Italian sovereign spreads have been driven by both euro area related and Italian specific factors, underscoring the importance of reducing country–specific vulnerabilities as well as addressing fragilities in the euro zone at large to contain common risks and spillovers. In turn, Italian sovereign spread shocks are rapidly transmitted to firm lending rates. Firm credit has contracted until March, driven both by demand and supply factors, although the latter seem to have prevailed at the end of last year. To ensure adequate supply of credit going forward, banks need to maintain strong capital and liquidity buffers.

Abstract

Italian sovereign spreads have been driven by both euro area related and Italian specific factors, underscoring the importance of reducing country–specific vulnerabilities as well as addressing fragilities in the euro zone at large to contain common risks and spillovers. In turn, Italian sovereign spread shocks are rapidly transmitted to firm lending rates. Firm credit has contracted until March, driven both by demand and supply factors, although the latter seem to have prevailed at the end of last year. To ensure adequate supply of credit going forward, banks need to maintain strong capital and liquidity buffers.

Italian sovereign spreads have been driven by both euro area related and Italian specific factors, underscoring the importance of reducing country–specific vulnerabilities as well as addressing fragilities in the euro zone at large to contain common risks and spillovers. In turn, Italian sovereign spread shocks are rapidly transmitted to firm lending rates. Firm credit has contracted until March, driven both by demand and supply factors, although the latter seem to have prevailed at the end of last year. To ensure adequate supply of credit going forward, banks need to maintain strong capital and liquidity buffers.

A. Introduction

1. Since the summer of 2011, the Italian sovereign bond market has been affected by a number of shocks. An important question is to what extent recent movements in Italian spreads reflect either country–specific vulnerabilities or more general euro area concerns. The first part of the paper analyses this issue by focusing on the impact of euro area and Italy specific news as well as macroeconomic variables on sovereign risk premiums, using daily time series as well as monthly panel regressions.

2. As the sovereign turmoil has spilled over to affect the banks, lending conditions, especially for firms, have tightened significantly. The second part of the paper illustrates the impact of sovereign tensions on firm lending rates and credit.2 A VAR approach shows that sovereign spreads shocks are rapidly transmitted to lending rates. Then, the paper tries to assess whether recent developments in firm lending have been driven by the slowing demand due to the contracting economy or by supply constraints.

B. Factors Driving Italian Sovereign Spreads

3. In the period preceding the global financial crisis, Italian government bonds spreads moved in line with those of other euro area government bonds. Indeed, during 1999–2007 sovereign risk premia were compressed as financial markets were not pricing in higher default risk for governments running higher deficits.3 There is indeed consensus in the literature that at least up to 2008, euro area sovereign spreads have been mostly driven by a common factor, reflecting international risk appetite (Codogno and others, 2003; Geyer and others 2004; Sgherri and Zoli, 2009; Caceres and other, 2010; Favero and others, 2010). However, since the Lehman bankruptcy, financial markets have been increasingly discriminating among government issuers (Sgherri and Zoli, 2009; Caceres and other, 2010).

4. Starting in July 2011, pressure on Italian government bonds intensified considerably. After remaining below 200 basis points (bps) until June 2011, 10–year bond spreads widened by almost 300 basis points in the second half of last year. They tightened only for a brief period in early 2012 after the 3–year Long term Refinancing Operations (LTRO) and remain about 280 bps above the end June 2011 levels. The volatility of spreads has also increased substantially, with the monthly standard deviation peaking in December 2011–January 2012. The largest daily changes in spreads have taken place at the time of international and Italian related announcements and events.

Dispersion in Euro Area Sovereign Spreads (1999-2009)

(Standard Deviation Accross Euro Area Sovereign Spreads)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: Bloomberg; and IMF staff calculations.

10-year Italian Government Bond Spreads against Germany

(Basis points)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Source: Bloomberg.

5. While sovereign risk premia continue to reflect common euro area factors, country–specific risks have become more important with the intensification of the euro area debt crisis. In the period January 2008–March 2010—preceding the first IMF Greek program— the first principal component explains about 87 percent of the variance in euro area spreads.4 By contrast, since July 2011 the variance share explained by the first principal component falls to only 55 percent.

