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Italy - Greece spread: what you need to know

Updated: May 20

Introduction


The spread is a key concept in financial markets that measures the spread between the yields of government bonds of two countries. Specifically, it refers to the difference between the yield on government bonds of a country considered riskier and the yield on government bonds of a country considered safer. In this context, we focus on the spread between Italian (BTP) and Greek (Ggb Tf) government bonds.

This indicator is often used to assess the risk associated with investing in a particular country's government bonds and reflects the markets' perception of that country's economic and financial conditions.

The spread between Greek and Italian government bonds is the difference between the yields on government bonds issued by the two countries. In other words, it measures how much riskier it is to invest in Greek versus Italian government bonds. If the spread between Greek and Italian government bonds is high, it means that the markets believe there is a higher risk associated with buying Greek government bonds. This can be attributed to several factors, including concerns about Greece's economic and financial stability, the level of public debt, political stability and the fiscal policies of the two countries

on the sustainability of its public debt or other factors influencing risk perception. The spread between Italian and Greek government bonds is calculated by subtracting the yield on Greek government bonds from the yield on Italian government bonds with the same maturity. A positive spread indicates that Italian interest rates are higher than Greek interest rates for securities with the same maturity.





Economic background



In recent decades, both Italy and Greece have gone through a series of economic challenges and significant changes.

Economic growth is certainly one of the most important indicators. Over the past two decades, Italy has experienced modest and fluctuating GDP growth, averaging around 0.5 per cent per year. In the case of Greece, the situation has been similarly complex, with periods of robust growth followed by a severe financial crisis and a drastic economic contraction, but has begun to show signs of recovery in recent years.


One of the key factors in this economic recovery has been the package of reforms implemented by Greece in response to the debt crisis between 2011 and 2013.

These reforms helped to improve fiscal stability and promote economic growth. However, it is important to emphasize that the reforms came at an initial cost in terms of income losses and social suffering. This was a painful, but necessary step in rebalancing public finances and creating the basis for future growth. The main reforms touched on the issues of workers' collective bargaining, redundancies and digitisation.


Another key indicator influencing the confidence and credibility of the two countries is the performance of their respective labor markets, so unemployment is another key indicator. Italy has struggled with a persistently high unemployment rate, fluctuating between 10 per cent and 12 per cent over the last two decades, while Greece experienced a significant increase in unemployment during the financial crisis of 2008, reaching peaks of over 25 per cent, but gradually declining to around 16 per cent in 2021. Public debt is a common problem for both countries. Italy has one of the highest public debts in the world, exceeding 130% of GDP. Greece faced a debt crisis in 2010, with debt exceeding 180% of GDP. Both countries had to adopt austerity measures to reduce budget deficits.

It is also crucial to note that a large part of Greek public debt is held by European institutions, mainly the European Stability Mechanism (ESM). This is important because Greek public debt has very long maturities, with an average residual life of around 17 years, and very low interest rates, averaging around 1.2%. Moreover, these rates are fixed.


This means that the increase in interest rates set by the European Central Bank (ECB) has a very modest impact on the average cost of Greek debt. Since the interest rate is fixed and the maturities are long, Greece does not face the same risks associated with rising interest rates that could affect countries with debt that is more sensitive to rate fluctuations.

This situation offers Greece greater stability in its debt servicing and contributes to the confidence of international investors. Moreover, long maturity debt and low rates reduce pressure on public accounts and allow the government to focus on investment and economic development.


Greece's economic situation has improved considerably in recent years, as evidenced by reports from international institutions, such as the International Monetary Fund (IMF), the Organisation for Economic Cooperation and Development (OECD) and the European Commission. This positive period is in contrast to the years of debt crisis that hit Greece in 2010, which caused significant income losses and social suffering.




The effects


The first effect, known to all, of a high spread is that the higher the spread, the higher the cost of financing and refinancing for the Italian Treasury, and this will have an impact on the state's finances as interest expenditure increases and reduces the fiscal space for possible maneuvers.

Various analyses report that with a public debt at 143.5 percent of GDP, a 1 percent (100 basis points) increase in the spread implies a 1.435 per cent increase in public expenditure on interest on public debt.

