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a blog from young economists at Nova SBE

The fall in expectations in the Italian sovereign debt crisis

One of the countries more affected by the Great Recession started in 2007 because of the subprime crisis was certainly Italy, that could observe a slump of more than 3% in its GDP. Despite this, at the beginning the situation seemed manageable and already in 2010 people were thinking that the worst period had passed. For some European countries it happened exactly like this, but not for Italy that had to deal with the sovereign debt crisis. The Italian public debt has been very high since the early 90’s, but due to the financial crisis the situation got worst and now it is about 2,400 billion euros with a debt-to-GDP ratio of 132%, the second biggest in Europe after Greece.

This dramatic increase in public liabilities is mainly due to a fall in market’s expectations about the solvency of the Italian debt. Until spring 2011 Italian bonds’ interest rate was low enough: even though the public debt was increasing every year more, Italy was still perceived by investors as a safe country. But since there, the spread between the BTP, an Italian bond with a 10 years maturity, and its German homologous Bund increased a lot, raising worries and uncertainty in the Italian and European economy. Investors started to require higher risk premia for buying Italian government bonds, that were not considered as risk-free as they were before. Because of a higher interest rate, the value of bonds fell as well, implying a decrease in banks’ assets and a higher default risk. Italian banking institutions hold an important part of government bonds and they are very sensitive to a plunge in their market price: in fact, they became weaker and less likely to fund families and companies, provoking a decrease in the level of consumption and investments. But why people started doubting about Italian government’s probability of repayment, leading to the realization of a self-fulfillment crisis prophecy? For sure it was a combination of different factors coming from both the financial crisis and the country’s economic and political situation. In the last 20 years Italian GDP growth rate has been very low comparing to the other European countries. As the governor of the Bank of Italy Ignazio Visco claimed, this is probably due to the lack of Italian companies to innovate and invest in raising productivity, that should be a necessary process to face the challenges brought by globalization. Moreover, the Italian political framework has always been characterized by a high level of instability: an inefficient system with frequent government crisis followed by abrupt changes of Prime Ministers did not have a good impact on the country’s credibility. Typically, during a recession, individuals’ risk aversion increases significantly, and this is what happened during the global financial crisis as well: due to its high public debt and the sense of uncertainty around the country, investors were willing to buy Italian government bonds only if they would have been well compensated for the major risk with a higher interest rate, otherwise they would have switched into the safer German bond.
On August 5th, 2011 the ECB sent a letter to the Italian government in which it listed a series of issues that Italy must take into consideration in drafting its future public policies to receive a financial support from the European Union. The main recommendations were about the need to stimulate the Italian growth potential, the control of the public debt and the necessary efficiency improvements in the public administration. As a proof of the delicate situation of the Italian economy, on September 20th of the same year the agency Standard & Poor cut Italy’s credit rating.

Both the Italian government and European institutions understood that stronger economic interventions were necessary. After Berlusconi’s resignation, the government chaired by the new Prime Minister Mario Monti decided to take sound measures to restore public accounts, reforming the pension system and the job market, cutting significantly the public expenditure in the country. Furthermore, in response to the sovereign debt crisis in Italy and in other European countries like Greece, Portugal and Ireland, the ECB implemented a series of policies with the aim to improve the situation. One of them was the foundation in 2012 of the European Stability Mechanism (ESM): based on the IMF model, the ESM works mainly as a guarantee fund for European countries and for banks that need to be recapitalized. Moreover, it can also buy national bonds in the secondary market on behalf of the ECB. The same goals had the creation of the Outright Monetary Transaction (OMT) and the Long Term Refinancing Operation (LTRO): while with the first the ECB announced the purchase of governments bonds, the second is more concerned about bank recapitalization. In addition, in 2015 the governor of the ECB Mario Draghi presented the “quantitative easing”, an expansionary monetary policy consisting of open market operations with a massive purchase of national financial assets.

During crisis, before the introduction of euro, Italian governments used frequently expansionary monetary policies: introducing more money in the economy led to an increase in exports, since national companies could count on a price advantage derived from its weaker currency. Adopting one single currency in Europe also implied the renunciation of using monetary policy in a direct way, a task now entrusted to the ECB, which during the decision processes must consider the different economic situations of all the eurozone countries. Nowadays, Italian government must pay attention also in practising expansionary fiscal policies: a reduction in taxes or an increase in public expenditure could be good solutions during recessions, but in doing so Italy would end up increasing its already high public debt, situation that would lead to an additional loss of credibility deriving from the incapability to respect the budget constraints established by the EU.

Given these issues, which could be other effective strategies for the government to reobtain investors’ trust? Some policies proposed by the government and the ECB have brought some positive results, but Italy seems still really involved in a negative expectations circle. The Italian Society of Financial Analysts (AIAF) underlines the need to set up structural reforms to increase reliability for the long term and reduce the public debt. In the AIAF opinion, it is necessary to reduce the high level of bureaucracy to avoid capital flights, attract investors and encourage the creation of new start-ups. To fulfil these goals, it is also essential to improve the efficiency of the Italian justice system, considering the long time that usually trials require. Moreover, it is important to keep fighting against corruption and tax evasion, that in Italy are still a very serious matter. To try to raise investors’ expectations, the AIAF suggests also to insert in the Constitution rules about the respect of the government budget constraint: a procedure such this one could make people presume that Italy really wants to put strong efforts in solving the situation.

