Posted by: Dirk | November 11, 2011

Institut der Wirtschaft on Italian bond yields

The SPIEGEL gives some room to the IW, using as a headline “New calculation: Hysterical reaction to Italian bond yields excessive“. The reasoning is the following. Secondary market bond yields are high, but they feed through slowly because only when old bonds mature and have to be replaced by news ones the interest rate is updated. Since Italy replaces only 750 billion euros worth of its 1,900 billion bonds outstanding, the interest rate for the Italian government will rise only slowly. Jürgen Matthes concludes that if the new bonds carry an interest rate of 7%, then Italy in 2015 would face an average interest rate on its bonds outstanding of only 4.66 percent. Ten years ago the same rate was at 6.0 percent and the country paid its interest, the article ends.

This argument misses the point. In the euro zone, a country with sovereign debt problems needs more growth (or inflation) for the repayment of debt. Italy is not growing (and cannot print money) – growth can be stimulated only by increasing net exports. After all, monetary policy, fiscal policy and devaluation are not available, neither is more borrowing by the government to invest in growth-increasing infrastructure or pushing domestic banks to buy more bonds (or lend money to those that would). So, let us look at the current account of Italy ten years ago, which would be 2001:

By 2001, Italy’s current account was almost perfectly balanced. The country had a history of current account surpluses, and it was credible that it might return to that situation. In 2001, the dot-com crash is not yet reflected in the data. The German export-led growth strategy kicked in only in the following years. You can see that the Italian current account deteriorated in the following years.

Today, ten years on, the picture looks quite different. Italy has had dismal growth, and a huge gap in the current account. That is why bond investors believe that, well, hysterical reactions are based on the underlying fundamentals. And by the way, the analysis of the IW does not tell you absolutely everything – Italy is also out of espresso!

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