The Threat of the Mini-BoT

Investors are having a fit.  For the first two months after the early March Italian elections, investors could hardly care less.  Italy's premium over Germany to borrow money for a decade fell to a two-year low in late April near 132 bp.  In the last two sessions, it has jumped nearly 40 bp to 1.87%.  

The economic program of the new government is not clear, but three initiatives were worrisome for investors.  The move to a two-tier flat tax of 15% and 20% was the most costly and the (Northern) League has insisted on keeping this campaign promise.  The Five Star Movement insists on keeping its campaign promise to give more assistance to the poor and unemployed.  The EC may be able to make peace with these in some form, especially if they are coupled with structural reforms that will boost the country's growth potential.  

Both political parties resist the reforms the EU demanded, and in particular the phasing in of later retirements.   The new government has promised to unwind those reforms.  With high rates of youth unemployment, it may be understandable to speed up the generational shift.   However, the parties do not seem particularly interested in linking the two together through reforms in the apprenticeship programs.   Forcing older workers out is not the same thing as creating employment opportunities for younger cohorts.    

These initiatives could cost between 100-125 bln euro as a ballpark estimate.   Italy's debt problem is not the result of recent deficits.  Even in 2009, during the worst of the financial crisis, Italy's deficit widened to about 5.3% of GDP, which is considerably smaller than many of the large economies.  Italy has been running a fiscal deficit of less than 3% of GDP since 2011, with an exception of 2014, when it recorded a 3% deficit, which is the most under the Stability and Growth Pact.  Italy's deficit this year was projected to be near 1.8% of GDP.  If the cost of the initiatives were paid in full this year, it would likely bring the deficit toward 3% of GDP.  

If it were just these fiscal issues, investors might not have become so agitated.  What makes it a systemic risk rather than an idiosyncratic Italy story, is the mini-BoT proposal.  Essentially, the initiative calls to study the feasibility of Italy's Treasury to issue small denominated T-bills (hence the mini-BoT) to pay state arrears.  

The fear is that these Treasury bills will become a stealth parallel currency.  They would be accepted by the Italian Treasury for tax obligations, and would likely sell a discount.  Moreover, since they are not technically currency, the min-BoTs would not face the 3k euro ceiling on cash payments, thus, in effect, offset some of the asphyxiation of the underground/cash economy, spurred by past reforms.    

A key issue is the size of the government arrears.   It appears to be around 2% of GDP,  which puts it close to 36-40 bln euros as of the end of 2016.  The national accounts for last year are expected to be released in the next week or two.  The problem of government arrears is serious.  Many of the goods and service providers to the government are small and medium-size businesses.  

The government's arrears add to the pressure on these businesses to pay their bills and services their debt.  The inexperience, and perhaps the ill-intentions of some involved, will obscure something important.  The arrears could be securitized and traded.    Many observers are suspicious of the scheme.  Not only because it there is risk that it becomes a parallel currency, but also because it could be used to reinforce rent-seeking behavior--where those are connected and in the know, can take advantage of those that are not as well connected or in the know, which includes foreign investors as well as some domestic investors.  It will be recalled that Greece has explored a similar scheme.  

Until these issues are sort out and intentions are clearer, it may difficult to stabilize the Italian asset markets.  Investors can handle idiosyncratic risk from Italy, but the threat of new systemic risks, may weigh on the euro and bolster non-EMU European currencies, like the Swiss franc, Danish krone, and the Scandis.  

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