6. Econometric analysis suggests that Italy’s high public debt is amplifying the impact of common shocks. Equations for daily changes in Italian 10–year government bond spreads are estimated over January 1, 2008–March 30, 2012 to assess the impact on country risk premia from common risk factors, international and Italian specific news, and projected country specific macroeconomic variables.5 Consistent with the literature, the implied volatility of the S&P stock price index options (VIX index) is used as a proxy for general risk appetite—a source of common risk. Indeed, Italian government bond spreads have moved in line with the VIX, and changes in the VIX are found to have a statistically significant impact on sovereign spreads. 6 Also, changes in the VIX index interacted with the projected debt to GDP ratio push up spreads, suggesting that the high level of debt has amplified the impact of investor risk appetite shocks.7

Italy’s Government Bond Spread and VIX

(Basis points)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: Bloomberg; and IMF staff calculations.

7. Both international and Italian–specific news have a sizable impact on daily movements in Italian 10–year spreads. Dummies capturing bad and good news related to important international events on the global and European sovereign crisis (e.g., the start of the Irish or Greek programs), as well as positive and negative news related to Italy specific events (e.g., approval of consolidation or reform measures) are found to have a statistically significant and large impacts on daily changes in spreads.8 9

Impact of International and Italian Specific Events on Daily Changes in Italian Government Spreads 1/

(Basis Points)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: Bloomberg and IMF Staff calculations.1/ Impact is based on a regressions for daily changes in 10-year government bond spreads estimated over the period January 1, 2008-March 30, 2012. The control variables are changes in the lagged dependent variable and the VIX.

8. Panel regressions find that changes in projected public debt to GDP ratios also affect euro area sovereign spreads, but the estimated impact is small. To assess the determinants of spreads movements in a broader context and exploit cross–country macroeconomic variables, a panel of 10 euro area sovereign spreads is estimated over the period January 2008–March 2012 at monthly frequency.10 Common factors, such as changes in the VIX and international news, have a statistically significant impact on country risk premiums. International good news reduced spreads by about 7 bps, while bad news raised them by 10 bps. The projected debt to GDP ratio has a significant, but small impact on spreads. Indeed, a 1 percentage point increase in the debt to GDP ratio leads to less than 5 bps rise in spreads. This is consistent with most of the literature that finds a limited impact of fiscal variables on government yields or spreads (Table 1). Lagged changes in the VIX index interacted with the projected debt to GDP ratio trigger an increase in spreads, again indicating that high debt amplifies the impact of investor risk appetite shocks. On the other hand, projected growth is found not to have a significant impact on spreads (Table 2).

Table 1:

Estimated Impact of Fiscal Variables on Government Spreads and Yields in the Literature.

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1. All changes are expressed in relation to GDP unless otherwise specified.Source: OECD.
Table 2.

Panel Regression Results 1/

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Sources: Bloomberg; EIU; NewsPlus/Factiva; and IMF staff estimates.

Equations were estimated at monthly frequency over the period January 2008–March 2012. A constant was included among the regressors. Bolded coefficients are those statistically significant at 5 or 1 percent.

Euro area good and bad news are dummies capturing good and bad news on international events related to the global crisis and European debt crisis. Details are reported in the Appendix.

C. Impact of Movements in Sovereign Spreads on Lending Conditions

9. Following the enhanced volatility in the sovereign debt market, credit conditions have tightened sharply, especially for firms. Higher sovereign risks has limited banks’ access to the international wholesale markets and pushed up funding costs.11 These were passed on to borrowers, as rates on new firm loans increased by 100 bps in the second part of 2011, and on new mortgages by 80 bps. In January, however, rates on firm loans started to decline, as sovereign spreads tightened (Figure 1).

Figure 1.
Figure 1.

