Italy and Spain Endure Rising Sovereign Debt Funding Costs

The Greek bailout plan announced on 21 July initially helped to ease some of the pressure on Spain, but bond yields have moved up again given increasing market concerns about the lack of detail relating to the new funds needed by the European Financial Stability Facility to meet its much wider remit. Indeed, the yield spread between Spanish and German 10-year bonds, the measure of risk of holding Spanish bonds, climbed to 390 basis points on 2 August, implying that Spain's average 10-year bond yield rose to a euro lifetime high of 6.3% after falling back to 5.7% after the summit on 21 July. Meanwhile, the average yield on 10-year Italian bonds stood at 6.0% on 2 August, from 5.3% on 21 July. This implied that the yield spread between the Italian 10-year bonds against the equivalent German Bund stood at a new euro-lifetime high of 363 basis points.

More Detail Needed on EFSF's Enhanced Role

The main concern is that the markets believe the EFSF has insufficient power to fulfil its enhanced role and that it needs to be increased substantially. The European Financial Stability Facility (EFSF) and its successor from mid-2013, the European Stability Mechanism (ESM)will be empowered to buy bonds in the secondary market and offer struggling states precautionary credit lines. This measure is designed to prop up Spain and Italy, which have suffered significant financial contagion during the Greek debt crisis. However, the markets are concerned that the new EFSF rules first need to be approved by national parliaments, likely to be a time-consuming and risky process, ensuring that Spain and Italy remain vulnerable to high bond yields until the rules are ratified. Furthermore, there needs to be a strong collective commitment to increase the size of the EFSF in line with its increased responsibilities. The EFSF currently has a lending capacity of EUR440 billion, and it has been argued that this amount needs to be doubled at least or even have its ceiling removed so that the EFSF would have the resources necessary in the event that Spain and Italy require support, while providing financial assistance to Greece, Ireland, Portugal and possibly Cyprus.

Bleaker Spanish and Italian Growth Outlook Another Factor

The markets have also taken a dimmer view of Spain and Italy's growth prospects. The recent indicators have been disappointing, and signal that both economies' export-led recovery is faltering. Furthermore, the contraction in service sector activity in July during the tourism season signals the continued fragility of the recovery in both economies. With increasing signs of a slowdown in economic activity in the Eurozone, coupled with major concerns about the strength of the US economy, Spanish and Italian exports are set for a bumpier road in the remainder of 2011 and 2012. Meanwhile, domestic spending is still too weak to pick up the slack, hurt by falling government consumption and dormant consumer spending. Worryingly, consumer spending in both Spain and Italy is likely to remain under acute pressure throughout the remainder of 2011 and 2012 with households alarmed by tough labour market conditions and rising energy-related prices, coupled with very deep reservations whether their still-fragile recoveries can withstand their governments' aggressive fiscal austerity plan. Finally, consumer confidence is likely to have taken a further blow in light of financial contagion hitting Spain and Italy from ongoing Greek sovereign debt crisis.

Political Intrigue Provides Extra Push to Italian Bond Yields

The situation in Italy has been exacerbated by rumours that Economy Minister Giulio Tremonti is set to step down, partly due to his rumoured links to a corruption scandal and a lack of support from Prime Minister Silvio Berlusconi. The prospect of Tremonti resigning has intensified financial contagion hitting Italy, with the markets punishing Italy for not supporting more robustly an Economy Minister who is very committed to breaking Italy's protracted cycle of modest growth and public debt mountain. Still, IHS Global Insight is not surprised that Tremonti's position is being questioned again. Although impressed by the new austerity package being passed in record time, we still believe Tremonti had to make major concessions, particularly with a large slice of the fiscal savings expected to be extracted from 2013, and not sooner to calm private investors and rating agencies. Furthermore, the austerity package was not accompanied by much-needed reform initiatives to improve Italy's indifferent productivity performance in recent years, thereby helping to lift its growth potential. This was a good opportunity to kick-start the process of dismantling excessive regulation in key sheltered service sectors, like electricity and gas, retail and professional services sectors. Our immediate concern about the pressure on Tremonti is that it undermines the perceived collective fiscal voice that emerged after Italy attempted to deflect the intensifying financial contagion following Berlusconi's rebuke of Tremonti. Clearly, political cohesion will be an increasingly important ingredient in keeping the markets at bay. Given Italy's economic growth prospects are too weak to bring about a significant improvement in its challenging debt dynamics, the markets will stress the importance of a stable political consensus able to deliver an extended period of punishing austerity and an unpopular structural reform agenda.

