Tuesday, August 2, 2011

No Dolce Vita for Italian Bond Investors

The second bail-out program for Greece has failed to ease stress in the other peripheral markets. Rather to the contrary, the Eurozone sovereign crisis is reaching a new level as the downward spiral (higher interest rates leading to a weakened solvability leading to higher interest rates) has reached Italy. Italy was generally assumed to be relatively safe despite its high sovereign debt level of approx. 120% of GDP. Reasons have been that the banking system appears sound amid low leverage/high capital ratios and a high level of deposits (and in turn not much funding stress). Furthermore, indebtdedness of the private sector is low and the savings ratio high. Finally, the deficit was "only" around 4% in 2010 and Italy is one of the few developed economies with a primary surplus (i.e. a budget surplus before interest payments). As a result, despite the high level of sovereign debt, the projections for the debt-GDP ratio were looking for a relatively flat development, i.e. no worsening in the solvability. Furthermore, the risk that Italy would have to take over a significant amount of banking debt (as in Ireland) appeared remote as well as the risk that the domestic economy would implode (as in Spain).

10y Italian and Spanish government bond yields reaching new records
Source: Bloomberg

However, amid the combination of private sector involvement in Greece, a negative rating outlook for Italy (amid chronic growth weakness), only a half-hearted austerity program as well as weakness in political leadership might all have lead parts of the international investor base to start selling/hedging their Italian bond exposure, thereby starting to drive up interest rates. Even more threatening, though, is the implosion of bank shares and the potential for a wave of capital flight by the Italian households. Once Italians lose their faith in the political system as well as their banks, they will increasingly shift their money elsewhere. Such a wave of capital flight would seriously undermine the stability of the Italian banking system (as it deprives them of a key source of funding) and significantly weaken the domestic demand for Italian debt (by the households themselves which take their money elsewhere but also by the banks which suffer already from high losses on their BTP holdings and would then need to shrink their balance sheets as funding via deposits dries up). So far data by the ECB for the development of banking deposits does not showw a significant flight out of Italy. However, the data cover only the period up to June, i.e. just when the rout in the BTP market as well as in Italian banking shares really started. Furthermore, banking deposits in Italy have not been growing anymore since late 2008, contrary to previous years.

Development of banking deposits by state (Dec 2007=100): Italian deposits drying up?
Source: ECB

Overall, this negative feedback loop has been set in motion and it seems that only further strong action by either Eurozone politicians, the EFSF or the ECB can break this downward spiral. We would either need very strong growth impulses for the Eurozone economy from key export markets (potentially also via a much lower euro), a large investment program for Southern Europe and/or a massive buying program for peripheral government bonds. However, the EFSF does not yet have the ability to do that (probably this will only be possible from autumn onwards) and even if it would, its size remains too limited. This would leave the ECB to do the heavy lifting and restart its bond-buying program, but this time also for Italian bonds and in much much larger size. So far, though, the ECB seems reluctant to go down that route.

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