However, ECB expansionary policies are well considered by AIAF and the governor of the Bank of Italy Ignazio Visco: in their point of view, the Italian government should seize the opportunity to continue with the structural reforms, to reverse the trend and show that investors can rely on Italy.

Giacomo Beltrame

– Knight Laurance, What’s the matter with Italy?, BBC News, December 28th 2011
– La crisi del debito sovrano in area Euro: il punto di vista dell’AIAF, AIAF Position Paper, 2012
– Busetti Fabio, Coda Pietro, L’impatto macroeconomico della crisi del debito sovrano: un’analisi controfattuale per l’economia italiana, Bank of Italy, 2013
– Blanchard Olivier J., Amighini Alessia, Giavazzi Francesco, Macroeconomia. Una prospettiva europea, Il Mulino, 2014
– Visco Ignazio, L’uscita dalla crisi del debito sovrano: politiche nazionali, riforme europee, politica monetaria, Almo Collegio Borromeo, 2014
– Lionello Luca, Il nuovo ruolo della BCE nella crisi del debito sovrano europeo, The Federalist, 2015
– Nicolini Juan P., Self-fulfilling Prophecies in Sovereign Debt Market, Federal Reserve Bank of Minneapolis, 2016


The Effects of Financial Market Frictions in the Asian Financial Crisis: The Case of Korea

The financial crisis that hit Asia in 1997-98 has severely affected the economies of Thailand, Malaysia, Indonesia and South Korea. During this period, these countries have experimented a crash of their stock market combined with a dramatic devaluation of their currency and high levels of credit rationing. They ultimately needed the intervention of the IMF to attenuate the extend of the macroeconomic shocks. This article will focus on explaining the main mechanisms that lead to the crisis in the case of Korea, while applying the framework of financial market frictions. I will examine how the actions taken by financial agents have worsened the difficult economic conditions during the crisis.

The information failure that characterizes relationships between economic agents often bring about problems such as adverse selection and moral hazard. These problems tend to have amplified effects when other macroeconomic variables are fostering a situation of financial instability, which has been the case in Korea during the crisis.

First, the initial economic context in Korea in the 1990s had a role to play in the development of the crisis. According to Hahm & Mishkin (2000), the root cause of the events had to do with the rapid financial liberalization that occurred in the first half of the decade, in the goal of obtaining membership in the OECD. Indeed, some of the requirements to join the organization include an advance state of “international cooperation” and a “stable and transparent financial system[1]”, which gave incentives to Korea to increase the pace of its economic development. This liberalization lead to a relatively large credit growth which, in turns, induced more borrowing and spending from consumers and firms. As we can see on the following graph, the total credit to private sector peeked around 1997-98, at a level higher than 160% of GDP.


Under the context of weak financial regulation that was in place in Korea, this resulted in an excessive risk-taking behavior from financial institutions. Information asymmetry caused an adverse selection problem: banks could not correctly assess the borrowers’ credit rating and ended up lending to an important share of risky agents and unprofitable projects. Financial institutions accumulated a large amount of non-performing loans, reaching a level of above 30% in 1998[2]. Their behavior during this period was also tainted by moral hazard. Indeed, the Korean financial institutions did not have the incentives to bear the evaluation costs of screening “good” from “bad” borrowers. It was implied that the government or even the international institutions (e.g. the IMF) would never let the banks go bankrupt. This implied promise is sometimes called a too-big-to-fail policy and is a matter of many debates on morally hazardous behavior in a number of countries. The accumulation of a large share of loans that were unlikely to be repaid put a lot of pressure of the Korean financial institutions.

It is also worth noting that this period was characterized by large capital inflows into Korea that were, in a sense, boosting the financial liberalization. The following graph shows that the country was holding a large current account deficit during the years prior to the crisis. The deficit started to increase in 1993, until it reached an amount of 15B $US in 1996.


Slowly, a context of uncertainty started to emerge. On one hand, the financial sector had accumulated a large share of poor quality loans and was reporting increasingly low capital adequacy ratios. This ratio, which is a measure of a bank’s total capital expressed as its risk exposure, had fell to 2.26% in 1997[3]. Under the Basel I Accords that were holding at the time, the minimum requirement for banks with an international presence was a capital adequacy ratio (Tier 1) of 8%[4]. Adding up to the financial instability was the factor of political uncertainty. Gidwani (1999)[5] explains how the country’s upcoming elections were raising questions about the willingness of the future government to commit to rigorous economic policy.

Thus, a confidence crisis materialized and important international investors started to question the solvency and the strength of the Korean financial institutions. In the midst of the panic, foreign investors started to withdraw their capital from Korea and the country experienced a sudden stop: a rapid capital flow reversal. The current account, that was holding an all-time low deficit in 1996, started to increase dramatically until it reached a surplus of 43B $US at the end of 1998 (as seen on the second graph).

