- On 29 May Italy’s risk premium soared as a populist government formed amid doubts about its commitment to the euro.
- The tension spread to Spanish debt for a few days.
- It is wise to keep financing in order and maturities staggered, without depending on a renewal at a particular moment.
On 29 May 2018, Italy’s risk premium soared as a populist government took shape amid doubts about its commitment to the euro. The tension spread to Spanish debt for a few days. It was a brief episode, but enough to remind us that the stability of the common currency depends in part on the confidence inspired by each of its members. A shared currency requires, by definition, a certain shared discipline.
At first sight, a movement in Italian debt markets seems remote from a Catalan business owner or a family paying a mortgage. Yet the euro area works as a whole: what happens in one of its large economies affects the cost of money, the perception of risk and investors’ decisions across the region. Understanding the mechanism helps to read the news better. And it makes it possible to tell the noise of a single day from the changes that really call for a reaction.
What the risk premium is
The risk premium is the difference between what a country pays to borrow and what the reference country, normally Germany, pays. When it rises, it means investors demand a higher return for lending to that country, that is, they perceive more risk.
It is usually measured in basis points and compared day by day. A sudden rise indicates a change of mood in the markets: investors doubt that the country will meet its commitments or that the rules of the game will hold. That is why the premium reacts quickly to political news, to deficit figures or to statements by leaders who talk about changing the framework of the common currency. It is enough for doubt to open for investors to ask for a higher return.
A passing contagion
Distrust of Italy spilled over to Spain, because investors tend to group together economies with similar characteristics. It was a brief episode, but it was a reminder that euro-area debt remains sensitive to political doubts in any of its members.
Contagion works by analogy: if a country with debt and governability problems causes concern, investors ask which other countries could find themselves in similar situations and apply a general caution. It is not always justified, which is why episodes tend to be passing when the second country’s situation is sound. But while it lasts, the effect on financing costs can be real. And it is transmitted, with a lag, to the conditions banks offer to companies and families.
Why it matters to business
The cost of public debt influences that of private financing. For business owners and families with variable-rate loans or a need to refinance, these episodes are a reminder that it is wise to keep financing in order and maturities staggered, and not to depend on a renewal at a particular moment. A sound company can be affected by factors that have nothing to do with it, and it is wise to be prepared for that.
A practical way to reduce exposure is to spread the sources of financing across more than one institution, avoid having several large loans fall due at once and keep a liquidity reserve for unforeseen events. Anticipating a renewal, rather than doing so when the deadline runs out, gives more room to negotiate and less likelihood of accepting unfavourable terms for lack of alternatives. It is better to negotiate from calm than from urgency.
Financial stability is built before the turbulence, not during it.
This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.
