Italy: Past the Point of No Return

Yesterday Italy’s ten-year government bond yields soared well above 7%, the level beyond which Greece, Ireland and Portugal were all pushed into EU/IMF bailout programmes. Having been frozen out of the markets, Italy now faces a buyer’s strike. Its only possible options going forward are a bailout or a bail-in. Because Italy is too big to bail out, a debt restructuring seems inevitable.

Buyer’s strike
The political drama in Italy has helped to push government bond yields to new euro area highs in recent days. The hope had been that once prime minister Silvio Berlusconi announced his intention to resign, borrowing costs would come down slightly. Instead, the markets have signaled that, even more than they dislike Mr Berlusconi, they dislike uncertainty over who will run Italy next and when the new government will be instated.

The only possible way Italy could regain market confidence at this point is if it swiftly implemented a package of austerity and structural reforms under a government with cross-party consensus and a strong, respectable leader, and this package immediately yielded results. This is nearly impossible. Austerity measures will immediately undermine economic growth in Italy, and a contraction of GDP will push the debt-to-GDP ratio up higher, making Italy look more insolvent. Structural reforms must first be agreed (the letter Mr Berlusconi presented to EU leaders at the last summit on October 27th was short on structural reforms) and implemented. Even then, it will take years for the structural reforms to bite and support economic growth.

Even if borrowing costs for Italy did fall slightly, investors would seize the opportunity to dump their Italian government debt, forcing bond yields back up. Italy is past the point of no return. Is this an immediate problem? Yes and no. Italy, unlike the other peripheral eurozone countries, has a relatively long debt maturity profile (just over 7 years). Italy could probably go for some time before it hits a month when it literally runs out of cash and would rather default on its debt than borrow at market rates. That being said, the longer Italy has to borrow at such punishing rates, the higher Italy’s debt stock will be in the future.

Prospects for an Italian bailout
There are only two real alternatives for Italy going forward: a bailout or a bail-in. With Italy’s debt stock at €1.9trn, it is hard to see where the eurozone could find a big enough bailout fund for Italy. The leveraged EFSF has clearly been grounded, with European and foreign investors alike shunning EFSF bonds. Besides, the EFSF is just a series of guarantees, and a bailout for a country with debt as high as Italy’s would need to be pre-funded to have any credibility. A second source of bailout funding for Italy could be the IMF. The IMF currently has €291bn in global resources. Italy’s financing requirements in 2012 alone far exceed this at €325bn (debt rollovers plus the targeted budget deficit). Emerging Market (EM) countries, particularly China, might be convinced to participate in a bailout through the IMF by raising their IMF contributions. However, it is very unlikely the US would agree to increase its contribution while facing its own double dip recession. If the US does not boost its contribution, it will also veto EM countries boosting theirs so as to maintain the balance of power within the IMF.

A final option for a bailout is for the ECB to become a lender of last resort (LOLR) and monetize eurozone debt. This is unlikely for a number of reasons. First, it is against the treaties and would require a treaty change. Even if eurozone leaders were willing to accept a treaty change, it could not possibly be done in the time frame necessary. Second, the ECB has indicated over and over again that it does not want to be a LOLR. In his first press conference following the ECB governing council’s November meeting, new ECB president Mario Draghi repeated ad nauseum that acting as a LOLR is not the ECB’s mandate and that the extraordinary measures the ECB has put into place (mainly referring to the Securities Markets Programme) are temporary and limited. Third, Germany is dead set against the ECB printing money to monetize debt. The German fear of hyperinflation is a social memory and looms large in the German psyche. It in very unlikely Germany would approve of the ECB becoming a LOLR.

Debt restructuring seems inevitable
In the absence of a bailout, Italy will be forced to undergo a debt restructuring, most likely in the form of voluntary Private Sector Involvement (PSI) similar to that already agreed for Greece. Just as the Greek PSI initially reduced privately held government debt by a paltry 21%, a relatively small haircut for Italy will probably be offered at first. This could well be followed by larger haircuts later on.

Even if Italy does restructure its debt, this would do little to solve its acute competitiveness problem. Here too, Greece could become a model for the larger country. Realistically, both countries face two options for regaining competitiveness and returning to growth: 1) austerity, internal devaluation and a decade of recession/depression or 2) abandon the euro, issue a national currency, allow it to depreciate significantly and regain competitiveness almost instantly (though leaving the eurozone would be extremely messy and painful in other ways). Given these two choices, I think there will come a time when the Greek and Italian (and Portuguese and Spanish) governments will opt for the latter.

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19 Responses to Italy: Past the Point of No Return

  1. jolyonwagg1 says:

    Italy as had the chance to reform its sluggish economy for years, and as usual ignored, side stepped, avoided its deep structural problems and now it is too late. The eurozone cannot carry the debt burden of Greece, Italy, Spain, and Portugal and the bond market investors abandoned then. I think the eurozone will now think the unthinkable and reorganize into a harder central core of stable economies.

