London, Asharq Al-Awsat- As the Eurozone crisis moved to Italy this week, market commentators began to chatter about the end of the Euro, financial meltdown and other elements of Armageddon. The spread of the Eurozone crisis to the third largest economy in the Eurozone and the world’s third largest borrower is certainly a matter of great concern. There are, however, some positive developments amidst all the gloom.
The first positive development is that the bond vigilantes have finally woken up. They are shouting loudly, and the Eurozone politicians are being forced to listen. Market complacency has contributed to the Eurozone crisis. The market’s failure adequately to price credit risk into the peripheral Eurozone government debt contributed to the accumulation of unsustainable debt burdens. More recently, markets have at least initially reacted complacently to inadequate or incomplete solutions to the Eurozone crisis.
Not any more. In Greece, the bond vigilantes have succeeded in securing the resignation of Papandreou and the appointment of a technocratic coalition government, led by Lucas Papademos, an economics professor and former Vice President of the ECB, committed to the implementation of the rescue package. In Italy, the bond vigilantes have managed to bring down the seemingly indestructible Berlusconi, secured the expected parliamentary approval of a sweeping set of austerity measures and appointment of a technocratic coalition government lead by Mario Monti, also an economics professor and a former EU Commissioner. In Spain the centre right Partido Popular led by Mariano Rajoy, which is committed to strict implementation of austerity measures, is favoured to win the general elections to be held 20 November.
The bond vigilantes are setting the terms of political debate: except for Papandreou’s failed gambit, no major political leaders or parties in the peripheral Eurozone countries are advocating defaulting and/or leaving the Eurozone. They are, however, struggling to articulate and implement the market’s demands and the electorate’s contradictory views, which include: disliking the consequences of austerity but not wishing to leave the Eurozone; not fully trusting that austerity measure alone will deliver economic recovery but fearing that failing to implement the austerity measures will lead to ejection from the Eurozone; disliking the austerity measure but fearing ejection from the Eurozone as the worst outcome. Only those political leaders and governments that have the credibility and political capital to continue implementation of austerity measures can hope to reconcile the demands of the bond vigilantes and their electorates.
The other positive development is that the sheer scale of the Italian problem means that the currently inadequate approach to rescue plans will have to be reconsidered. Italy has €1.9 trillion of debt outstanding, and over €300 billion maturing in 2012. In addition, Italian banks have €88 billion of debt maturing in 2012. The top 10 European bank holders of Italian debt have an exposure of €170 billion, and the overall bank exposure to Italy could amount to €590 billion. The size of the problem means that the existing EFSF facility is inadequate to fund a rescue of Italy. Excluding the EFSF’s existing commitments to rescue programmes and Italy’s own funding commitment to the EFSF, only €110 billion would be available from the EFSF for an Italian rescue programme, well below Italy’s €300 billion refinancing requirement for 2012 alone. Even the expanded €1 trillion EFSF facility would be inadequate, as the facility has yet to be funded, would be consumed by an Italian rescue and leave little funding for other contingencies. This means that the EU would need to expand the EFSF yet again and find the funding, a formidable challenge. The other option is to allow unlimited ECB purchases of bonds issued by solvent Eurozone governments. Despite Germany’s strong opposition to unlimited ECB bond purchases, this may be the only viable solution. It is ironic that the German monetary discipline is preventing the ECB from using quantitative easing to help deal with the crisis while the US and the UK are enjoying “safe haven” status while reflating their economies through quantitative easing.
We must bear in mind that Italy is not Greece. Italy is facing liquidity issues, but it is not insolvent. Italy’s 10 year bond yield breached the 7% level this week. Nevertheless, Italy is still able to access the markets, issuing €5 billion of 1 year bills on 10 November, admittedly at a yield of 6.087%, almost double the 3.57% yield of its bill issue in October. These increased funding costs will not hit Italy all at once but only as Italy refinances and to the extent that the funding costs remain at these extraordinary levels. Italy has €35 billion of cash reserves so it does not need to access the markets immediately. The decision to proceed with the bill auction was probably to avoid scaring the markets any further. Furthermore, Italy is able to service its debt, including any likely increased funding costs. Italy’s interest bill this year was €75 billion compared to tax receipts of €500 billion. Even if Italy’s interest bill increases to €85 billion next year, Italy can service it. Of course it is not a positive development, but it is not terminal.
Italy will need to refinance €200 billion of bonds and €108 billion of bills next year. The first bond maturities of €26 billion are due in February. Italy and the EU thus have a window of opportunity to seek to restore confidence to the markets. In the event that confidence has not been restored by February or that the EU has not devised a suitable rescue plan, Italy could avail itself of a bilateral IMF loan, which had already been offered and declined by Italy at the G20 Summit last week.
Likewise for the banks, their exposure to Italian debt will impact their liquidity rather than their solvency. There is yet no basis to claim that Italian government debt is impaired and that banks should write down Italian government debt. However, the possibility of a future impairment may contribute to Italian banks and other banks holding substantial Italian debt experiencing funding pressure. In October, Italian banks borrowed €113 billion from the ECB, compared to €41 billion in June, an indicator of increasing funding pressure. Italian banks will need to refinance €88 billion of bonds maturing next year, adding to the funding pressure.
Hopefully, the prospect of Italian contagion has been a wake up call for markets and EU politicians alike.