What followed is a good depiction of the financial accelerator mechanism. In the following years, the sudden stop spread through the credit channel. It caused a serious credit rationing which affected several large corporations that had heavily borrowed to finance risky projects and that were not able to repay or extend their loans. As illustrated on the first graph, the total credit to private sector declined sharply between 1998 and 2000, until it reached back its pre-financial liberalization level. Resulting was a series of corporate bankruptcies that came along with falling asset prices and devaluation of the Korean won that, altogether, seriously hurt the Korean economy. The reaction of financial institutions to restrict credit during that time of the crisis had aggravated the effects of the shock on the economy.

Another channel by which the crisis spread is the balance sheet channel. Financial institutions typically impose collateral constraints to their borrowers in order to reduce moral hazard problems. Falling asset prices caused the value of collateralized assets to decrease, which resulted in borrowers having more incentives for moral hazard (e.g. to fail to repay their loans), thus also worsened the effects of the shock.

The case of Korea during the 1997-98 crisis is, among others, a good example of how the behavior of financial intermediaries, in a context of information asymmetry, can have adverse effects on the business cycle.

Laurence Allaire (29917)



[1] OECD (2017). Report of the Chair of the Working Group on the Future Size and Membership of the Organization to Council: Framework for the Consideration of Prospective Members.

[2] Hahm J., Mishkin, F. S. (2000). Causes of the Korean Financial Crisis: Lessons for Policy.

[3] Hahm J., Mishkin, F. S. (2000). Causes of the Korean Financial Crisis: Lessons for Policy.

[4] Bank for International Settlements (1988). International Convergence of Capital Measurement and Capital Standards.

[5] Gidwani, K. (1999). Korea and the Asian Financial Crisis, EDGE, Trade & Environment Journal.



The Financial Crisis effects on Health Systems (The Baltic Case)

The financial crisis repercussions affected many sectors across the globe. The health system, as an important segment of this global conjuncture, did not escape from the economic cataclysm.

To properly study this sub-prime crisis effect on the recent trend of pharmaceutical expenditure, we will focus on the Baltic situation, particularly, in countries as Estonia and Latvia.

In a first naked-eye analysis, it will be a surprise for me if the financial crisis, as a negative shock to the economy, does not provokes a subsequent bad effect on the health system status. The WHO data, that will be presented later, confirms the correlation between the two previous indicators: in Estonia, Latvia and other Baltic countries, the trend of rising pharmaceutical expenditure has been curtailed by governments in the last years, using an arsenal of policy tactics to fight the crisis “contagion” on the heath sector.

Particularizing, we see that the health conjuncture in Estonia is very particular. In this country, in the long term, the financial sustainability of the health system is mostly related to the level of wages and the rate of employment, as the majority of revenue comes from the earmarked part of the social tax on wages (13%). In the end, households with higher gross incomes pay relatively more towards health care financing, denoting the progressivity of the system. Therefore, I will say that for those services more dependent on out-of-pockets, such as outpatient pharmaceuticals, there is a more probability of impoverishment risk.

It is important to note that with the crisis and the subsequent economic downturn of the country, the health expenditure decreased in the same proportion of the GDP, being stable at around 5%–6% of that indicator. Among the readjustments that conducted to this balance, it was introduced a 15% coinsurance for inpatient nursing care, paired with an increase in the patient co-payment rates for prescription-only and reimbursed pharmaceuticals, in the order of 43% and 39% respectively. Furthermore, as the EHIF’s (the core purchaser of health care services for the insured) pharmaceutical expenditure gradually decreased to 15.6% of total health care expenditure, no further reductions relating to pharmaceuticals were planned. As a consequence, the rejection rate of outpatient pharmacotherapy increased, raising the need for future emergency care and hospitalisation, while many cheaper pharmaceuticals were withdrawn from the Estonian market.

Other Baltic countries, namely Latvia and Lithuania, faced similar problems. In Latvia, the government decided that the most prudent remedy was to reduce public expenditure together with the implementation of structural reforms. This binomial policy, in my opinion, makes senses, since the control over the expenditure should be accompanied with a structural improvement in the supply side.

Since the Latvian health sector is funded by the State budget, the government indirectly reduced the health care budget in the same proportion of the public expenditure cut, which appeared as ineffective to turn over the reduction in both the value of the total pharmaceutical and the reimbursement budget.  To jink the crisis, the market has had to reduce the costs of the health care system, which has also affected the financing for reimbursed medicines. Here, to fight this last negative effect, I think it would be very important the supply of reimbursed medicines for as many people as possible.

Resuming, today we assist an attempt to invert the co-payment scenario in Estonia, with the implementation of measures towards the decreasing of patient co-payment rate, while in Latvia, the economic situation asks for a reduction in the costs of the health system. In my opinion, the perspectives are good, but due to the germinal state of these policies, it is too early to draw any conclusions or expect considerable progress.


Guilherme GG