Surprisingly decisive

The terrifying prospects of Italy and Spain dragged into unsustainable sovereign debt situations has concentrated minds and led to a rather surprising package. Enough seems to have been done for now. But much depends on economic growth returning..

The most important points:

  1. EFSF loans to Greece, Ireland and Portugal will be lengthened (from 7.5 to a minimum of 15 years, on average) and interest rates reduced to around 3.5%)
  2. Greece gets a new 109B euro aid package
  3. For Greece, and Greece alone, there will be voluntary private sector involvement in lightening the Greek debt load (through a menu choice of bond exchange, roll-over, and buyback) supposedly saving up to 54B euro over three years (if 9 out of 10 bondholders play along), although figures are unclear
  4. The EFSF gets a widened task, it’s able to buy up debt on the secondary market and even providing (‘pre-emptive’) loans and recapitalize banks.
  5. There is a indefinite commitment to countries until they have regained market access, provided that they follow the program (austerity, economic reform)

Some conclusions:

  • The Italian situation should now be eased. much of the attack on Italian debt last week was caused by the policy paralysis in Italy and Europe, both situations have now been substantially addressed. Italy itself took decisive budgetary steps in the form of a rather large austerity package
  • For all the new ambitions of the EFSF (some like Sarkozy spoke of a European Monetary Fund), no new funds were provided for it
  • Much will depend on the growth-debt dynamic. If, as it to be expected, deep austerity leads to further negative growth the problem will not go away.
  • The “voluntary” private sector contributions will almost certainly lead to rating agency calling a Greek default, but there is a lot of arm twisting to let the European Central Bank (ECB) still accept Greek bonds as collateral. In fact, 20B euro is earmarked to recapitalize Greek banks (the main holders of Greek debt) and 35B euro for the ECB to keep providing liquidity to Greek banks.

Some observations about Italy:

  • Italy’s public debt stands at 120% of GDP, at almost 1.9 trillion euro
  • It’s the third largest bond market in the world
  • In the next three years, some 500 billion euro needs to be refinanced
  • However, Italy’s public sector deficit, at 4.6% of GDP, is comparatively benign (it actually has a small primary surplus)
  • Balance sheets of the private sector are actually much healthier as Italian households are traditionally high savers and Italy has avoided most of the debt, housing, and financial derivatives excesses of many other countries
  • Banks are also generally sound but are the biggest holders of Italian bonds
  • More than half the public debt is in domestic hands due to the high household savings
  • The Senate approved a $68 billion austerity package on July 14, but most of the savings are scheduled for 2013 and 2014 (after elections scheduled in 2013), although the package does little to liberalize the economy, which is badly needed. 60% of the package consists of tax hikes.
  • To stabilize the debt at present levels, it needs to close the budget gap and nominal growth has to equal interest rate on outstanding debt. Neither conditions are met, interest rates are increasing, in fact (see here for an intro to debt dynamics)
  • Berlusconi has missed a golden opportunity to cash in on the longevity of his government to be an ‘Italian Thatcher’ and reform the economy, as the economy is sclerotic, economic growth very slow and competitiveness getting worse

Italy money supply plunge flashes red warning signals
Monetary experts are increasingly disturbed by the pace of money supply contraction in Italy and most recently France, fearing that it could prove a leading edge of a sharp economic slowdown over the winter.

By Ambrose Evans-Pritchard
6:15AM BST 14 Jul 2011

“Real M1 deposits in Italy have fallen at an annual rate of 7pc over the last six months, faster than during the build-up to the great recession in 2008,” said Simon Ward from Henderson Global Investors. Such a dramatic contraction of M1 cash and overnight deposits typically heralds a slump six to 12 months later. Italy’s economy is already
vulnerable – industrial output fell 0.6pc in May, and the forward looking PMI surveys have dropped below the recession line.

“What is disturbing is that the numbers in the core eurozone have started to deteriorate sharply as well. Central banks normally back-pedal or reverse policy when M1 starts to fall, so it is amazing that the European Central Bank went ahead with a rate rise this month,” Mr Ward said.

Italy is not a high-debt nation. Italian households are frugal by Spanish and UK standards. However, Italy has a toxic trifecta of problems that affect long-term debt dynamics: a public debt stock of €1.8 trillion or 120pc of GDP; rising interest rates; and economic stagnation. It is the interplay of these elements that has set off flight from Italian bonds.

Italy has to roll over or raise €1 trillion over the next five years
, with a big spike as soon as August. “Any new issuance will be above the average rate. That is the real cause of the destructive market action,” said Paul Schofield from Cititgroup.

The Italian and Spanish bond markets stabilised yesterday after coming back from the brink. News that US bond fund Pimco has taken advantage of the sell-off to accumulate Italian debt cheaply helped restore calm.

The IMF has endorsed Italy’s €40bn austerity package, though the measures are “back-loaded” with most of the pain in 2013.

However, RBS said the eurozone storm is far from over. “We expect the crisis to continue deteriorating, and threaten to undermine the entire euro area as European policy-makers still misunderstand market dynamics. They show no sign of catching up with reality,” said Jacques Cailloux, the bank’s Europe economist.

Mr Cailloux said the EU’s bail-out machinery (EFSF) must be increased to nearly €3.5 trillion in committed funds to staunch the crisis. This would give the authorities effective firepower of €2 trillion. “It is a lot of money but the euro is a big project. This is all about political appetite. The longer they wait, the worse it gets..”

A fund of this size would amount to 27pc of eurozone GDP. The effective lending power of the EFSF at the moment is just €255bn, and half of that will be needed for Greece, Ireland, and Portugal. Greece’s problems took a further turn for the worse yesterday after Fitch downgraded the country by three notches to CCC.

RBS compares the euro crisis with exchange rate turmoil in East Asia in 1998, though the EMU effect has this time switched risk from devaluation to bond default. Eurozone borrowers face the same “reversal in confidence” after years of deceptively benign conditions.

Hopes that eurozone leaders would deliver a “big bang” solution at a summit on Friday have been dashed after German officials said Chancellor Angela Merkel may not attend. Finance mininster Wolfgang Schauble warned against a “hectic” response, a way of saying Berlin will not be bounced into a decision.

There is stiff resistance in Mrs Merkel’s coalition to steps that drag the country into a fiscal union where sovereign debts are shared. German officials are drawing up possible plans to allow the EFSF to
lend to countries such as Greece so that it can buy back its bonds in the
market at a discount

However, Bundesbank chief Jens Weidmann issued a caustic critique of the plan.”It has a high cost, limited use, and dangerous secondary effects. This discussion is going in the wrong direction,” he said. He added that the ECB would not accept Greek bonds as collateral if Athens defaults. “It is not our job to finance insolvent banks, let alone countries,” he said.

The real M1 data show countries are vulnerable. There have been sharp contractions in Austria and Belgium. The Netherlands and Germany are negative. The ECB believes sluggish money supply figures reflect the reduction of an “overhang of liquidity” left from before the crisis and are benign. The claim has raised eyebrows among monetarists.

Tim Congdon from International Monetary Research said the ECB had drifted away from monetary orthodoxy after the departure of Otmar Issing as chief economist in 2006, tolerating “crazy lurches” in the broad M3 money supply. “The ECB did not see the collapse in money growth in 2008 and the great recession that followed, and they are getting it wrong again.”