Public Debt Sustainability in Italy: Problems and Proposals - Paolo Manasse SYRTO Code Workshop Workshop on Systemic Risk Policy Issues for SYRTO (Bundesbank-ECB-ESRB) Head Office of Deustche Bundesbank, Guest House Frankfurt am Main - July, 2 2014

1. Public Debt Sustainability
in Italy: Problems and
Proposals
SYstemic Risk TOmography:
Signals, Measurements, Transmission Channels, and
Policy Interventions
Paolo Manasse, Università di Bologna
Silvia Merler, Bruegel
SYRTO Code Workshop
Workshop on Systemic Risk Policy Issues for SYRTO
July, 22014 - Frankfurt (Bundesbank-ECB-ESRB)

2. 1. Public Debt in Italy: Some Facts
2. Is Public Debt «sustainable»?
3. If not, what can be done? Muddle through vs
Mutualisation vsUnilateral Rescheduling
4. Historical Experience?
5. Conclusions
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3. Austria 79.085
Belgium 99.829
Cyprus 121.534
Estonia 10.916
Finland 60.164
France 95.756
Germany 74.551
Greece 174.697
Ireland 123.668
Italy 134.509
Latvia 32.711
Luxembourg 24.125
Malta 72.542
Netherlands 75.030
Portugal 126.689
Slovak Republic 58.621
Slovenia 74.857
Spain 98.805
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4. Debt and nominal GDP:
Solvency issue (source: OECD)
Debt Com ing Due: 550b in 2014-19
Liquidity issue (source: Panizza,
2014)
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5. Debt Composition: good news
(source MEF)
Rate: mostly fixed rate (vs
floating) Currency: Domestic (vs Foreign)
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6. Maturity: reasonably long
Short vs. medium and long-term
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7. Who Owns the Italian Debt?
Source: MEF
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8. Paolo Manasse 8

9. Public Debt in Banks’Assets: Back to where it once belonged
(source BoI)
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10. Italian Banks -% total assets, holdings of securities issued by:
Italian Eurozone (exc. Italy)
Govern
ment Banks
other
sectors
Govern
ment Banks
other
sectors
1999 12.3% 2.2% 0.2% 0.2% 0.2% 0.1%
2001 8.5% 2.2% 0.5% 0.5% 0.2% 0.3%
2002 8.5% 2.4% 0.7% 0.2% 0.2% 0.4%
2003 7.6% 2.7% 0.9% 1.0% 0.4% 0.4%
2004 6.9% 2.6% 1.1% 1.0% 0.5% 0.4%
2005 5.8% 3.0% 1.0% 0.7% 0.4% 0.4%
2006 5.6% 2.8% 0.8% 0.7% 0.5% 0.5%
2007 4.9% 3.6% 0.9% 0.4% 0.6% 0.6%
2008 5.1% 5.3% 1.7% 0.3% 0.7% 0.8%
2009 6.0% 5.6% 1.6% 0.2% 0.7% 0.7%
2010 6.0% 5.6% 3.7% 0.2% 0.6% 0.7%
2011 7.7% 8.2% 3.6% 0.1% 0.4% 0.7%
2012 9.4% 8.7% 3.3% 0.1% 0.3% 0.5%
2013 10.5% 7.8% 3.4% 0.2% 0.4% 0.2%
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11.  Italian debt is almost entirely governed by Italian law
 All short term debt is under Italian law (BOTs).
 Longer maturities: more than 97% governed by local
law (Moody's, as Jan 2012). Remainder under U.S.
law (1.8%) and UK law (.2%).
 Spain (98.8%), Belgium (99.8%), Germany (100%),
France (100%), and the Netherlands (100%),
Greece(prior to the Greek exchange) 92%
Sources: Boudreau et al. (2012); Moody’s (2012)
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12.  Decreto Presidente Repubblica Dec.30, 2003, no 398,
art.3 «…Ministry can proceed in order to restructure
the national and external public debt, to the
reimbursement before maturity of bonds, to the
transformation of maturities..»
 Creditor protection clauses : 96% of bonds due after
Feb 2012 have no contract terms (CAC after Jan.2013)
legal conditions favorable to debtor
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13.  Trading Books: according to EU 2011 stress tests, 66%
Mark-to-Market , today estimated at 20-30%
 Banking Books, according to EU 2011 stress tests 34%:
«Hold-to-maturity» Face Value, today estimated at 80-
70%
Potentially Limited impact on banks asset value
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14. 2015 2016 2017 2018 2019
IMF Forecasts
Interest rate 0,039 0,041 0,042 0,043 0,044
GDP growth 0,01 0,013 0,012 0,01 0,01
Inflation 0,012 0,014 0,015 0,015 0,016
Primary Surplus 0,033 0,045 0,049 0,052 0,052
Scenario 1:
Debt/GDP stable 1,35 1,35 1,35 1,35 1,35
Scenario 2:
Debt/GDP Fisc compact 1,35 1,31 1,28 1,24 1,21
1.Primary Surplus 0,023 0,019 0,020 0,024 0,024
2. Primary Surplus 0,056 0,056 0,058 0,056
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15. Paolo Manasse 15

