It’s not about Berlusconi
Nov 11th 2011, 16:51 by G.I. | WASHINGTON
ASK any pundit why Italy is in crisis and they will mention some combination of Silvio Berlusconi, a towering national debt, and a moribund economy. The explanation resonates since all three have undeniably been enormous negatives for Italy. Today’s market action seems to vindicate the reasoning: with the prospect of a new government under Mario Monti and speedy implementation of a new budget, Italian bond yields have plummeted below 7%, and stocks around the world have rallied.
But these factors are not the root cause of the crisis and as long as Europeans behave as if they are, a resolution will elude them.
Italy has been burdened by Mr Berlusconi, a large national debt and a moribund economy for most of the past decade. As Daniel Gros points out, some of Italy’s key fundamentals—investment, R&D, educational attainment—have actually improved relative to Germany in that time. Yes, its debt remains a problem but, unlike Greece, it did not suddenly spiral out of control and was not, as far as we know, systematically underreported. As recently as 2009 Italy’s debt was 97% of GDP (it’s 100% now) and its deficit was 5% (compared to 4% this year, according to the IMF). Yet that year Italy could borrow at 4%, not much more than Germany, whereas now it must borrow at 6-7%, triple what Germany pays.
What changed is not Italy’s political or economic fundamentals but how investors perceive Italian debt. For most of the euro era, investors considered euro-zone sovereign bonds to be risk free. Prices and yields would fluctuate but anyone who held an Italian bond to maturity assumed they would get back 100 cents on the dollar (or euro), as they would for a US Treasury or British gilt. This was always something of an illusion. Risk-free can only apply to the debt of country that controls the currency in which it borrows. A holder of its bond knows he can always sell it to someone else, in the last resort the central bank. As Chris Sims of Princeton points out, such bonds may have inflation risk but not counterparty risk.
That has never been true of a euro-zone member country, but investors happily ignored the fact, thanks in part to the European Central Bank which treated all sovereign bonds equally in its refinancing operations. (See our analysis here.) It no longer can. Investors who once classified their sovereign bonds as risk free must now treat them the way they might a bond issued by a railway company or an electric utility (i.e. as “credit”) and have concluded they own too much.
A staggering amount of debt must now migrate from the portfolios of investors who want only risk-free debt to those of investors comfortable treating it as credit. That is why yields on Greek, Portuguese and now Italian bonds have shown only fleeting responses to multiple bail-outs, austerity programmes and rounds of buying by the European Central Bank. Investors have treated the dip in yields that follow each announcement as an opportunity to lighten up.
In the case of Greece, the volume of debt is small enough to find a new home on the balance-sheets of the official sector (the ECB and eventually the European Financial Stability Facility). Italy is an entirely different matter. People often comfort themselves by saying Italy owes most of its debt to Italians. But according to Bank of Italy statistics(thanks to Fabrizio Goria for the pointer), non-residents held 43% of the country’s €1.9 trillion of debt as of June. That’s a staggering €820 billion of securities, or $1.1 trillion, and it is being sold.
IFR Markets via Thomson Reuters reported November 13th:
European banks are planning to dump more of the 300 billion euros they own in Italian government debt, as they seek to pre-empt a worsening of the region’s debt crisis and avoid crippling write downs…Still reeling from heavy losses on money they lent to Greece, lenders are keen not to make the same mistake twice. Then, under the pressure of governments and a hope that credit default swaps would protect them against heavy losses, they held on until it was too late to sell. With the ECB providing a bid for Italian bonds that might not otherwise exist, board members at some of Europe’s largest bank say now is the time to accelerate disposals.
Mohamed El-Erian of Pimco recently noted:
It has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can. In the last few days several banks have rushed to announce that they have been actively reducing their holdings of Italian debt—as a means of reducing market concerns about their own well-being. This phenomenon is similar to the 1980s phase of “macho provisioning” that saw banks trying to outdo each other in telling the world that they were fully protected against their past loans to Latin America. The result today is to encourage and push other Italian creditors to also sell, adding to the market pressures. In too many cases, the damage to the demand for Italian bonds is much more than transitory.
It is hard to know what Italy can do to change this dynamic. Mr Berlusconi’s exit will help, but the focus on him as the cause of the crisis is misplaced: he mattered only insofar as the rest of Europe makes the structural reforms and austerity that he had failed to carry out a condition for bail-out. His departure does not guarantee that a bail-out, if needed, will be forthcoming, much less that it would work. True, Italy’s new borrowing needs are small, given its modest deficit. But its refinancing needs are massive. According to Bloomberg, it must “refinance about 200 billion euros of maturing bonds next year and more than 100 billion euros of bills,” a sum that would virtually exhaust the EFSF.
That leaves the European Central Bank. Conceivably it could reward a serious budget plan by Italy’s new government with a commitment to keeping Italy solvent via far more aggressive bond purchases. (My colleague describes how the ECB could use Spain to show the way.) But it has so far signaled no interest in doing so, and in any case it may be too late. Whereas the Bank of England can be compelled, if need be, by Parliament to be lender of last resort, the ECB does so only by choice. If it did so now, it could easily change its mind later, if for example Italy falters in implementing its reforms. This denies investors the comfort of once again being able to treat Italian debt as risk free. They may take stepped-up ECB buying as an opportunity to sell rather than buy.
Italian bonds do not have to be restored to risk-free status—they only need their yields dragged low enough for Italy to remain solvent. Whether outside investors have the appetite to absorb all that paper at sufficiently low yields is unknown. In the meantime politicians repeatedly undermine the market confidence necessary for that to happen. As Barry Eichengreen notes, France and Germany broke a taboo when they threatened Greece with expulsion from the euro if its bail-out were rejected in a referendum. It had the desired effect of forcing George Papandreou, then the Greek prime minister, to abandon the referendum, but investors must now incorporate not just the risk of default into their decisions but of forced conversion to a different currency.
The worry, then, is that as each new turn of the austerity screws fails to produce the hoped-for relief in the markets, more austerity will be prescribed, until the Italian political system rebels, making default and exit from the euro unavoidable. Is there an alternative? Our leader this week concludes:
For the euro to survive, Italy must succeed. For Italy to succeed, its squabbling politicians must find unaccustomed reserves of unity and courage. That depends on ordinary Italians being willing to make sacrifices, the ECB backing Italy, and France and Germany standing resolutely behind the euro. It is a dauntingly long list of things to go right.
This post has been corrected.