A Quick Primer On Chances Of Italy Destroying The World Economy – Seeking Alpha.At first sight, it is somewhat curious why Italy is in such deep trouble and posing such a mortal risk for the world economy (make no mistake, the eurozone can survive a Greek default but not an Italian one).
After all, this has happened before. Italy in the 1990s had the same debt/GDP ratio as today (roughly 120%) and faced much higher interest rates, see figure below (from Paolo Manasse)
(Click to expand)
Yet few people at the time argued that Italy was close to default or that it would take Europe and the whole world economy down with it when interest rates were twice those today.
Why did Italy have such high interest rates in the 1990s? Well, bond investors demanded a rather large risk premium to compensate for the currency risk. Italy still had its own currency, the lira. The lira was devalued from time to time to restore competitiveness, as Italian inflation tended to be higher than that of its most important trading partners, most notably Germany.
It was the prospects of having that currency risk removed through membership of the European Monetary Union, the EMU, which set of something of a virtuous cycle: interest rates started shedding that risk premium as bond investors increasingly thought the membership would be real, so interest rates came down, reducing financing cost, which reduced the budget deficit, and ultimately the debt/GDP ratio started to decline. You can see all these things happening in the graph above.
Lower interest rates and the capital inflows also boosted the economy somewhat. However, this made it more difficult for the underlying problem to disappear, the fact that Italy had a tendency to create more inflation than that of its main trading partners.
Once Italy was within the EMU, devaluation, the method to resolve that issue and restore competitiveness, could not be used anymore and Italy increasingly became uncompetitive. This slowed growth to barely a crawl (in fact, Italy had negative economic growth per head).
The slow growth worsened the budget deficit and the debt/GDP ratio started to climb again, but interest rates did not. These only started to increase when officials started talking about the possibility of a Greek default (or ‘haircut’, the difference is that the latter isn’t supposed to trigger paying out credit default swap contracts).
This time, the risk premium bond investors were asking wasn’t because of any increased devaluation risk (like in the 1990s), it is to compensate for increased default risk. With the talk (and then policy) of a Greek ‘haircut,’ bond investors simply woke up to the reality that countries in a currency union are basically borrowing in a foreign currency, which they cannot control.
So we’re now faced with the real possibility (if we’re not already in it) of the virtuous cycle turning vicious; higher interest rates increasing the budget deficit, which leads to the debt/GDP ratio to increase (and a second one, higher budget deficit leading to more necessary austerity, leading to lower growth, reducing tax income and making any improvement in the debt/GDP ratio very difficult).
Due to market specifics, we might be very close to the point of no return already:
This is partly because feedback loops kick in and additional widening could easily accelerate. For example, if spreads of 450bp on 10-year governments are exceeded for five consecutive business days, LCH haircut requirements for banks borrowing against Italian collateral will rise by 15%. If banks liquidate their BTP holdings, this will simply exacerbate the problem. If instead they choose to seek funding at the ECB (for example, if they are running short of collateral), publicity around different countries’ banks’ usage of ECB facilities seems likely to lead to more selling in both the banks and the countries concerned. [FTalphaville]
(Some explanation is warranted. ‘LCH haircut requirements’ refer to the world’s biggest clearinghouse LCH Clearnet, ‘BTP‘ are Italian bonds.)
Yet, this situation is not entirely hopeless yet.
ECB creating a new virtuous cycle?
For starters, if the ECB were to announce tomorrow that it will ‘do whatever it takes’ to back Italian debt, interest rates would come down, quite possibly in rather dramatic fashion. If not mismanaged, this could very well create a similar virtuous cycle, comparable to the one in the 1990s, where lower financing cost reduces the deficit and debt/GDP ratio, diminishing default risk further and leading to yet lower yields.
Funny enough, it would only take an announcement (and perhaps some token bond buying) of the ECB to establish this. It wouldn’t have to massively intervene in the markets as the announcement itself would be such an about face that it would be credible in itself.
However, before you start to rejoice, the ECB isn’t actually going to do this (at least not anytime soon), and it’s important to understand why.
The fundamental problem
The fundamental Italian problems, the low growth and the higher inflation compared with the core EMU countries were never really addressed, an absolutely crucial mistake. The simple reality is, a country cannot accumulate inflationary differences for too long within a monetary union, because it cannot devalue its way out of the resulting uncompetitiveness (which is significantly responsible for the low growth).
If the ECB would ‘bail out’ Italy by limitless interventions in its bond market, the pressure to do something about this fundamental problem would be significantly reduced, perhaps to such an extent as to lead to inaction (or symbolic reforms). There is quite a bit of a moral hazard problem attached to the ECB ‘solution.’
Which is why it has made it conditional on structural reforms that are supposed to address Italy’s growth and competitiveness problems. The ECB will buy Italian bonds as a reward for good behaviour.
Is there hope?
Well, actually, not all is lost yet. Countries like Ireland, and Spain, are in fact traveling the route, which Italy should take as well. Most remarkably, in Spain, the socialist prime minister Zapatero has shown Berlusconi what needs to be done. Zapatero made important reforms to the Spanish labour market, for instance, making it easier for companies to fire workers. This is more or less political suicide for a socialist, Zapatero has also written new elections and is not standing for re-election.
While the jury is still out whether Spain has done enough to escape a bailout of its own, it is noteworthy that from being ‘the next domino to fall’ half a year or so ago, it has at least stabilized the situation and, more importantly, its bond yields.
Are you watching Berlusconi?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.