Italy: Lending Conditions

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: Bank of Italy; Bloomberg; and IMF staff calculations.1/ Data adjusted for the accounting effect ofsecuritizations.2/ Data adjusted for the accounting effect of securitizations. Loans exclude repos, bad debts and some minor items.3/ Limited partnerships, general partnerships, informal partnerships, de facto companies and sole proprietorships with up to 19 workers.4/ Difference between the share of firms that declared to find access to credit more difficult compared to the previous quarter and the share of firms that declared to find access to credit less difficult compared to the previous quarter.5/ Net percentage.

10. Indeed, Italian sovereign spreads and lending rates have moved together since the onset of the euro area crisis in early 2010.12 Consistent with this, VAR analysis suggests that changes in sovereign spreads quickly affect corporate borrowing costs.13 About 30–40 percent of the increase in sovereign spreads is transmitted to firm lending rates within three months, and the transmission is nearly complete within six months, for both large and small loans. This suggests that a decline and stabilization in sovereign spreads would be essential for a sustained decrease in lending rates.

Sovereign Spreads and Firm Lending Rates

(Percent)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Source: Bank of Italy.

Response of Firm Lending Rates on New Loans to a 1 Percentage Point Increase in 10-year Government Bond Spreads

(Percentage points)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: Bank of Italy; Bloomberg; and IMF staff

11. Credit growth has also slowed down sharply, especially for small firms. 12–month credit growth to the non–financial private sector dropped from 3.5 percent in November to 1.6 percent in April 2012. This reflected the decrease in loans to non–financial corporations, concentrated especially in December, and a slowdown in household lending. The credit contraction was more severe for small firms, and more pronounced than in 2009 (Figure 1). Indeed, the 12–month growth in loans to small firms—net of bad debt and repos— declined from 0.4 percent (y/y) in November to –1.9 per cent in March. Bank and business surveys conducted toward the end of 2011 point to tight lending standards similar to those observed in the immediate period after the Lehman bankruptcy, owing to banks’ high cost of capital and funding difficulties, while more recent surveys indicate some improvement in loan supply conditions and a significant decline in credit demand (Figure 1).

12. As in previous recession episodes, the ongoing slowdown in credit growth is partly driven by the decline in loan demand. Historically, the sharpest slowdowns in credit growth in Italy have been associated with the severe recessions of the 1970s, early 1990s, and 2008–09, with the lowest nominal annual credit growth (−0.1 percent) taking place during the 1992–93 recession. Interestingly, the most recent episode of lending slowdown has been somewhat milder than in the 1992–93 recession, despite the severe 2008–09 output contraction, probably thanks to lower interest rates supporting demand and the policies put in place to sustain credit to small and medium sized enterprises.14 The 2009–10 credit slowdown was mainly driven by weak demand, even though supply constraints appear to have prevailed for a period in early 2009 (Albertazzi and Marchetti, 2010; Panetta and Signoretti, 2010; Del Giovane et al., 2010; Zoli, 2010).15 So far the pace of the slowdown in private sector credit seems to be consistent with that experienced in previous recession episodes. Indeed, almost three quarters since the start of the recession, nominal annual credit growth to the private sector has declined by 3.3 percentage points, compared to declines of 6.5 and 4.7 percentage points respectively during corresponding periods in the early 1990s and 2008–09.16

Credit Growth in a Historical Perspective

(Percent)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Annual Nominal Credit Growth Compared Across Recessions 1/

(percent)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Sources: ISTAT, IMF; and IMF staff calculations.1/ The legend shows the dates of recession episodes. t is the recession starting period.2/ Data adjusted for the impact of securitization.

13. However, the picture changed at end 2011 with supply constraints prevailing over weak demand. To assess the relative importance of demand and supply in affecting corporate lending, a loan supply and demand functions are estimated, using the bank survey on lending standards and credit demand from firms (BLS). Disentangling demand and supply effects in credit markets is not straightforward, as suitable exogenous instruments for identification are difficult to find. The approach adopted here assumes that the responses from loan officers in the BLS are good proxies for unobserved demand and supply. Hence, loan supply and demand are modeled as linear functions of the indicators of supply and demand conditions obtained from the BLS, respectively.17 Evidence of a potential supply-driven credit crunch is then assessed by evaluating whether the difference between fitted demand and supply (excess demand) is positive and large. The estimates of excess demand suggest that growth in loan demand the exceeded that of credit supply by 0.5 percentage points in 2011Q4, similar to that observed in the aftermath of the Lehman bankruptcy. A supporting piece of evidence at the end of last year can be found in net corporate bond issuance, which issuance returned positive in the fourth quarter of 2011, after having been negative for several months—a sign that firms were possibly substituting bank borrowing with bond issuance.