Spanish Government Will Miss Growth Targets, Pointing to More Austerity

The fundamentals in Spain have altered during the crisis. Prime Minister Jose Luis Rodriguez Zapatero has called an early general election for 20 November, as opposed to later than March 2012. The markets will be concerned that the election outcome does not provide the winning party with a clear mandate to prop up the austerity drive, and push through a more aggressive reform agenda, particularly with a further dismantling of collective wage bargaining and employment protection legislation. Furthermore, the remainder of 2011 and early 2012 will present Spain with some tough challenges. First, the deepening Eurozone sovereign debt crisis is a significant threat to the planned share flotations by major savings banks Bankia and Banca Civica, despite both banks offering steeply discounted valuations to investors. The main risk would be if Bankia fails to launch its initial public offering (IPO) successfully, which could threaten the whole recapitalisation process of parts of the Spanish savings banking sector. Second, the recent economic data have been disappointing, and suggest the economy will fall short of the official growth target of 1.3% for 2011 as a whole, and hampering the government's ability to deliver its budget deficit reduction targets. This is a significant risk given that nearly two-thirds of the required fiscal adjustment has to be achieved in 2011. Specifically, a weaker economic growth outturn in 2011 (which would have negative implications for 2012) could curb the recovery in state tax receipts, which will be under increasing pressure with the revenue-boosting impact of the VAT rise on 1 July 2010 expected to wane from the second half of 2011. Although fiscal consolidation occurred at an encouraging pace in 2010 and the first half of 2011, the government may need to reassure investors by adding another layer of austerity. With Spain still enjoying one of the lowest VAT rates in the European Union (EU), the government could be tempted to implement another VAT increase in late 2011/early 2012. However, Economy Minister Elena Salgado has rejected the idea, arguing that it would have a negative effect on consumption, but this could be less painful then deeper central and regional government spending cuts or income tax rises. Indeed, regional and local governments are already struggling to deliver the proposed budgetary savings in the previous austerity measures.

Outlook and Implications

Spain's Still Relatively Low Public Ratio Helps to Ease Pain

Spanish long-term bond yields now stand closer to the supposedly unsustainable position, the 7% and higher level. The spike in bond yields in recent weeks will have a limited impact on Spain's current debt structure: most of the public debt is held under fixed interest rates. However, higher interest rates on new issuance will worsen the country's debt profile and could generate an unsustainable debt dynamic, but this does not present an imminent risk, particularly with the Spanish Treasury more than halfway through its medium/long-term bond-issuance schedule for 2011. Spain is still to able to meet its debt obligations, and refrained from cancelling any debt auctions during the height of the crisis in early July. However, we accept the threat represented by bond yields rising above 7.0% is significant, which could be unsustainable should they persist for more than six months, resulting in a punishing rise in borrowing costs as maturing debt is rolled over at higher yields (probably two to three percentage points higher than the yield paid on the maturing paper). This is compounded by having to issue new debt at expensive yields to cover the still sizeable budget shortfalls expected in 2011/12. It is worth noting, however, that Spain still has relatively low levels of public debt, which should provide some protection. Spain's public-debt ratio stood at 63.6% of nominal GDP in the first quarter of 2011. Furthermore, general government interest expenditure as a share of GDP in Spain stood at 2.0% of GDP in 2010 (compared with 4.6% in Italy, 2.9% in Portugal and 20.7% in Greece).

Italy Faces a More Punishing Rise in Sovereign Debt Financing Costs

The spike in Italian bond yields is set to reverse the downward trajectory in debt serving costs witnessed over the last twenty years. General government interest expenditure has fallen from a historical high of 12.7% of GDP, or EUR105 billion in 1993 to 4.5%, or EUR70.3 in 2010. Again, higher bond yields will not affect Italy's current debt structure: most of the public debt is held under fixed interest rates.

Italy will have significantly higher interest rates paid on new issues, totalling EUR176 billion of debt redemptions between now and the end of 2011, which will have to be rolled over at higher interest rates. Indeed, a 1% rise in bond yields would increase general government interest expenditure by more than EUR1.5 billion per annum on the public debt that has to be refinanced during 2011. The situation is more dangerous in the medium term, with Italy's public debt expected to peak at 120% of GDP by 2012, implying it will need to refinance EUR860 billion of relatively inexpensive debt by the end of 2015, according to Evolution Securities. Given the average yield on current government debt stands at 4.125%, bond yields surging well in excess of 6% would present a significant risk to Italy's financial stability in the medium term. A spike in debt servicing costs would draw away resources from economic growth and employment, through higher taxes and less public investment.