The decoupling of Italy from the periphery
I had intended to write this post yesterday morning. However, after the bank scandal in Italy and the surprise drop in US GDP, I waited a day. The gist of what I intend to say here is that Italy is in the process of decoupling from Spain. The Monte Paschi scandal certainly complicates this thesis a bit. But I think there are valid reasons for the decoupling.
What precipitated the post was an article in Spanish newspaper El Pais on yield movements. The article notes that the differential between Spanish and Italian yields is at its highest level since the European sovereign debt crisis began. Here’s the snapshot they used to present their case:
According to this figure, if you look at the periphery and France the spread to German bunds goes from France to Ireland and Italy to Spain to Portugal and then way out to Greece. There are a few things that one can take away from the 10-year government bond yields. First, France has not re-coupled to the periphery in any way. Despite any similarities between the French and Italian predicaments, France is only 60 basis points wide of Bunds all the way out to 10 years. Italy and Ireland both sit a further 200 basis points further back. Second, it is clear that Ireland and Italy have benefitted the most from the OMT program’s announcement as the yields on their bonds would be low enough in a non-austerity environment to maintain some semblance of stability in government debt to GDP. Third, Spain has now decoupled from Italy. The differential in yield is now vast, 100 basis points. Fourth, Greece remains apart, excluded from the other countries. They can easily be seen as a separate case, an example of what not to do, without it inflicting harm on the rest of the periphery via contagion.
I want to go through each of these five points with special emphasis on the Italian-Spanish decoupling and the contrast to France.
In the euro zone, the real areas to watch now are France and Spain. In my view, the biggest difference between the two countries is the housing-downturn driven budget deficit. On a macro level, the government statistics are not dissimilar. France has over 90% government debt to GDP now. And this is about the same level as Spain’s. But Spain had a deficit of 9.4% of output in 2011 and 6.3% target last year, one they probably missed. They are looking to achieve a Herculean move down below 4.5% this year and then to 2.8% in 2014 via the austerity path that has caused the economy to sink into depression. There is no chance of this working and the EU Economics Commissioner Olli Rehn has already said they may relax Spain’s targets by a year to give the economy more breathing room.
France’s new government was elected specifically because it rejected the austerity path. The pension age was reduced, not increased. And the budget it produced last year was not austere in the least. This year the budget deficit is about 3.5%. And France wants to make the 3% hurdle next year via 1.7% growth in the domestic economy. The question has always been ‘how does France get away with this while the periphery is cutting?’ The answer might be political, meaning France is at the very heart of the euro zone, a currency that cannot survive without them. But I think the answer is also about deficits because that’s the only place where Spain differs from France. And we should remember that Spain had low debt levels before the crisis. All of the debt is a result of the financial crisis and imploding housing market.
So, my worry here is that France is a Spanish wolf in French sheep clothing. Look at the Economist’s recent global housing market piece. France has an incredibly overvalued housing market when compared to rents or income. Only Canada, Hong Kong and Singapore are worse. And if you know your sectoral balances, you know that a popping housing bubble that leaves large swathes of the household sector with underwater housing assets causes severe consumer retrenchment, ballooning deficits. That’s what we have seen in the US, the UK, Ireland and Spain. And so the major difference between Spain and France vanishes once the housing bubble there pops. What’s more is France would have much further to go up in debt to GDP given how elevated their market is relative to rents. It is not inconceivable that France could match Italy at 125 or 130% government debt to GDP after a housing bust and the concomitant bank bailouts it would engender.
This last point therefore brings us to Italy, which is now decoupling from Spain. Legitimately, Italy is a different case from Spain. It does not have a household sector debt problem at all. The household sector in Italy is less indebted than the household sector in Germany. Where Italy’s problems lie are in slow growth and poor demographics – just like Germany. However, as opposed to Germany, Italy has seen a terrific increase in its unit labour costs. And so exports have stalled, making trade as a recovery tool one route that is blocked to Italy which has saved Germany. But if you look at Italy’s demographics and household sector, it is similar to Germany. The big differences are the unit labour cost increases and the existing pot of government debt.
So, I would make the case that Italy is an indebted, less export-efficient version of Germany than anything that resembles Spain. There is no real reason for these two countries to be tied together in this crisis other than age-old thinking about southern Europe being risky. I would say that France is actually as risky as Italy. So, if I were betting on how this proceeds over the long term, I would short French debt and go long Italian debt. The problem is that over the short term, Italy is still very much tied to Spain and Spain is still in the midst of a horrific debt deflation. To the degree Spain’s economic situation deteriorates and the country is forced into an OMT program, we should expect pressure on Italy then.
Of the other countries in the periphery, the spreads tell us a lot. Ireland is going to make it fully back to market and will certainly be eligible for an OMT program. If the country does apply, the ECB backstop would only be implicit because Ireland would go to market as normal, with the ECB ready to buy bonds in the secondary market only if necessary. Ireland, having gone into a Troika bailout before Portugal would be a test case for Portugal, which would be eligible six months later. If Spain has not already done an OMT, then OMT success in Ireland might cause the Spanish to think about doing so in order to affect their yields. So here I think an Irish OMT application is bullish for Spanish yields more than it is for Irish yields because it means Spain would be next onboard.
Greece is a separate case altogether. The yields in Greece are much higher than anywhere else in the euro zone. Investors see Greece as different – and that means excluding Greece or giving Greece differential treatment will be easier. This is something to keep in mind regarding contagion because it may be that Greece does find a euro zone exit down the line that has no significance for any of the other euro zone members. That is what I believe will occur.
For now, the focus is on France and Spain with me expecting France to ‘converge’ to Spain due to difficulties in housing in France. Italy, which does not have these difficulties, should diverge from Spain and continue to pull away from the periphery as Ireland has done.