In the aftermath of the Great Recession of 2008–09, there were serious concerns about the fragility of euro area government finances. Fathom uses CDS spreads to calculate the market-implied probability of a euro area sovereign defaulting on its debt. These proprietary indicators were broadly unchanged in February and, with the exception of Greece, remained below 10%. This represents a vast improvement relative to levels seen through 2011 and into 2012 at the height of the euro area crisis, and can be attributed to reductions in government budget deficits.
However, declining budget deficits do not stem solely from the sustained fiscal adjustments of European governments; in part, they also reflect the improved economic conditions brought about by the euro area’s cyclical upswing.
It would, however, be reckless to forget that public debt remains elevated, especially in the periphery. Consequently, European sovereigns must make sizeable interest payments that, on average, equate to 2% of GDP each year. This, in itself, provides a clear incentive for maintaining fiscal discipline.
Nevertheless, Italy goes to the polls on Sunday amid promises by leading politicians to pursue expansionary fiscal measures. This is in spite of a debt-to-GDP ratio in excess of 130% and an annual interest burden that is second only to Portugal.
Thus far, markets have not reacted to the likelihood of fiscal largesse and Italian bonds have performed on a par with their Spanish counterparts over the past month. Indeed, the Italian probability of default indicator declined by 0.4 percentage points in February. More broadly, peripheral spreads have remained low in recent months, even with the end of QE in sight.
Despite growth firming last year, the recovery of the Italian economy has been a long time coming, and growth remains slower than the euro area average. Moreover, the benefits of growth do not appear to have been evenly spread, with unemployment rates remaining persistently high in the South.
It is therefore unsurprising that a populist, anti-establishment party (the Five Star Movement) is currently ahead in the polls. However, the party, which had previously promised a referendum on euro membership, has recently toned down its rhetoric, making the prospect of Italexit unlikely. This message is also borne out in a separate proprietary indicator, constructed by Fathom, which calculates the market-implied probability of a euro exit within five years. The Italian indicator declined to 3.1% in February, and remains below 5% for all countries measured.
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