November 9, 2011
The crisis has now moved to Italy. Italy is no Ireland, no Greece and no Portugal. It is the EU’s fourth-largest economy and the eighth-largest in the world. Its bond market is the third-largest in the global financial markets. It is far too big to bail out.
The total size of the Italian government debt is â‚¬1,900bn. One quarter of this falls due over the next few years.
Italian yields are heading towards 7pc and this would mean that Italy would pay 5pc more for money than Germany. No monetary union can survive such a differential and narrowing the differential was one of the main selling points of the monetary union in the first place.
The reason the figure of 7pc is important is because once a yield hits this type of territory it will be downgraded. In this environment, the market just shuts down to the country in question. This is what we saw in Ireland, Greece and Portugal. The omens for Italy look dire.
Once the yield reaches a certain level, then a downward, self-reinforcing cycle begins which involves your pension.
Traditionally, pension funds around Europe have bought the bonds of governments like Italy, thinking they were safe. The investing rules of many (rightly) conservative pension funds debar them from holding assets which are not rated Triple A.
So if Italy is at risk of being downgraded — as is now the case — and would be guaranteed to have yields going ever higher, then pension funds will be obliged to sell their holdings of Italian bonds. This drives yields up even higher and the only buyers of Italian bonds, which would now be “junk” bonds, would be high-risk investment and hedge funds that are allowed to buy risky assets. Therefore, there would be huge general selling of Italian bonds and the “normal” markets would essentially close to Italy.
According to analysis by Dow Jones, Greek bond yields hit 7pc the day after they hit 6.5pc, Irish yields took 34 days to travel the same distance and Portuguese bond yields took 43 days. But they all went to 7pc eventually.
Given the enormous amount of Italian debt which needs to be refinanced in the next two years — close to â‚¬200bn — it is easy to see why the eurozone wants to avoid this trigger mechanism at all costs. This fear explains why the European Central Bank has hit the panic button in the past few weeks and bought over â‚¬80bn of Italian government debt — because no one else will touch it.
Present policy at the EU level is in tatters and, more egregiously, the reputation of the EU has been badly tarnished by events of the past seven days.
First, we have the sight of the Greek prime minister being forced out of office because he wanted to get a mandate from the people. This reminded many yet again of the deep fear of popular democracy that exists at the highest level in Europe.
But just because the people will not be allowed to vote in a referendum does not mean that they won’t speak or act. A few months ago, this column wrote about the Italian financial police stopping people at the Swiss border who were driving across the border to deposit money in Switzerland. Given the size of the black economy in Italy, the financial police could charge people with tax evasion while at the same time keeping liquidity in the Italian banks.
Despite this, the Bank of Italy has now revealed that at least â‚¬20bn has left Italian deposit accounts over the last two months. This will dramatically increase in the weeks ahead unless there is a comprehensive pan-eurozone settlement.
The eurozone is faced with a perfect storm of three enormously negative headwinds. The first is that growth has disappeared and doesn’t look like coming back any time soon. In fact, recession in Europe is on the cards for the final quarter of this year. The second is that without growth the enormous debt mountain that has built up in Europe over the past 15 years can’t be paid back. And the third element of the storm is the fact that we have a total absence of leadership. So you take the three together — not enough growth, too much debt and not enough political leadership — and you get a recipe for panic.
This panic will be felt all over the periphery as money leaves the periphery and goes to the core. This capital flight will undermine whatever fragile stability has been achieved in Ireland and Portugal, while at the same time exposing the unfinished business in debt-mired Spain and possibly Belgium.
ULTIMATELY, the only solution is for the ECB to take control. Taking control means buying up all the bonds that it needs to buy, replacing these bonds with money, driving down interest rates and increasing liquidity. In carrying out this approach, it also has to know that some of the bonds will not be paid. Such an approach would be financial suicide for a central bank — if it had to make a profit. But it doesn’t. So it can.
The main stumbling block to this is the German public, who will fear the inflationary consequences of this monetary jamboree.
There might also be those who believe that the bank should be extracting some concession in return for its cash. At the moment, the mainstream orthodox view is that the price for help has to be austerity. But it also has to be debt write-offs borne by the creditor. And the creditor in most cases is the German and French banks.
After significant debt forgiveness, some banks — not all — will have to be recapitalised. Initially, this should come from the bondholders being forced to take equity and then this will be bolstered by the governments or the ECB taking protected equity stakes in the banks that survive.
It is crucial that the banks’ job of providing liquidity to the economy is maintained. And if this is impossible with the present banking system, then we should create a new one. We should close down the ‘zombie banks’ and be allowed to move our deposits to new ones.
In order to even have a chance for this to proceed smoothly, the ECB will have to get its act together, find its mojo and realise it is the only institution that can save the euro. And it has to do this by Christmas.
Unless we get this enormous shift in the way the ECB thinks and acts, Italy will be locked out of the markets and the crisis we have seen thus far will appear like small beer in comparison to what is to come.