Italy: Past the Point of No Return
November 10, 2011 19 Comments
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.
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.