Italy In the Cross Hairs
By Win Thin
Events continue to spiral beyond the control of European policy-makers. With so much time and effort being put into Greece, the troika now finds itself facing a much bigger problem: Italy. While it has been difficult to remain committed to a short EUR trade, we believe the crisis is entering into territory that will take a huge, sharp toll on the single currency in the coming days. Our year-end target of 1.29 remains intact, and we think the risk is that we hit it before the month is out.
Italian borrowing costs have continued to march upwards to new euro-era highs, with the 10-year quickly approaching the 7% level that many see as the point of no return. While it may be tempting to talk about contagion, we note that Italian debt numbers were already bad heading into this crisis. Rather, we think it is the failure of euro zone policy-makers to effectively bring closure to its debt crisis that has led to deterioration in sentiment that has ultimately brought Italy into crisis too. It was reported today in newswires that the IMF approached Italy about a stabilization program, but that Italy turned it down and instead requested IMF monitoring. This may have actually been the correct course of action for Italy. As we have noted countless times before, the current crisis response structure from the troika is simply too small to be able to help Italy in any meaningful manner.
That Italy is actually running a primary budget surplus means very little when markets are looking at a debt/GDP level above 120% in 2011. In the euro zone, only Greece is higher. With Europe and Italy heading into recession, it will be that much harder for debt-laden countries to improve that ratio. Italy has already been downgraded by all three agencies to stand at A/A2/A+, and further downside is seen as our sovereign ratings model has it at A-/A3/A-. While ratings have lost a lot of their significance during this debt crisis, we simply note that underlying fundamentals in the periphery are getting worse, not better, and that the recession there will only make things worse on the fiscal side.
Indeed, it was slow growth over the past decade that really prevented the fiscal consolidation that others were able to see. Over the past 10 years through 2011 (with full year growth forecast at only 0.6% by IMF), Italy has averaged annual real growth of only 0.1%. So while Spain saw its debt/GDP fall from a peak of almost 70% in 1996 to a trough of 36% in 2007, Italy saw an improvement from a peak of 122% in 1996 to a trough of 104% in 2004.
Much of this is a confidence issue, with markets increasingly pessimistic about Prime Minister Berlusconi’s ability to deliver fiscal consolidation. Speculation swirls that he could step down, including press reports that his own Finance Minister Tremonti called on Berlusconi to resign. As of this writing, Berlusconi has shown no signs of acceding to these wishes, and ongoing political uncertainty will only prolong this turmoil in Italy. To us, the best solution for Italy would be for a technocrat government to take over that can deliver the stabilization measures that markets are demanding. Italy’s macro outlook won’t improve overnight, but getting confidence back is a necessary (but not sufficient) condition for this crisis to get come under control.
With regards to Greece, the political situation remains fluid as markets await the vote of confidence on Papandreou’s government. We cannot pretend to know what the outcome will be or how markets will react, but we simply posit that the bottom line is continued uncertainty. A disorderly default and euro exit by Greece is still tail risk, but markets have recognized that the tail has fattened in recent days. Even a best case scenario of Greece sticking with the October plan faces implementation risk. Even if everything falls in Greece’s favor, it will still only get debt/GDP down in the coming years to 120%, where Italy is right now. Deeper than 50% haircuts are needed to get Greece on a sustainable debt trajectory, so the debate is by no means over. Oh, and we got a reminder today that euro zone banking sectors remain under severe stress, with Moody’s putting an Austrian bank on review for downgrade due to recently-revealed losses related to its peripheral holdings. If a disorderly hard restructuring by Greece is seen, most of the euro zone sovereigns will have to backstop their banking systems and the resulting liabilities will certainly weigh on sovereign ratings. In the core euro zone, Belgium, France, and Austria remain the weakest credits.