Italy’s Debt Is Potential ‘Time-Bomb’ That May Lead to Default

Italy’s debt, the highest in the euro region last year, remains a “potential time bomb” and the country is at risk of default unless it boosts productivity, Capital Economics said.

“We think the size of the government’s debts will eventually prompt the markets to turn their sights on Italy,” Capital Markets Managing Director Roger Bootle and chief European economist Jonathan Loynes said in a report today. “A default is a distinct possibility.”

Italian banks would be hard hit by a default and foreign investors would face losses of 400 million euros ($500 million) if Italy defaulted and forced bondholders to take a so-called haircut of 50 percent of their investments, they said. Italian banks such as UniCredit SpA or Intesa Sanpaolo SpA, which own about half the government’s debt, would have 80 percent of their Tier 1 capital wiped out, they said.

Italy has so far fared better than other peripheral markets such as Spain and Portugal since Greece’s near default prompted investors to spurn their bonds, according to the report. Italy limited its stimulus spending and emerged from the recession with a budget deficit of 5.3 percent of gross domestic product, less than half that of Spain and Greece. That still boosted the government’s debt to 115.8 percent of GDP.

Yields Climb

Greece, Spain and Portugal have seen the yield premiums that investors demand to buy their debt over comparable German bonds surge on concerns they won’t be able to tame their budget deficits and that rising financing costs could lead to a default. Italy, whose debt ratio is more than twice Spain’s, has seen a smaller increase in that risk premium because it has a smaller budget deficit, low household debt and a relatively strong banking system, Capital Markets said.

Italy’s debt is almost twice the European Union limit of 60 percent of GDP. To reduce it to 100 percent of GDP in the next 15 years, the country would have to run a primary surplus -- the budget balance less interest payment -- of 5 percent of GDP.

Economic growth averaged just 0.6 percent in the last decade, and to achieve a primary surplus of that magnitude, the country will need to lift productivity growth or put up with years of stagnation, Capital Economics said.

“Weak productivity growth means Italy will need to accept years of wage and cost deflation and economic stagnation if it is to restore competitiveness within the euro zone,” Bootle and Loynes said in the report. “With the economy having barely expanded over the past decade, Italy could be staring at a total of more than 20 years of stagnation.”

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