Both Italy and Japan face high debt ratios. Yet while Italy is seen as a cause for concern, the Japanese market remains favourable among investors.
Continued shocks have dominated the global landscape in recent years. From the coronavirus pandemic to escalating geopolitical tensions, a tone of uncertainty prevails – and economies continue to struggle with the economic fallout globally. Notably, high interest rates and mounting costs have seen sovereign debt levels escalate and, in some countries, bond yields have risen to levels not seen since the 2008 global financial crisis.
Yet the reaction from investors has not been uniform. Japan and Italy, for instance, are both contending with incredibly high public debt ratios. However, while Italy, which has the second highest ratio in the Eurozone, is seen as a cause for concern, Japan – which has the highest ratio of any developed country globally – is still enjoying strong investor appetite.
Chronic economic underperformance and a complex political environment undermine the Italian market
Increased public spending has become a trend for governments globally, with many introducing support measures to offset the financial impacts of ongoing crises. But as interest rates have risen, Italy’s government is facing a huge challenge to manage rising debt, sparking concerns about its long-term solvency.
European bond yields have continued to rise steeply, and the 10-year interest rate on Italian bonds reached 4.7% in October 2023 – an increase of more than 400 basis points (bps) since January 2021. What’s more, Italy’s debt ratio currently stands close 140% of GDP, representing the highest in the Eurozone after Greece. It is expected to stabilise around this level. However, the rebalancing of the public fiscal balance will be slow and is not expected to fall below the European deficit limit of 3% until at least 2025 .
Italy’s GDP growth has consistently underperformed that of other European countries: since the creation of the Euro in 1999, Italy’s GDP growth has sat between 1.3% and 1.7% lower than the rest of the Eurozone.
When it comes to investors, Italy’s unstable political and economic reputation further compounds doubts. Its long-term sovereign debt is currently rated just one-to-two notches above junk by the top three credit ratings agencies. Meanwhile, its political system has been plagued by instability for decades. Since 1979, the average tenure for a prime minister has been just 16.5 months. A high political fragmentation within its two chambers and perfect bicameralism means new legislation is slow to adopt and coalitions can break easily.
Perhaps most damaging for investors, Italy’s debt burden has continued to escalate. Indeed, while high levels of public debt is not a new phenomenon in Italy, its debt burden – which currently stands at 3.8% and is expected to increase to 4.3-4.5% in 2024 – is becoming more and more costly. Coupled with inflated government macroeconomic projections and unambitious measures to stabilise fiscal debt, the outlook for Italy is not looking positive at a first sight.
However, some factors might offset this negative view like the average debt maturity of almost 7 years, the share of public debt securities held by domestic investors, including the Central Bank of Italy, and the institutional firewalls that can act as a deterrent against an attack on Italian debt.
The debt burden in Italy - which currently stands at 3.8% - is becoming more and more costly, we expect it to increase to 4.3-4.5% in 2024.
Jésus Castillo – Eurozone & Southern Europe Economist
Favourable financing conditions stabilize Japanese debt market
At a glance, Japan’s fiscal position appears to be equally as precarious as that of Italy. Its public debt has risen above 240% of GDP – the highest of any developed economy globally – and its sovereign rating has also faced steady decline. In tandem, as a result of its aging population, social security expenditures have progressively increased, with no pension and healthcare reforms on the horizon to compensate.
However, the Japanese debt market has remained remarkably stable, supported by the Bank of Japan’s (BoJ) accommodative monetary policy. In line with the BoJ’s Yield Curve Control (YCC) measures, the 10-year yield for Japanese Government Bonds (JGBs) has remained below 1% – a sharp contrast to yields in other developed economies, which have soared amidst hawkish central bank measures to contain inflation.
What’s more, maturity risk has been declining with the average maturity of JGBs rising to above 9 years, as the Ministry of Finance (MOF) switched from medium to long-term bonds. Importantly, the Japanese government doesn’t incur foreign exchange risk, since JGBs are financed entirely in Japanese Yen.
Japanese households and non-financials are net savers, leading to a current account surplus which has been used to finance JGBs. Meanwhile, the BoJ has rapidly increased its share in terms of JGB ownership, reaching 47.1% in Q2 2023, while foreign ownership was limited to just 14.6% containing the risk triggered by sudden capital outflow.
Reforms to public spending necessary to stabilise debt
Despite Japan’s current stability, fiscal sustainability remains challenging. Without a further improvement in the primary balance and potential growth, the government could face a tipping point when the BoJ begins to normalize.
With the public debt in Japan expected to remain above 200%, the government could face a tipping point when the BoJ normalizes.
Kohei Iwahara – Japan & Pacific Economist
Japan’s growth rate has also been stagnating. As its population ages, it has seen a decline in the size of its labour force, lowering the contribution to potential growth. Despite the BoJ’s accommodative monetary policy, capital has stagnated, meaning it will be difficult to life fiscal revenues without significant reform.
In Italy, on the other hand, retail investors may absorb a part of the ECB expected quantitative tightening which puts part of Italian bonds back into the private market. This would also create more stability for the Italian bond market as domestic investors are typically less likely to withdraw capital at short notice compared to foreign investors.
That said, Italy will eventually need to run primary surplus in the medium run and adopt measures to boost potential growth to reduce its vulnerability to a higher interest rate environment.
Italy will eventually need to run primary surplus in the medium run and adopt new measures to boost potential growth to reduce its vulnerability to a higher interest rate environment.
Théophile Legrand – Rates Strategist
In order to overcome their respective struggles, both countries will need to carry our far-reaching reforms to public spending, which would stabilise debt ratios – at least in the medium term. Looking further ahead, higher productivity gains would enable both countries to reduce public debt, but will be largely dependent on both government decisions and the wider trajectory of the global economy.
