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Italian problem is driving market melt-down, but it’s solvable

August 5th, 2011 · 2 Comments

In principle at least. But do European leaders have the balls??


The big part of this crisis comes from what’s happening in Europe and we’ve been warning about it for some time. After Greece, Portugal and Ireland were unable to service their debt and a EU/IMF rescue had to be organized, the crisis has now spread to Spain and Italy.

While the EFSF (the European rescue fund) has (just about) sufficient funds to deal with Spain, Italy is a bridge too far. It’s the third largest bond market in the world.

  • Italian outstanding debt is about 1.8T euro (120% of GDP)
  • Italian public deficit is 4.6% of GDP however, there is a small primary surplus
  • The coming three years Italy needs to refinance 500B euro
  • Growth is slow
  • Italy didn’t have a bursting of any real-estate bubble (it didn’t have a bubble), household savings are high (half of the public debt is held domestically and it’s banks are sound, in principle
  • There is an approved austerity package, although most savings are penciled in after the 2013 elections

In principle, these are bad figures but not necessarily untenable. With the right measures (structural reforms to free up markets seem especially promising), growth can be stimulated.

What makes all the difference are the interest rates against which Italy can borrow, set out in the graph below from Barclay’s. If the interest rate spreads remain as big as they are now (or rather, as they were a couple of weeks ago, around 3%), then we can see that debt/GDP ratio is running up to 200% in 2050.

We can also see that growth inducing structural reforms will have the opposite effect. The great disappointment of Berlusconi, supposedly a right-wing market loving prime minister who, by Italian standards, has enjoyed an unprecedented time at the helm, hasn’t embarked on the necessary reforms at all.

But even with very modest growth and ‘normal’ interest rates, the debt situation can be contained. ‘Normal’ interest rates would be the 1.5-2% spread over German bunds that were common until they started rising at the end of June (see below)

10-Year interest differential with Germany
One-Year Chart for ITALY 10 - GERMANY 10 SPREAD (.ITAGER10:IND)

Why the rise in the interest rates now? Some elements:

  • It started with a public row between Berlusconi (Prime Minister) and his Finance Minister Tramonti (who enjoys a great deal of market respect)
  • Italy was quick to react, introducing a fairly large austerity program though, and the rift between Berlusconi and Tramonti was mended
  • The second Greek bailout after a brief euphoria which you can see in the graph, provided a new leg up. Not only the cost of the second Greek bailout (109B euro), but more especially the lack in increase of the European rescue fund is what have led the markets to test the resolve of policy makers.

In our view, Italy’s public finances are precarious, but it’s not insolvent. What’s going on is that the markets are testing the resolve of Italian, but more especially of European policy makers.

We know that, in the case Italian interest rates become unsustainably high, the present policies and funds in place are insufficient to deal with that. So market participants are selling, because there is no safety net for if things go wrong and this is becoming a self-fulfilling prophesy.

There is a fairly easy answer to this. We need massive fire power to call the market’s bluff:

  1. Pending parliamentary approvals, the European rescue fund (EFSF) can buy up bonds in the secondary market
  2. The EFSF has 440b euro, this should at least be doubled to give it the necessary fire power
  3. While we’re awaiting 1 and 2, the ECB should buy Italian bonds in the mean-time.

We think that this would be enough to stop the speculative attack against Italian government bonds, and by extension, against Italian banks and stop the fall-out on global markets.

Over to you, Trichet.

And then to Berlusconi to introduce structural reforms to speed up Italian growth.

Tags: Sovereign debt crisis

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