Nouriel Roubini's Global EconoMonitor

Italy’s Debt Must Be Restructured

Here is my latest article from the Financial Times:

It is increasingly clear that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a disorderly default. The eurozone’s wish to exclude private sector involvement from the design of the new European Stability Mechanism is pig-headed – and lacks all credibility.

With public debt at 120 per cent of gross domestic product, real interest rates close to five per cent and zero growth, Italy would need a primary surplus of five per cent of gross domestic product – not the current near-zero – merely to stabilise its debt. Soon real rates will be higher and growth negative. Moreover, the austerity that the European Central Bank and Germany are imposing on Italy will turn recession into depression.

While the technocratic government headed by Mario Monti is much more credible than Silvio Berlusconi’s former government, the constraints it faces are unchanged: debt is unsustainable and the policy to reduce it will make matters worse. That is why markets have shrugged off news of the new government and pushed Italian spreads to yet more unsustainable levels. The government is born wounded and weakened, as Mr Berlusconi can pull the plug on it at any time.

Even if austerity and reforms were eventually to restore debt sustainability, Italy and countries in a similar position would need a lender of last resort to support them and prevent sovereign spreads exploding while they regained market credibility. But Italy’s financing needs for the next twelve months alone are not confined to the €400bn of debt maturing. At this point most investors would dump their entire holdings of Italian debt to any sucker – the ECB, European Financial Stability Facility, IMF or whoever – willing to buy it at current yields. If a lender of last resort appears, Italy’s entire debt stock of €1,900bn will be soon supplied.

So using precious official resources to prevent the unavoidable would simply finance the exit of others. Moreover, there is no official money – some €2,000bn would be needed – to backstop Italy, and soon Spain and possibly Belgium, for the next three years.

Even current attempts to ramp up EFSF resources from the IMF (which is reportedly readying a €400 to €600bn programme to backstop Italy for the next 12-18 months), and from Brics, sovereign wealth funds and elsewhere, are bound to fail if the eurozone’s core is unwilling to increase its own contributions, and if the ECB is unwilling to play the role of an unlimited lender of last resort.

If, as appears likely, Italy remains stuck in an uncompetitive recession and is unable to regain market access in the next twelve months, then even if such large official resources were mobilised, they would be wasted on financing investors’ exit and thus postponing an inevitable debt restructuring that would then be more disorderly.

So Italy’s public debt needs to be reduced now to at worst 90 per cent of GDP from the current 120 per cent. This could be done by offering investors the choice to exchange their securities either for a par bond – with a longer maturity and a low enough coupon to reduce the net present value by 25 per cent – or for a discount bond that has a face value reduction of 25 per cent. The par bond would suit banks that hold bonds to maturity and don’t mark to market. There should be a credible commitment not to pay investors who hold out against participating in the offer – even if this triggers the payment of credit default swaps.

With appropriate regulatory forbearance, it would allow banks to pretend for a while that no losses had occurred and thus give them more time to raise fresh capital. Since about 40 per cent of Italy’s public debt is held by non-residents, a debt restructuring will also imply some burden sharing with foreign creditors.

Some influential figures in Italy have suggested a capital levy, or wealth tax, could achieve the same reduction in public debt. But a debt restructuring is superior. To reduce the debt ratio to 90 per cent of GDP, a wealth tax would need to raise €450bn (30 per cent of GDP). Even if payment of such a levy were spread over a decade that would imply an increase in taxes equivalent to three per cent of GDP for ten years running; the resulting drop in disposable income and consumption would make Italy’s recession a depression.

To reduce such negative effects one would have to focus the tax on the wealthy – raising the rate to ten per cent of their wealth. Leaving aside the political risks of such a move, a debt restructuring is still preferable, as the burden would be shared with foreign investors. It would therefore hit consumption and growth less. Since Italy is running a small primary surplus, a debt restructuring would be feasible even without significant official external financing.

So debt restructuring is preferable to a Plan A that will fail and then cause a bigger, disorderly restructuring or default down the line. Even a debt restructuring would not resolve the problems of lack of growth and outright recession, lack of competitiveness and a large current account deficit. Resolving those requires a real depreciation that may well demand the eventual exit of Italy and other member states from the euro.

But exit can be postponed for a while. Restructuring, however, has to be implemented now. The alternative is much worse.

The writer is chairman of Roubini Global Economics and professor at the Stern School of Business at New York University

9 Responses to “Italy’s Debt Must Be Restructured”

Mark AllanNovember 29th, 2011 at 4:18 pm

You’re so right in what you say but you know deep down they won’t do as you suggest.
Obstinancey and pig-headedness rule the roost at the moment. The Eurozone is a busted flush and the fiddling and fudgeing is just staving off the inevitable.

MarcusSedlmayrNovember 29th, 2011 at 7:17 pm

As a physicist I do not agree that debt restructuring or some form of default would solve anything. Fiat money is something virtual. And changing some accounting figures would not entice people in those PIGS countries to work harder or to become more productive.

What counts are assets and collateral. Sovereigns have many options to increase the value of their asset under management. Retirement age could be increased to 75, working hours per week could be extended to 60 hours without pay increase. But yet the best idea to make people more productive, which comes to my mind, would be to put the debts directly onto people. Asking everybody to repay a certain amount of sovereign debt during their lifetime. People in Greece for example then would have the freedom to migrate to more productive countries in order to repay their debt more efficiently.

I am also not convinced that those hysteric creditors should really be taken too seriously. This hysteria is luxury. Investors are understandable nervous because they could put their money in emerging economies to more productive use at the moment. But image an Asian power which may become aggressive after 2013. Imagine a major war in the Pacific region or a confrontation with a conservative Islamic regime. Bringing some European countries to the brink of bankruptcy would seem childish in hindsight.

RcoutmeDecember 1st, 2011 at 8:22 am

@MS…asking everybody to repay a certain amount of sovereign debt during their lifetime.

Are you kidding? Suppose they simply refuse?

KiersDecember 7th, 2011 at 9:06 am

Good analysis! But even after all this doom and gloom how come the Euro is still trading at 1€= 1.30$!

Bring the euro to parity with the dollar then we’ll see how the crisis evaporates. But I suspect there is some arrangement that will prevent this from being reality. Its not all free markets.

MandeepDecember 7th, 2011 at 3:31 pm

Italy’s debt is owned by investor’s who are supposed to have invested with eyes open. investments can go up or down i.e. losses can occur. So either the debt gets restructured and investor’s take a orderly haircut or Italy defaults on a payment. If Italy defaults investor’s/insurers that issued the CDS’s and pocketed the premium’s need to payout (its not a free lunch to issue CDS’s). Any new issuance of debt by Italy will subsequently be correctly priced for risk. And in the worst case if nobody will lend to Italy anymore it will be forced live within its means by painful reform. Any of those options should be viable. Let the dominoes of failed inestor’s/institutions fall where they may, the important functions of those institutions can then be salvaged through bankruptcy process and merged with surviving banks that are managed more judiciously. Instead of throwing trillions of good tax payer money at private investors, it can be used later to salvage the key functions required for market operations out of busted banks and also to prime lending in the economy.
My two bits, to stop the perpetuation of the Scam by the RBS’s and the GoldmanSac’s of this world

CacapsiJanuary 6th, 2012 at 8:11 pm

oh cazzo, ma questo qui non è che mena rogna???….mi tocco le balle…un saluto agli amici del FOL:)