Taking the GDP values of 2022, it leads to higher interest expenses of close to 25 billion annually, which will then have to be covered with new taxes or spending cuts (i.e. also reduction of public services).

The increase in the spread does not increase the cost of financing the state in the short term, but since the residual life of the debt securities issued by the Italian state is 7 years (the residual life of a security is the difference between the redemption date of the security and the current date), it does increase it over the years. The residual life of Italian debt has been wisely lengthened to 7 years in the past few years, favoring the issuance of longer-term rather than short-term bonds by taking advantage of the historical period in the past decade when interest rates were extremely low.

Consequently, an increase in the spread today means that interest costs will gradually rise as the state has to borrow to finance new deficits or to roll over old bonds coming to maturity.


A second, equally relevant reason is that an increase in the spread may signal that the state is about to lose access to the market. In situations where the spread explodes upwards, this leads to a loss of confidence on the part of savers and institutional investors. This loss of confidence translates into a further increase in the spread to the point of potentially refusing to buy government bonds because they are considered too risky, something that happened during the sovereign debt crisis in Europe in 2011.

The loss of access to the market is a catastrophic event, because it means that the state no longer has the financial means to meet its obligations, considering that Italy has to refinance around EUR 400 billion every year on the market. This would mean requesting credit from other states in order not to go bankrupt or from supranational bodies such as the International Monetary Fund by commissioning the country.


Finally, the last reason is that an increase in the spread puts the banks in a crisis situation and generates a restriction of credit. This happens for two factors, the first being that it raises the cost of bond funding for banks, forcing them to raise the cost of money for households and businesses. The second reason is that banks would see the value of the securities they hold fall, and since government bonds now account for about 10 percent of banks' assets, an increase in rates would reduce their assets, forcing them to cut back on credit as a result of international rules.



As analyzed above, the situation of Italy and Greece are almost opposite. For Italy, there is a risk that in the coming years there will be a widening of the spread with respect to Greece and the countries considered more reliable in the EU, especially if inflation were to be higher for longer than estimated today. As far as the Greek situation is concerned, after the various fundamental reforms carried out and the much tighter fiscal policy maintained in recent years (also due to constraints), it is in a situation where the spread is closing. If it were to continue to grow at the current rate and maintain low public deficit ratios, while also taking advantage of the markets' regaining confidence, it could see its spread fall, which would entail a reduction in the cost of refinancing over time and consequently more fiscal space that could also be used to reduce debt, thus exploiting an effect that economists call snow-ball.



Italy and Greece faced significant economic challenges, with Greece overcoming its debt crisis through painful reforms, long-dated debt and low interest rates. For Italy, rising spreads pose a financial threat, increasing debt financing costs and undermining investor confidence.

This could lead to a loss of access to financial markets and put banking stability at risk. Responsible public debt management remains crucial for both countries to ensure economic stability and future prosperity.


Forecasts on the economic and social future of Greece and Italy are complex and influenced by a number of evolving factors. However, it is possible to identify some elements that might suggest that Greece will have a better situation than Italy in the future. First, Greece has faced a deep financial crisis in recent years, but has undertaken significant structural and austerity reforms that have helped improve its fiscal situation. Italy, on the other hand, has struggled with high public debt and stagnant economic growth. Greece, thanks to these reforms, has started to recover and see signs of economic growth, whereas for Italy the job is much more complex and much longer.

Secondly, Greece has benefited from foreign direct investment, particularly in the tourism sector, which has supported its economy in recent years.

The beautiful country has always had to reckon with some structural problems at organisational, judicial and social level that do not allow it to fully exploit its potential.


In the short term, however, Italy's prospects are better than Greece's, also as a result of the numerous adjustments Greece has had to make in recent years. In the long term, however, the situation is reversed, as the reforms that have been carried out, which have increased the potential GDP growth rate and restored public finances, will lead to a better situation in the future. This is also observed and priced by the financial markets, with the result that the spread, the 10-year interest rate paid by Greece, is lower than that paid by Italy.






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