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Capital Markets

Back to the future for Spain and Italy, debt edition

Spain and Italy's yield curve can take a lot more pain.

Seven – the psychologically important threshold for 10-year eurozone bond yields – is not the magic number. Post-super Mario's bullish comments on Thursday, here's another boost for battle-hardened euro investors, courtesy of Commerzbank. In short, market fears over public debt sustainability in Spain and Italy, given the elevated bond yields, are clearly overdone, argues the bank, citing the fact that the additional debt interest these economies might have to bear is only in line with pre-European Monetary Union (EMU) history.

First, the math. As any conventional emerging market sovereign debt analyst will tell you, when the real rate of government debt interest payments leaps above the real rate of growth, an economy’s debt-to-GDP ratio will jump without an offsetting primary budget surplus. As we have reported, Italy requires higher primary budget surpluses than its eurozone peers – and, in recent years, has achieved this – given its hight debt-to-GDP ratio at 120%. Here are Commerzbank's projections:  

 

In Italy, higher interest rates have a bigger impact on the public budget than in Spain over the long term because its debt pile is higher, and as a result the primary surplus needed to stabilize the debt ratio rises more sharply. If we assume a long-term nominal growth rate of 3%, Spain would have to increase its primary surplus to nearly 3½% of GDP over the long term, assuming an average interest rate on all public debt of 7%, and Italy would even need a primary surplus of 5%.

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