A model for managing Italy's country risk
The Italian economy is facing significant challenges due to its high government debt to GDP ratio, which has remained at around 150 percent in 2022. This economic imbalance creates a widespread country-risk premium, which affects both the financial markets and the real economy. The country-risk premium refers to the extra amount of money investors demand to lend to a country with a high level of debt. This, in turn, affects the cost of borrowing for firms, making it more expensive for them to invest in their businesses.
Additionally, the high level of government securities in banks' assets has weakened the balance sheets of banks, making them more vulnerable to financial crises. During times of sovereign debt crises, banks' balance sheets can deteriorate further, leading to a reduction in their ability to lend money to businesses. This can create a "financial accelerator effect," whereby the credit restrictions cause a negative impact on the economy, leading to further financial issues.
To tackle these challenges, Italy's Department of Treasury has created a model called ITFIN (see, Barbieri Hermitte et al. (2023)). This is a quarterly stock-flow consistent econometric model that allows for a better understanding of the link between sovereign risk and output growth. The model considers not only the impact of productivity and GDP growth on the cost of sovereign debt, but also the feedback loop between sovereign risk and output growth.
The structure and the properties of the model are helpful to understand the transmission mechanisms in recent crisis, such as the 2008 crisis, driven from contagion effects due to sharp contraction of foreign demand and the drop of foreign stock prices, and the subsequent 2011 crisis, where the rise in market yields and the losses generated by nonperforming loans have clearly originated from domestic political instability. The ITFIN model can help identify the factors behind these crises and suggest strategies for mitigating their effects.
In particular, ITFIN features a dynamic structure in which the evolution over time of the financial assets and liabilities of the different sectors of the economy is explicitly modelled and originates from financial flows associated to agents' decisions determining the supply and demand of financial assets. A model closure, based on taking a single item of each sector balance sheet as residual, imposes consistency between financial stocks and flows for each sector of the economy.
Moreover, the financial positions of the various institutional sectors affect the agents' economic decisions and the real economy. The breakdown of the model in institutional sectors broadly reflects the one of the National Financial Accounts (Flow of Funds) data. In addition, the model is characterized by a detailed breakdown of financial instruments issued and held by each sector. ITFIN is a highly data-driven model, where the specification of the behavioral equations, although broadly consistent with theory, is designed to generate residuals that pass diagnostic tests. Modelling stocks and flows implies simultaneous modelling of (stochastic) trends and cycles.
The economy consists of seven different sectors: Government (G), Banks (B), Insurance companies, pension and mutual funds (P), Households (H), Non-financial firms (F), the national Central Bank (CB) and the Rest of the World (R). The national central bank does not implement conventional monetary policy as policy rates are set by the European Central Bank and taken as exogenous in the model, instead it implements unconventional monetary policy on behalf of the ECB by executing sovereign debt purchases on the secondary market as well as long term refinancing operations (e.g. LTRO and TLTRO). It also operates through the standard banks' refinancing channel.
The model assigns a central role to money, credit and finance in determining the pattern of financial and real variables in the economy and considers the demand and supply of a large number of financial instruments, that are simultaneously assets for some sectors and liabilities for others.
In doing so the model keeps track of the interconnectedness of the sectors up to modelling simplification. Not all assets and liabilities are modelled but only those that exhibit significant variation over time in the balance sheets of the various sectors.
By tracking the structure of the Flow of Funds database, it is possible to quickly assess the impact of any omissions or simplifications in a model. This is because any differences in the net financial positions of each sector in the model compared to the data can indicate the effect of variables that have been left out. Essentially, any discrepancies between the model and the data can indicate what variables are missing from the model.
In conclusion, the ITFIN model has been developed specifically to simulate and evaluate the effects of monetary and fiscal policies on the Italian economy.