Risk Assessment of Italy

Investing in Italian Sovereign Debt |

Q2 2012 Risk Assessment |

Alexander, Jason ● Fogliati, Mario ● Li, Peng ● Sidhu, Joban ● Teece, Alex |

5/6/2012

Investor Recommendation: Proceed with Caution

Given the current state of the Eurozone, a period of prolonged uncertainty should be expected in regards to any exposure to Italian sovereign debt. Depending on risk appetite, investors should take caution with regard to exposure and consider hedging using appropriate methods and durations. Political and fiscal decisions will all play a role in how the country fares with its debt obligations and investors are advised to consider the possibility of events occurring that are hard to predict.

Overview, the Economy, & Policy

Together with many other European countries, Italy is currently in the throes of an economic crisis. The Italian crisis began in July 2011 when investors began to fear financial contagion could spread from major issues stemming from Greece. Although Italy’s budget deficit (4.5% of GDP as of November 2011 still stable from 2010 – Appendix I) was low compared to the Eurozone average of 6% of GDP, it had the fourth highest sovereign debt in the world (119% of GDP as of November 2011, up from 126.8% in 2010 – Appendix I). Despite having the third-largest economy in Europe and one of the largest in the world in terms of GDP, Italy had a slow-growing economy and very high debt.

Historically, Italy’s strong manufacturing and export sectors, especially in industries such as automobiles, clothing, and chemicals, fueled strong economic growth. Growth was also propelled by reduced public spending, a declining deficit, and lower inflation (Appendix I). However, Italy’s economic growth eventually stagnated and investors often found Italy unattractive because of its high level of corruption and strong labor regulations that increased labor costs. A lack of investment in infrastructure, particularly in southern Italy, also presented obstacles...