16. Paolo Manasse 16

17. a) Kick-the-can-down-the-road:
Large fiscal consolidation
Risks:
 interest rates up
 political backlash
 possible debt runs
 ECB’s OMT challanged
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18.  Buy-backs (externally financed ?): expensive, debt price
rises, creditors benefit more than debtor
 Debt Swaps/Reprofiling (new senior debt): «voluntary»
exchange, old creditors loose as old bond price drops,
debtor gains
- Risks:
 financial repercussions on banks (590b)
 legal challange at ECJ, litigation costs
 trigger CDS (italian banks likely net purchaser of
protection)
 rating downgrade
 ECB collateral
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19.  Debt-Equity Swaps (privatisation): solvency improves
only if
 loss of control of privatized assets
 large inefficiency of public sector
 deep pocket investors
Risks: ineffective
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20. (b) Concerted Lending/Forgiveness/Mutualisation
 Voluntary Exchange/Interest Standstill
 Euro-bonds
 Euro-bills
 Redemption Fund
 Red-Blue Bonds
 PADRE
Problem: Politically difficult (No Mutualisation without
representation)
For a comparative summary and assessment of previous proposals :
http://www.bruegel.org/publications/publication-detail/publication/733-paths-to-eurobonds/
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21. Costs of a Restructuring and Default
 Borrowing costs and exclusion from capital markets
- depend on the size of creditor losses. An increase in haircuts by
20 percentage points is associated with 50 basis points higher
borrowing costs (next six years), and lower likelihood of re-
accessing capital markets.
 Output and trade costs
- Drop in GDP of between 2 and 5 percent per year (depending
on duration, banking and currency crises). Bilateral trade flows
fall up to 7 percent for more than 10 years
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22.  Financial Sector Implications:
-banking sector distress, causing bank failures and bank
runs, such as in Russia in 1998.
 FDI Flows and Private Sector Access to Credit:
- drop in FDI of up to 2 percent of GDP per year.
- Corporate external loan and bond issuances have
dropped by up to 40 percent.
 Negotiation Costs and Fees:
The expenses for financial and legal advisors can be
substantial. During the 1980s, fees reached up to 2
percent of restructured volumes.
Problem: Italy’s case implies systemic risks
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23. - Now is good time to raise the issue of debt
sustainability: markets are calm, maturity and currency
composition are favorable, legal and accounting
features likely to reduce litigation costs, risks of
systemic banking crisis are not overwhelming, required
haircuts and adverse economic consequences are
reasonable
- Multilateral approach and reprofiling seems to
minimize costs.
- The idea if ain’t broke don’t fix it» is myopic and
potentially more risky. Maral hazard can be dealt via
conditionality
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24. Delpla and Von Weizsäcker (2010), subsequently changed
 Mutualise debt of each member state equal to 60% of GDP with Blue
bonds. The remainder (Red bonds) still to be issued on a national basis
 This split and the joint and several guarantees are designed to insulate
banks from national sovereign risks, lower borrowing costs for some
sovereigns, and reduce flight to safety
 Any borrowing above the 60% of GDP threshold would be through the Red
bond. Red Bonds are explicitly junior and hence at a (marginal) cost
reflecting the country’s own creditworthiness, thus maintaining price
signals and fiscal discipline incentives.
 The proposal has been amended to clarify that the transition would be
gradual, with guarantees and common bond financing phased in over a
period of 3-4 years.
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25. Euronomics group (2011)
 Create a form of common safe debt by pooling and tranching a balanced
portfolio of EZ sovereign debts.
 The result would be a two-tier structure with a senior tranche (European
Safe Bond - ESBies) and a junior tranche (EJB).
 Benefit (1): banks holding ESBies would no longer be exposed to national
sovereign risks, but to combined EZ risk;
 Benefit (2): any flight to safety would be from the EJBs, the junior (risky)
bond, to the ESBies and not from one country to another
 The core of the proposal requires no sovereign guarantees, so it faces
possibly limited hurdles to implementation, yet it can also be easily
reversed. However, it is a form of financial engineering, which may limit its
appeal to policymakers.
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26. German Council of Economic Experts (2011)
 A Redemption Pact would transfer debt of a member state in excess of 60% of
GDP into a European Debt Redemption Fund (ERF) for which all members
would be jointly and severally liable.
 The total debt covered would amount to some 27% of EZ GDP, with Germany,
Italy, and Spain the largest participants.
 In return, countries would agree to repay ERF the transferred debts within 25
years, with these obligations senior to remaining national debts and possibly
backed up by collateral and dedicated tax revenues from each country.
 During a roll-in phase of 3 to 4 years, participating countries would, by
transferring obligations coming due up to their issued quota of guaranteed debt,
be able to meet much of financing requirements. Any other debt would remain
of national responsibility and be junior.
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27. Hellwig and Philippon (2011)
 A variant to the Blue-Red proposal limited to short-term common debt (i.e.,
Eurobills), envisioned to be about 10% of GDP.
 The proposal pools all short-term borrowings, backed up by joint and several
guarantees, and thus allows (some) member states to borrow some amounts at
lower interest rates—thereby improving their debt sustainability dynamics,
while at the same time providing a safe asset to banks—thereby reducing
financial stress.
 The short maturity has the benefit of imposing some continuous discipline (as
guarantees need not be renewed). And while the proposal is easily scalable to
longer-term claims, it also has a built-in exit mechanism (as claims with
guarantees can be rolled off).
 Because of its more limited nature, the proposal is thought to more easily
comply with European and national legal constraints.
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28. European Commission (2011)
 The EC version is called stability bonds.
 There are three options listed, which largely build on
abovementioned proposals and range from complete substitution
of national debt by common bonds issued under a joint and
several framework, to issuance of both common and national
debts, and to a more modest option of bonds with just several
guarantees.
 Depending on the option chosen, changes to institutions,
including EU-Treaties and financial markets, would be needed to
minimize risks, especially moral hazard, ensure budgetary
discipline, and keep costs low.
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29. This project has received funding from the European Union’s
Seventh Framework Programme for research, technological
development and demonstration under grant agreement n° 320270
www.syrtoproject.eu
This document reflects only the author’s views.
The European Union is not liable for any use that may be made of the information contained therein.