Interest Rate Shock and Sustainability of Italy’s Sovereign Debt

Previously published as Policy Brief PB12-5, Peterson Institute for International Economics, Washington, February 2012. Reproduced by permission.

By February 1–6 the 10-year rate had improved further, falling to an average of 5.7 %. Data are from Bloomberg and Datastream.

Rita Nazareth, US Stocks Decline as ECB Lends Record Amount, Bloomberg, December 21, 2011.

Net interest payments are €80.7 billion (the difference between primary and total fiscal balance). With financial assets at €328 billion, and assuming earnings at 2 % on these assets, gross interest payments are €87.3 billion, or 4.5 % of end-2011 gross debt of €1.92 trillion (IMF 2011a).

For a description of the model, see Cline (2011).

The table presents an estimated decomposition of the debt into medium- and long-term (MLT) pre-2012; new MLT debt borrowed in 2012 and after; and short-term debt, assumed to be rolled over at the end-2011 level. The interest rate on pre-2012 debt is based on total interest payments after taking account of earnings on assets (at 2 %) and interest on short-term debt at a lower rate. For 2012 and after, the interest rate on new MLT debt is imputed at rates likely to have been applied at the time of the September WEO: a spread of 300 basis points above the German 10-year bund in 2012, 250 basis points in 2013, and 200 basis points thereafter. The bund rate is shown in the table as well, and is taken from IMF (2011c).

The Organization for Economic Cooperation and Development (OECD 2011) places financial assets even higher, at €450 billion at end-2011.

The debt-ratio-stabilizing primary surplus as a percent of GDP is: π = λ (r − g), where λ = debt/GDP, r is the interest rate, and g is the nominal growth rate; see Cline (2010).

A somewhat more optimistic conclusion is reached by Banca d ’Italia (2011: 14–15). In its baseline the debt to GDP ratio declines from 120.5 % in 2011 to 112.5 % by 2014. In its simulation increasing the interest rate on new borrowing by 250 basis points, there is still a decline in the debt ratio to 115.5 % of GDP by 2014. The difference reflects a more optimistic fiscal baseline (overall surplus of 0.2 % of GDP by 2014 instead of a deficit of 0.8 %, Table 1), and higher projected growth (an average of 0.9 % annually in 2012–2014 versus 0.55 %). The incremental impact of the higher interest rate scenario is broadly consistent with, albeit somewhat stronger than, that found here. A 2.5 % increase in the interest rate on new borrowing boosts the debt/GDP ratio by 2.9 % of GDP by 2014. In comparison, in the calculations here, an increase in the new borrowing interest rate by 1.7 % point above its baseline average of 5.4 % (MLT and short-term weighted average) raises the debt/GDP ratio by 1.2 % of GDP by 2014. The difference reflects the Bank of Italy’s use of summary elasticities of outlay with respect to the interest rate, in contrast to actual application to new borrowing projections in Table 2.

Based on amounts outstanding in the weeks ending April 29, 2011 (€76 billion), July 29 (€74 billion), December 2 (€206.5 billion), and January 20, 2012 (€219 billion). ECB, Weekly Financial Statements, press releases. Available at www.​ECB.​int.

Note further that the ECB’s SMP purchases are on the secondary market. Nonetheless, their effect should be broadly comparable to purchases in initial auctions.