When Italy is already priced to wreck the eurozone

Posted by Joseph Cotterill on Jun 22 13:20. 9 comments | Share

It’s a funny old world. In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. More…

It’s a funny old world. In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency.

It was always Italy. High-debt, low-growth, Italy. Obvious tail risk, really.

Then again, Italy has of course so far escaped a ‘debt’ crisis that’s mostly been about anything but the sheer quantum of sovereign debt to GDP facing a particular country. But it’s always been latent that any long-term repricing in sovereign risk premia, following the Greek default, would affect Italian interest payments.

So this is an interesting chart on the growth of Italian sovereign debt, or as Barclays Capital call it — ‘the knife-edge’:

Note the reference to current spread to Bunds. While everyone is naturally focused on the acute crisis to the future of the euro emanating from Greece, there’s a chronic crisis brewing right here.

The chart is from a BarCap note generally bemoaning Italy’s new fiscal strategy for 2011 to 2014, which is meant to bring in around €73bn of extra adjustment. The plans involve devolution of tax powers to local government (which could well lead to mezzogiorno risk basically) while fully three-quarters of the projected extra revenue actually comes from clawing back tax evasion. It’s a bit Spain, given the emphasis on regional problems, and a little bit Greece, on tax execution difficulty.

BarCap’s analysts — Fabio Fois, Antonio Garcia Pascual and Pietro Ghezzi — included this chart on the adjustment in their Tuesday note:

More to the point, BarCap think low growth means that debt outstanding would only stabilise at 120 per cent of GDP — not decline in any way — not only by 2014 but by 2050.

The real kicker though is the current spread of Italian debt to Bunds.

All BarCap’s workings-out above assume a 100 basis point risk premium. Currently it’s of course 200bps. You really must wonder what’s going to bring it down in a post-Greece market, especially where it becomes normal to treat the eurozone as a two-tiered union, and including interest rate movements (up), a global shift in the cost of capital (also up), and so on. BarCap are wondering:

The urgency is even more acute if one considers that markets yields can move very violently. The cost-benefit analysis suggests it makes sense being pre-emptive in anticipation of a potential additional increase in spreads were Greece to restructure…

If you were looking at the eurozone purely in terms of its capital structure, it’s hardly looking like it’ll be around in a decade (even if it does survive the Greek crisis) given the long-term risk from Italy. That’s even assuming the bond market doesn’t give up on the country in the immediate aftermath of the Greece fallout. The crisis will move to the core one day.

Admittedly BarCap can think of plenty of ways out, such as focusing on structural reforms that favour growth above anything else, or indeed the power of financial repression. It’s well known by now that Italian banks buy up their government’s bonds like no one’s business. About a third of bonds outstanding are held by banks, insurers and pension funds in Italy. We know that the country’s own interbank market has taken a lead in collateralised lending too.

Still, when one person’s natural government bond investor base is another’s sovereign-banking loop waiting to happen…

Related links:
Wake up and smell the BTPs – FT Alphaville
Italy will be eurozone’s biggest test, says Altman Z-score creator – FT Alphaville

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