviously now starts to put the whole fiscal adjustment process in doubt. Italy has already put back the objective of achieving a balanced budget by one year - to 2011, as compared to the 2010 deadline being adhered to by most member states and more slippages here unfortunately now look even more likely. In addition, with both major party groups in the election promising tax relief if elected it is hard to see how the books can be made to balance.

As previously covered on this blog, the European Commission this month halved its Italian economic growth forecast for 2008 to 0.7%, down from a forecast of 1.4% made in November, predicting exports will suffer as a result of the strong euro and the global slowdown, while consumer spending will slow due to higher prices.

The Wealth Effect in Italy

guest post by Claus Vistesen

cross posted from Alpha Sources


With all things the global markets and her economies have going on at the moment it is difficult to catch anything remotely resembling a breath. Having been inspired recently by Gabriel Mihalache I am going to try anyway. One of the more notable pieces of research passing my desk recently is consequently a working paper from the ECB authored by by Charles Grant and Tuomas A. Peltonen entitled Housing and Equity Wealth Effects in Italy. The paper is short, concise and to the point and what's more; it comes up with some interesting tentative conclusions for further investigation not least in the context of my own research. Especially the authors' use of the the present data set is worth watching out for I think. Here are some snippets to get you going with the main argument ...

This study analyses housing and equity wealth effects on
households’non-durable consumption using the Survey of Italian Household and
Wealth (SHIW) published by Banca D’Italia. This dataset contains detailed
information on Italian households’ consumption, income and wealth from
1989-2002, and is constructed as a panel. The main contribution of our study is
that, using the variation through time and across households, the idiosyncratic
shocks to households' ’income and wealth can be identified…ed. Furthermore, we
analyse the consumption responses of different age and wealth groups of
households. In addition, we also investigate indirect wealth effects, i.e.how
different types of households react to aggregate equity and housing price
changes. (...)


Our main contribution arises from using this single dataset to analyze
household consumption responses to housing and equity wealth shocks.
Furthermore, we analyzed the consumption responses of di¤erent age and wealth
groups of households. In addition, we investigated indirect wealth effects, i.e.
how different types of households react to aggregate equity and housing price
changes. Regarding direct wealth effects (those arising from the self-reported
change in wealth), our results indicate that homeowners.consumption react
statistically and economically significantly to realized housing wealth shocks
(the estimated MPC is over 8 percent). This is slightly larger than many US
studies, where Peek (1983), Skinner (1984, 1986) and Engelhardt (1996) all found
effects between 3 and 5 percent, but is in the range of estimates found by
Disney et. al. for the UK and by Hori and Shimizutani (2003) for Japan. Our
results also indicate that the estimated unrealized equity wealth effects for
stockowners, although statistically signi.cant, are economically quite small,
with an average MPC of 0.4 percent. The estimated effect is lower than estimates
for other countries such as the US where Dynan and Maki (2001) estimated a MPC
of 5-14 percent. We additionally find that the estimated elasticity for old
(45-65 years old) households is larger (the estimated MPC is around 15 percent),
whereas for younger (25-44 years old) house- holds, the estimated elasticity is
smaller (around 5 percent), but not statistically significant. Unexpectedly, the
estimated elasticity for the richest wealth group households is the largest
(around 10 percent), but not statistically significantly di¤erent from the
medium wealth group households. elasticity (around 7 percent). For the lowest
wealth group household, the estimated elasticity is statistically not
signi.cant. One possible explanation is that binding credit constraints are
preventing households in the lowest wealth group households from increasing
their consumption in response to housing wealth gains. We also investigated the
effect of the house-price and stockmarket indices. For these indirect wealth
effects, we find no support for indirect housing wealth effects, whereas
indirect equity wealth effects are found to be statistically signi.cant and
economically large. The indirect equity wealth effects are likely to be related
to expected improvements in income outlook, given that both stockholders and
non-stockholders increase their consumption in response to positive stockmarket
developments, and that the estimated coefficients between these two groups are
found to be similar.

As can be observed from reading the paper the generic application of 'wealth effect analysis is' somewhat impeded by the heterogenous degree of homeownership rate, life course events (in this case purchase of first home), mortgage and credit markets, degree of households' stock ownership ... and I am sure you can come up with many more. In short, institutions and cultural specificities matter; on this area in particular. However, and as many of my regular readers will have expected I am especially intrigued by the implicit findings in terms of the wealth effect over the life cycle. The following is thus an important observation ...

We additionally find that the estimated elasticity for old (45-65 years old)
households is larger (the estimated MPC is around 15 percent), whereas for
younger (25-44 years old) households, the estimated elasticity is smaller
(around 5 percent), but not statistically significant.

Leaving the issue of statistical significance aside for a moment I do think that this point with respect to the life cycle effect of wealth responsiveness is important to take aboard. When you think of it it is not that unexpected. Older households will thus tend to depend more on their savings and crucially the income they can earn on those savings than their nominal income itself in the form of regular cash flows. At least, this is a pet hypothesis of mine and if you could isolate the effect of income earned on saving it would be interesting to see whether this elasticity divergence holds. However, this point opens up the door to a much more profound discussion as to how we deal with the assumption of dissaving over the life cycle as consumers and by derivative populations age. Specifically, I am talking about how to to incorporate two important stylised facts or, as it were, to investigate the extent to which they exist. These would be; 1) the point that economic agents (consumers) don't dissave to 0 over their life cycle and 2) that increasing life expectancy makes the life cycle pattern uncertain in the latter years. In general the authors make the following point ...


(...) the standard life-cycle model predicts that older households should have higher MPCs to income and wealth shocks than younger households because of the di¤erences in ex- pected life times. In addition, as shown by Carroll and Kimball (1996), adding income uncer- tainty to the standard life-cycle model induces the consumption function to be concave, in which the marginal propensity to consume out of transitory income shocks, as well as wealth shocks, declines with the level of wealth.

Formally, the authors estimate the following model in first differences except the risk free rate.

Where Cit is non durable consumption for household i, Rt is the risk free rate at time 't', lnYit is income of household i at time 't', Wh is housing wealth at time 't' and We is equity wealth at time 't'. Epsilon (or Ut) as always is an error term. A good place to start for further study I would say.