Q & A: What does Italy's high bond rate really mean?

On Nov. 9, Italy's key borrowing rate surged past seven per cent, leading some observers to fear an upcoming debt default. CBC News spoke to an expert on capital markets about the significance of bond rates and the future of Italy's economy.
On Nov. 9, the day after Italian Prime Minister Silvio Berlusconi, centre, announced his resignation, the country's bond rate surged over seven percent. Greece, Portugal and Ireland all asked for bailouts after hitting that bond rate. (Tony Gentile/Reuters)

The news that Italy’s bond rate had surged above seven per cent sent markets into a tizzy on Nov. 9. The number is not necessarily a harbinger of economic collapse, but the seven per cent figure has symbolic value — Greece, Portugal and Ireland all asked for bailouts after hitting that bond rate.

Government bonds are financial instruments that allow countries to borrow money from other countries. As the size of a nation’s debt grows, so does the interest rate on its bonds.

The yield, or interest rate, on Italy's 10-year bonds hit 7.4 per cent. As a point of comparison, the yield on Germany’s 10-year bonds is around 1.7 per cent.

CBC News spoke to Laurence Booth, an expert on capital markets and a professor at the Rotman School of Management, about the significance of bond rates and the future of Italy’s economy.

CBC News: Why are bond rates such a key signal of a country’s fiscal health?

Laurence Booth: They represent the market’s perception of the creditworthiness of the borrower. Clearly, as countries get downgraded, just like an individual or a company, there’s greater fear that you’re not going to get back all of the money that you lent to them. And because of that fear, people turn around and sell their bonds, and the action of selling their bonds drives up the interest rate — and that’s what we’re seeing in Italy today.

Much has been made of the bond yield spread between Italy and a stalwart economy like Germany. Do you think Italy’s high yield is a cause for immediate concern?

It has no direct impact on Italy until [the country] has to turn around and refinance its debt. What’s important is that the direct impact is really minimal at the current point in time, but it points to the fact that when a lot of Italy’s debt comes up for renewal, people are not going to be willing to renew it unless there are significantly higher interest rates. Sooner or later, that will factor into their budget deficit, and events will snowball, as they have in Greece.

What are your thoughts on the market’s reaction to Italy's economic issues?

Personally, I think the market’s sell-off today is totally exaggerated. Italy has had what we call a "structural surplus" on its government budget for about the last 10 or 15 years. Its debt-to-GDP ratio [about 118 per cent], which is what we look at, has remained pretty stable for the last 10 to 15 years.

The big problem is that the market is not willing to finance countries on the same basis that it was even a couple of years ago. Italy really hasn’t changed that much – it’s still the low-growing, inefficient country with a large amount of debt that it’s been for a long time. What’s changed is the perception – if banks have been forced to take a 50-per-cent loss on their loans to Greece, perhaps they may be forced to take a loss on their loans to Italy.

Would people be as worried about Italy’s bond rate if its economic growth were more robust?

Italy’s got a really pathetic growth rate. If you’ve got a fast growth rate, you just grow yourself out of debt. We look at debt relative to GDP the same as we look at [the creditworthiness of] an individual. We look at their mortgage debt relative to their income, and if they get a rapid series of promotions their income grows rapidly, and the debt relative to their income drops, and we say, "Well, there’s no risk there anymore."

If Italy was a rapidly growing economy, then it would rapidly grow itself out of its problems. This is the central problem in the whole of the Euro zone – we haven’t recovered, in Europe and the United States, from the job losses during the recession. If we had that growth, we wouldn’t have a significant problem.

Is the Euro crisis having any adverse effect on government bonds as an instrument?

It’s certainly had an impact on government bonds in Canada, the United States, the U.K. and Japan, where the yields are at record lows, because they’re the safe havens. Because you know you may lose money on the exchange rate if a Canadian invests in the U.K., Japan or the U.S., but you know you’re going to get your money back. The same is true if you invested your money in Germany and to a lesser extent France.

But there’s a serious problem now with the precedent set in Greece, that after two years of saying that Greece will pay all its money back, there will be no haircut, no defaults, no cuts, we have this now. People are saying, "Well, they said that about Greece; what about Italy, or Portugal, or Spain?" Perhaps banks and everyone else are going to take losses on those — if the banks take losses on those, how much extra capital are they going to need, which banks are going to fail? Perhaps if the banks fail, we’re into a credit crunch, and if we’re into a credit crunch, perhaps this is Lehmann Brothers in 2008 all over again.

Personally, I don’t buy that scenario, but that’s what’s motivating what’s going on in the market.