Is Italy “too big to fail, too big to save”?
This week the European sovereign debt crisis took on another dimension. Long-held fears of contagion
were realised with Italy, the third richest Eurozone country and the world’s third largest issuer of sovereign
debt, suddenly in the firing line.
As a result of prime minister Silvio Berlusconi’s erratic management of fiscal policy, investors lost
confidence in Rome’s ability to tackle its debt mountain. The yields on Italian bonds rose to 7.5%, beyond
the ‘danger zone’ breached by Portugal, Ireland and Greece, before each was forced to ask for bailout
funds. The problem is that Italy’s debts are simply too big to be covered by a bailout. As one commentator
put it this week, Italy requesting a handout would be “like an elephant getting into a life raft”.
The announcement from Berlusconi of his intention to resign did little to boost confidence, with the
downward momentum in Italian bonds creating a dynamic all of its own, what bond markets call ‘cliff risk’.
This occurs when yields on debt reach critical levels in comparison with another issuer’s (in this case
German Bunds). Once this occurs, forced selling begins which drives yields even higher and triggers a
tailspin that becomes extremely difficult to recover from without external intervention.
But let’s be clear about what has caused this to happen to Italy. It’s less to do with ‘bond vigilantes’ forcing
yields higher or predatory hedge funds taking bets. This escalation has occurred because European banks
holding Italian bonds have been left with little alternative but to sell, or face even tougher recapitalisation
requirements to meet European Union (statutory requirements). It was, after all, the EU that changed the
rules of the game, making it no longer a valid assumption that European sovereign bond holdings could be
taken at face value. It’s no surprise, then, that those financial institutions carrying Italian debt, but also
facing stiff capital adequacy requirements, are increasingly reluctant to be left holding it.
It should be remembered that Italy’s problems aren’t the same as those that brought down Portugal,
Ireland or Greece. Yes, it has to refinance some €300 billion in outstanding debt over the next six months,
but it has a low budget deficit and a robust, well diversified economy. Also, its citizens are not heavily
indebted and nor are they struggling to cope with a burst property bubble. Perhaps this is why equity
markets haven’t fallen as heavily this week as one might have expected.
Why the ECB lacks the mandate to be Europe’s ‘lender of last resort’
So what solutions are on the table? The most obvious one is for the European Central Bank (ECB) to take
clear and decisive action. It is the only institution capable of buying up Italian debt in quantities large
enough to help calm the agitated bond market. So far though, the ECB has preferred to stay on the
sidelines. They’ve made a few Italian debt purchases to help push yields back below the 7.0% threshold,
but have really only been tinkering at the margins. This is because the ECB insists that its primary goal is to
target inflation and that it does not have a clear mandate as lender of last resort for individual members of
the EU. Furthermore, it doesn’t want to be seen to be printing money to help countries with their debt
problems for fear of stoking up longer term inflation. We would argue though that it is well within the
ECB’s power to act as the lender of last resort, particularly if the financial stability of the EU is at serious
risk, which it clearly is.
We’d therefore like to see the ECB take a ‘belt and braces’ approach, announcing an all-out bond
purchasing programme with the power to buy unlimited amounts of debt. Such a statement, with the
weight of the ECB behind it, would be enough to discourage speculation and effectively put a ceiling on the
yields of Italian (and also potentially Spanish) debt, without having to actually buy up a significant
proportion of Italian debt. We think that an intervention from the ECB will only be likely once political
uncertainty within Greece and Italy is resolved, and once it can be sure that its actions do not simply add to
existing inflationary pressures.
Outlook
The European sovereign debt crisis remains unsolved, markets continue to be volatile and we’re still at the
mercy of politicians and policymakers to come up with meaningful solutions. The imperative is there, they
need to prevent a liquidity crisis becoming a solvency crisis. So we can expect more debate, more
uncertainty, more calls for concerted action and more emergency summits in the weeks ahead.
Markets have been given a glimpse this week of just how catastrophic a collapse of the EU would be. The
stakes are therefore increasingly high, but we believe that relatively straight forward action, particularly
from the ECB can reverse the current negative sentiment significantly. Therefore we’re keeping our powder
dry, knowing that with macro economic data still on an improving path, there’s still more upside than
persistent downside potential to be found within equity markets.
Lothar Mentel, 11 November 2011