Difference between Estimated Demand and Supply in Bank Credit to Firms 1/

(Quarterly growth, percentage points)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

1/ Loan supply and demand are estimated as linear functions of the indicators of supply and demand conditions obtained from the bank lending survey, using equation [1] in Table 3.
Table 3.

Estimated Credit Demand and Supply 1/

article image
Sources: Bloomberg; EIU; NewsPlus/Factiva; and IMF staff estimates.

Equations were estimated over the period 2003Q1–2012Q1, using instrumental variables.

A constant was included among the regressors. Bolded coefficients are those statistically significant at 5 or 1 perce

Bank lending standards from bank lending survey responses.

Demand for loans from bank lending survey responses.

ISAE consumer confidence indicator, as a proxy for expected economic activity.

14. In 2012, the situation appears to have reversed with weak demand now driving changes in credit. After the LTROs and other actions taken by policy makers to support banks, estimated demand for credit fell well short of supply, as it happened in 2009, as the severe recession curbed loan demand. The decline in corporate borrowing rates observed in early 2012 is consistent with this conclusion.

15. While demand for credit is expected to remain subdued with the weak economy, a number of factors will probably continue to impinge on credit supply going forward.

  • Despite the large LTRO intake by Italian banks, the supply of loanable funds remains constrained by the need to repay debt coming to maturity and provide funding to the public sector. This is compounded by the decline in non-resident deposits and the difficulties in wholesale funding market.

  • Banks need to build up higher capital ratios to meet EBA and Basel III requirements and therefore may be inclined to shrink their loan portfolios.

  • The stock of bank non-performing loans is sizable, discouraging banks from increasing exposure to risky borrowers.

  • Firms’ ability to borrow may be constrained by (i) weak balance sheets, as financial leverage is at historical highs; and (ii) low capacity to repay and service debt due to higher interest bills.18

Non-financial Corporate Leverage

(Percent)

Citation: IMF Staff Country Reports 2012, 168; 10.5089/9781475506525.002.A003

Source: Bank of Italy.1/ Ratio to equity.

D. Conclusions and Policy Implications

16. With Italian sovereign spreads at elevated levels, the government bond market continues to be vulnerable to several risks. The analysis presented above indicates that news related to the euro area debt crisis as well as Italy specific news have been important drivers of Italian sovereign spreads. The analysis also indicates that Italy’s high debt levels amplify the impact of investor risk appetite shocks on spreads. These findings underscore the importance of reducing country-specific vulnerabilities as well as the need to address fragilities in Euro area at large to contain common risks and spillovers.

17. Lending conditions have been considerably affected by tensions in the sovereign markets. The analysis shows that increases in sovereign spreads raise bank funding costs, which in turn drive up firm lending rates. Therefore a decline and stabilization in sovereign spreads would be essential for a sustained decrease in banks’ funding and lending rates.

18. Credit growth to firms has declined significantly, reflecting both weak demand and supply constraints. The latter appear to have prevailed at the end of last year, and continue to impinge on lending. Going forward banks need to maintain adequate capital and liquidity buffers to ensure adequate loan supply.

Appendix – List of Events Corresponding to Good and Bad News

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References

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1

Prepared by Edda Zoli (EUR).

2

The focus is mostly on firms rather than households since the former receive about 60 percent of private sector credit and have the largest impact on investment and economic activity.

3

See Garzarelli and Vaknin (2005), Debrun and others (2008), and Attinasi and others (2009).

4

The principal component analysis uses an orthogonal transformation to convert a set of observations of possibly correlated variables into a set of values of linearly uncorrelated variables called principal components. The first principal component is the one that accounts for most of the data variability.

