Monday, 30 September 2013

Italian BTPs ... an economic reasoning to short

Monday 30th September 2013

I closed my Euro Bund short (Heresy to the Monetarist Taliban) a while back and will monitor it for a re-entry. This morning I’ve begun to short Italian BTPs, via the Long Term BTP Future (5 Dec 13) thru ETX. The weekend’s news flow, courtesy of the 'feckless and vain' (US officials assessment) Silvio Berlsuconi and his attempt to bring about a fresh election caught my eye and prompted some data digging. From my analysis below, I reckon that the Italian’s have been incredibly lucky to get their debt service cost back below 5%.
   
The debt-deficit arithmetic (DDA) doesn’t stack up. What DDA does is to quantify the ‘race’ between GDP and public debt, or more precisely, between the economy’s trend rate of growth and the rate at which public debt accumulates. If the real GDP growth rate exceeds the real interest rate, and the government achieves a surplus primary budget (i.e. takes in more revenue than expenditure ex-debt service costs), then the debt to GDP ratio shrinks. When the real interest rate exceeds the economy’s growth rate, the debt piles up, unless a primary budget surplus is enough to offset this.

This is evident in the charts below, which demonstrate how Italy got to its c. 120% public debt to GDP level. The International Monetary Fund (IMF) data highlight that Italy’s real GDP growth rate began to significantly decline from the 1980s, while its public debt to GDP ratio ballooned.

During the period 1950 to 1979, Italy averaged a primary annual budget surplus of 2.0% of GDP pa. This compared with 5.4% average real GDP growth pa and an average 0.9% real interest rate over the same period. However, during the period 1980 to 2011, the average primary budget surplus had fallen from 2.0% of GDP to just 0.6% pa, while average real GDP growth fell from 5.4% pa to 1.5% pa. Meanwhile the average real interest rate rose from 0.9% to 3.7%. It is little wonder that Italy’s public debt to GDP rose from 58% in 1979 to 120% in 2011 and is projected by the IMF to be as high as 131% in 2013-14.

Amongst other variables, Italy’s borrowing rate will respond to two key factors over the next five years; Italy’s GDP growth rate, and its primary budget balance. In terms of the growth rate, the problem is that the IMF forecasts Italian real GDP growth to average 1.1% pa during the next five years and inflation to average 1.4% during the same period.

Growth will likely remain anaemic because Italy is now so uncompetitive as compared to Germany, France and even Spain. Italy’s unit labour costs (ULC) are 26% higher than that of Germany’s, 18% higher than that of France, 17% higher than the UK, and 9% greater than Spain’s. Further, they are a whopping 43% higher than ULCs in the US. Unless Italy’s ULCs improve on a relative basis it would appear unlikely that Italy will achieve a significant pick-up in GDP growth. And as the country can no longer depreciate its currency, the only real way that ULCs can improve is either through productivity gains or lower wages. The former appears unlikely (or at least unlikely to prompt a relative improvement compared to other nations). The latter could lead to a nasty debt-deflation spiral whereby the public debt to GDP becomes even greater. It is unsurprising that the Italian Lira devalued by 600% from the seventies through to the mid nineties prior to Monetary Union. That lever is gone.
  
With the borrowing rate currently at c. 4.8%, real interest rates appear likely to average 3.4% or possibly higher; the latter of which I suspect will be the case. In this instance, Italy will need to achieve a primary budget surplus of 2.3% or greater pa over the next five years, in order for the stock of public debt to stand still. This appears a tall order when considering that Italy has only managed a budget surplus of 2.3% or more in 11 out of the last 70 years. Six of those years were during the all important fiscal rectitude period in the run-up to Euro entry. Further, during those 11 years, GDP growth averaged less than 1.3% pa, which would be about right in comparison to the IMF's projections.  

Now that Italian BTPs have fallen again through the 200d ma, I reckon they go lower to somewhere between €95-100. Which is why I’m building a short position.

IK1 Comdty - Generic Italian Long Bond
Source: Bloomberg
Yield on Generic Italian Long Bond
Source: Bloomberg
Italian Gross Public Debt as a percentage of GDP, and IMF forecast 2012-18
Source: International Monetary Fund (IMF)
Italian Primary Budget Balance as a percentage of GDP
Source: International Monetary Fund (IMF)
Italian Real GDP Growth, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Inflation Rate, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Real GDP growth, Real Interest Rate,
and Government Primary Budget Balance, and IMF forecast 2013-18
Source: International Monetary Fund (IMF)
Italian Unit Labour Costs in manufacturing compared to other nations
Estimated cost to employers
Source: Bureau of Labour Statistics (BLS)
Italian Unit Labour Costs in manufacturing
competitiveness gap to other nations
Estimated cost to employers
Source: Bureau of Labour Statistics (BLS)
Historical cross rate of Italian Lira / Deutsche Mark
Source: Bloomberg
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