  2. tempo dulu says:

    “The only possible way Italy could regain market confidence at this point is if it swiftly implemented a package of austerity”

    This is the greatest fallacy ever. Austerity by definition means lower economic activity REDUCING a country’s ability to service its debt. The best thing is for Italy and Greece to do is SELL their assets – companies, land, property etc – to solvent countries like Germany. Sure they may not like it, but tough luck.

    • Tim Chirnin says:

      The Italian government is in financial difficulty not the Italian families which have a total net asset value of 8 trillion six hundred million Euros or 350,000 Euros per family. Compare those figures to the “non troubled ” countries and you will be quite surprised. The Italians live to save money to such an extent that I once read in an American economy magazine that they make the high saving Japanese look like drunken sailors on shore leave in that regard.The only time they ever defaulted was immediately after WW2 when they suspended reparation payments to their former enemies. I think that situation was a lot more dire than the present one.Their new government can always tap into those savings and repay its debt with ease and still leave plenty of money for its people to buy up the country’s assets rather than have to sell to any foreigners..As far as Greece, the proper Germans should pay it the war reparations which they never finished doing and Greece would be able to pay its debt.

  3. Aaron says:

    Tempo dulu
    That’s the difference between “market confidence” and reality – you hit the nail on the head there. Mr Market doesn’t do the ruthless job a lot of people like to think. Otherwise all this would have come to a head a long time ago….

  4. Europe is obsessed with avoiding default by banks or sovereigns. But of course, when a borrower can’t pay, default is what must happen. For a bank, it means liquidation. The state might protect ordinary depositors by transferring their deposits in an orderly restructuring. But lenders to insolvent banks should sit and wait for the work out by the bank of its loan assets, good or bad. For states, it is different because you can’t liquidate a state (in peacetime). But the state will probably be unable to borrow for many years to come. Is that a bad thing? Is it not better that states fund their expenditure out of domestic taxation? Of course in states with high current deficits, cutting off borrowing would mean a very sudden reduction of funding for current expenditure and therefore the need for extensive, sudden and painful cut backs. It goes without saying that existing lenders to defaulting states would simply have to wait for their money i.e. until the borrower could run surpluses sufficient to start paying down debt. Does that seem like an extraordinary idea? It shouldn’t. What is extraordinary is the current system of sovereign borrowing on an unsecured interest only basis, with no effective means of enforcement, with additional borrowings of 3% of GDP or less per annum considered acceptable, and with principal repayments funded from new borrowing so that there is never any actual reduction in debt, ever. Instead of fighting defaults, Europe should accept them. No need for anyone to leave the Euro. No need for a huge EFSF. No need for treaty changes. No need for harmonised or centralised taxation. No need for the breakup of the EU. All you need is to accept that certain countries can’t repay and that they must therefore default and learn to live within their means without the ability to borrow in future.

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  7. JonB says:

    iBob101 is completely right. The debt level has been manageable in the past by the ability to borrow in order to service it. This situation and these levels of debt are unprecendented.

    Countries should certainly start living within their means. If countries like Greece and Italy can’t afford to pay welfare, pensions, national health, etc then their citizens should be told that won’t be provided with these things. Perhaps getting ahead of myself but the trouble if this happens is that since the EU enables citizens to move freely, Italians and Greeks might decide to resettle in an EU country that does provide these things….

    Another question if all outstanding debt (Sovereign, Corporate, Personal, etc) were to fall due today would there be enough money globally to clear it all?

    • Tim Chirnin says:

      The whole 75 million between the both., great thinking, I’m sure the people of those other countries would be thrilled.

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  9. CharlesG says:

    Very interesting to see how some people are largely undervaluing the extent of the crisis an Italian default would trigger. The effects would not be limited to Italy or Europe. The Euro would fall and an unprecedented global crisis would start again. Therefore I believe nobody should talk about it so lightly: “Italy cannot pay… Fair enough! Let it default and everybody will be happy”)

  10. C High says:

    As I write PM Monti seems to be taking some time to put together a credible and cooperative government for Italy – presumably due to political infighting and demands for policy debates (not entirely unreasonable) – and the cost of borrowing hits the 7% danger mark again. I hope for Italy’s sake they get a competent cabinet together quickly, they need one.

    • C High says:

      Now that the Italian cabinet has been formed it has been noted that there is not one member who is an elected politician. That’s a staggering development. Oh well, needs must when the devil drives.

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  14. jaybone2010 says:

    I think the EU debt crisis is going to affect everyone, not just the EU. Take a look at this:

    http://www.payplan.com/debt-news/2011/11/22/the-eurozone-debt-crisis-explained/

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