5

Monthly macroeconomic variable projections are used instead of actual variables since the former are in the investor information set when portfolio allocation decisions are made. During the sample period monthly projections have changed quite dramatically over time, and at times, were very different from the actual outcome. For example, in January 2009, the growth Consensus Forecast for Italy for that year was –1.6 percent, while actual growth turned out to be –5.2 percent.

6

Since Italy is a systemically important county, movements in the VIX may not be completely exogenous to changes in Italy’s spreads. However, Granger causality tests indicate that changes in the VIX affect Italian sovereign spreads movements, but not the other way around. To address possible endogeneity, equations are estimated using instrumental variables.

7

For example, at the debt to GDP ratio projected for this year, a one standard deviation shock in the VIX index sustained for 5 days (a 10 percentage point increase) would increase spreads by about 20 bps.

8

The Appendix provides the list of events captured by the dummies.

9

Using government bond yields changes instead of spreads as the dependent variable does not alter the overall results. International and Italian specific good news reduce yields by 6 and 34 bps, respectively, while international and Italian specific bad news raise yields by 11 and 12 bps, respectively.

10

For program countries, only the pre–program period is included in the sample.

11

An analysis of the link between sovereign risks and bank funding costs in Italy is presented in Zoli (2011).

12

The correlation between changes in 10–year government bond spreads over the Bund, and changes in lending rates on firm new loans was 0.1 in the period January 1999–April 2010, and 0.4 afterwards.

13

The VAR, estimated at monthly frequency over January 2006–February 2012, includes changes in sovereign bonds spreads and changes in bank CDS spreads, as well as changes in the 3–months euribor as an exogenous variable. The model focuses on the impact of sovereign spreads, instead of yields, as the former measure the country risk premium affecting banks’ CDS spreads and their cost of funding, whereas the euribor is a proxy for the underlying interest rate.

14

A comparison with the 1974–75 recession is rather difficult, due to the impact of high inflation rates on nominal and real credit growth at that time. Comparisons with more recent recession episodes could be misleading, as in those cases the output contraction was much milder.

15

Albertazzi and Marchetti find that supply restrictions account for 1 percentage point of the 7 percentage points slowdown in credit growth in September 2008–March 2009. Panetta and Signoretti (2010) estimate that in 2009 the output contraction due to lending supply tightening was 1.2 percentage points.

16

Annual credit growth data expressed in real terms show a similar pattern.

17

Specifically, the dependent variable is the quarterly growth in seasonally adjusted credit to non-financial firms. Regression results are reported in Table 3. A similar approach is used in Jakab and Benes (2012). Results similar to those presented here are obtained if the indicators of demand and supply from the BLS are “purged” as in the Jakab and Benes’s study.

18

According to Bank of Italy, the share of firms with a ratio of interest expense to gross operating profit of more than 50 percent could raise from 32 percent in 2010 to almost 40 percent in 2012 (and even more under a stressed scenario) on account of lower profits and rising interest rates.

Italy: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Dispersion in Euro Area Sovereign Spreads (1999-2009)

    (Standard Deviation Accross Euro Area Sovereign Spreads)

  • View in gallery

    10-year Italian Government Bond Spreads against Germany

    (Basis points)

  • View in gallery

    Italy’s Government Bond Spread and VIX

    (Basis points)

  • View in gallery

    Impact of International and Italian Specific Events on Daily Changes in Italian Government Spreads 1/

    (Basis Points)

  • View in gallery

    Italy: Lending Conditions

  • View in gallery

    Sovereign Spreads and Firm Lending Rates

    (Percent)

  • View in gallery

    Response of Firm Lending Rates on New Loans to a 1 Percentage Point Increase in 10-year Government Bond Spreads

    (Percentage points)

  • View in gallery

    Credit Growth in a Historical Perspective

    (Percent)

  • View in gallery

    Annual Nominal Credit Growth Compared Across Recessions 1/

    (percent)

  • View in gallery

    Difference between Estimated Demand and Supply in Bank Credit to Firms 1/

    (Quarterly growth, percentage points)

  • View in gallery

    Non-financial Corporate Leverage

    (Percent)