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    Vicious loop

    Fatih Özatay, PhD01 December 2011 - Okunma Sayısı: 1286

    The current public debt/GDP ratio in Italy is too high, at 120 percent. The main reason why the interest rate is high is the high level of public debt.

    During the auction held on Tuesday, Italian Treasury sold bonds worth € 7.5 million. Interest on three-year and ten-year bonds rose to 7.89 percent and 7.56 percent, respectively. The rate that appeared in the previous auction on ten-year bonds was 6.06 percent. Average inflation rate for the last twelve months was 2.5 percent. If we assume that the rate will remain more or less constant, the given rates correspond to 5 percent in real terms. In short, currently Italy has to agree to pay 5 percent interest to borrow. OECD expects that Italy will grow by 0.5 percent in 2011. Growth estimations for 2012 and 2013 are minus 0.5 percent and 0.5 percent, respectively.

    A difference of 5.5 points

    For countries that make borrowing in domestic currency terms, there are two main factors that determine the change in public debt as a ratio to gross national product (GDP). First is the difference between real interest rate and real growth rate. As the above data suggests, the difference between the two for Italy will be 5.5 percent by 2012. This implies that by the end of 2012, the public debt/GDP ratio will be higher for Italy. The current public debt/GDP ratio is already too high, at 120 percent. On the other hand, the main reason why the interest rate is elevated is the high level of public debt. This is where the vicious loop emerges: If public debt is high, real interest rate on borrowing will also be high. If the perception that the country will face difficultly in repaying the debt dominates the market along with certain triggering factors, the country ends up with higher real interest rate on borrowing. Thus, public debt increases further in the next stage. The debt ratio and real interest rate increases feed each other and in the end both increase. This is why I called this a “vicious loop” not a “vicious circle.” The precondition to overcome this loop is to record a primary budget surplus, the second factor determining the change in debt ratio. As the above calculations suggests, Italy has to achieve a budget surplus corresponding to 5.5 percent of GDP to keep debt ratio constant at 120 percent.

    Growth rate might decrease

    This is quite a difficult target to achieve; but it is not impossible. The problem is that, 120 percent budget debt ratio cannot be reduced even with such a high level of primary surplus. Two conditions have to be met to reduce the debt ratio. First is that, markets have to agree to lend Italy at lower rates with the positive effects of the expectation that it will achieve a primary budget surplus. Second is that, Italy has to achieve a higher growth rate which will narrow down or even close the gap between the real interest rate and real growth rate and lower debt ratio with the help of the primary surplus. Again, the problem is that if Italy steps on the brake that hard, growth rate might not increase but fall. In the face of this risk, it is thought that markets might be completely convinced that Italy’s debt is unsustainable and hence might stop lending or raise interest rate further. Countries in a similar condition had faced such problems before. In such occasions, another institution (say the IMF) had provided the countries in question funds at an interest substantially lower than the bubbled market interest (obviously on the condition that the countries in question put on the brake and recorded budget surpluses) and tried to lower risk perception against the country and thus the real interest rate without requiring the country to gear down sharply. Then it was hoped that a new process during which the debt ratio will fall would start. For the last time, the problem is that Italy is a large country. What is more, Spain and Belgium are also waiting in the queue. The finance requirement of the three for the 2012-2013 period is calculated to be around € 1 billion at best. Neither the IMF nor the European Financial Stability Fund (even neither the both) can provide this amount.


    This commentary was published in Radikal daily on 01.12.2011