Wednesday, June 13, 2012

Is Italy next in line?

As Spain teeters on the edge of the abyss, Italy now also finds itself back in the crosshairs of the market and eurozone leaders.

A debt auction this morning saw Italy pay 3.9% to borrow for 12 months, an exorbitant rate despite there still being strong demand. Tomorrow’s auction of 10 year debt will be more telling, while comments from the likes of Austrian Finance Minister Maria Fekter that Italy may need external aid as well do not inspire confidence.

With all the concern over Italy we’d recommend (re)reading our report from last November. The politics focused on Berlusconi are clearly irrelevant now, but economic analysis on Italian borrowing costs is still valid, notably on how much longer Italy can stomach higher borrowing costs for (now back to the levels seen then):
• Italy’s funding needs over the next three years are between €825bn and €907bn. This is broken down as follows:
• Open Europe estimates that rolling over expiring debt at the higher rates seen today will cost Italy an extra €27.8bn over the next three years and up to €58.7bn over the next five years. Given the size of Italy’s economy this is not disastrous, but would undo a significant amount of the €60bn in budget savings by 2014. Considering the difficultly in passing these measures (which are yet to be implemented) this could easily cause Italy to miss its debt and deficit targets over the next few years. In addition to the markets losing faith in Italian finances, this would further the growing political division between the EU/IMF and the Italian government;
• At these higher yields, rolling over its existing debt load would cost Italy an extra €225bn over the life of the debt. Combined with low growth, this could have a substantial impact on Italy’s longer term debt sustainability. Italy could still absorb higher borrowing costs for a few months given its low average interest rate and the liquidity of its bond market. However, it is clear investors are beginning to lose patience and need to see some progress soon.
So is all this concern over an Italian bailout valid?

Not quite. Sure, Italy has a mountain of economic and political problems, but there are far fewer short term triggers which can push it into a bailout in the near future. Its banks are solid – they have little external exposure to problem countries, a solid deposit base, large domestic sectors and decent liquidity following the ECB LTRO – and they did not face the same Spanish boom and bust.

Italian households and corporations are not heavily indebted. There is less chance of this being a drag on spending in the economy as in other countries, while the state is unlikely to have to guarantee any private sector burdens anytime soon.

Although the state is facing higher borrowing costs as the figures above suggest, it can handle this in the short term given the size of the economy. If it persisted then it would surely cause problems but with the horizon of a few months, it is likely to be manageable. The government can also rely on its domestic banking sector to buy up large amounts of its debt using liquidity from the ECB. This strengthens the dangerous sovereign-banking-loop and will store up problems in the long term but in the short term it would keep Italy out of a bailout. In many senses Italy is closer to Japan than some of the other eurozone economies – this may not seem like a favourable comparison but remember that despite its huge debt load Japan has managed to finance itself at low rates.

Ultimately, the main problems in Italy are political – this is the key source of uncertainty. Technocratic Prime Minister Mario Monti has failed to deliver on many of the reforms promised, while the chance of a stable succession in the spring 2013 elections looks slim. The best chance Italy has had of reforming for over a decade could soon be squandered. Over the long term Italy’s economy looks far from positive – worrying demographics, inefficient government spending, low economic growth, poor business climate and no willingness to reform (the list could go on as well).

The concern then over Italy should be political and focused on the wayward reform programme. Unless funding to eurozone countries locks up completely it is unlikely to need a bailout in the immediate future and besides, if that happens it is likely to be all she wrote for the eurozone anyway.

1 comment:

Rik said...

If things really will go bad probably we first will see Spain (proper, not its bankingsector) going. Not Italy directly.

The problem for the EZ, now 7% is seen as the cliff, may be for Italy even a bit more. But looking at Portugal and Ireland rates can quickly go to 10+% and none of the 2 can carry that.

Another part of that problem being that EZ reaction is very slow (certainly compared to market reactions).
The ESM is not yet approved and therefor operational and anyway too limited to safe Italy. If Spain proper goes (not far from now) which doesnot seem unlikely the scenario presented for Italy is not very credible the Spanish rescue would take all the remaining resources of the EFSF.
If the ESM is not yet operational and/or will be combined with EFSF too small anyway for Italy. There would not be a safety-net in place for Italy. Which in itself will create a lot of downward price pressure on its bonds. As an extended net will likely take another year, providing it is approved in the first place.

Leaving de facto the ECB as the only white knight and will these bail the rest of the EZ out (for the third time) and ruin its BS and risk civil war within its ranks?

With Italy it is the refinancing that could cause the problem. And not only the direct refinancing but also the fact that a future refinancing would most likely be seen unsustainable. Because everybody is selling existing bonds. Which can take place in a higher pace than the refinancing (have Greece and Spain shown). These 2 effects could cause a sort of chain reaction (like Spain with its banks). One causes the next which causes more of the first etc.

My bet would be go now for a PSI in both Spain and Italy. They cannot go to the markets for the next 2-3 year minimum anyway as they are kept alive by all sorts of measures but stand alone they are finished. The present measures are simply too costly. Require roughly 2x the amount for roll overs. Better a PSI possibly for Spain and Italy only in the term of the loans (make them all 10,20,30 year).
The gap can be filled by EFSF/ESM loans which would then be rather marginal. You only finance the deficit, not the refinancing plus a lot of bondsales.