Why here? Why now? Why this particular eurozone peripheral? | FT Alphaville

Why here? Why now? Why this particular eurozone peripheral?

It’s a question FT Alphaville has been pondering for some time.

Why do markets suddenly seem to ‘wake up’ to the problems of one particular country or market, while ignoring similar and even worse issues in other areas? It is, perhaps, a pattern that was first seen in the Asian crisis and the emerging market drama of the 1990s. The question then was “what’s the difference between Russia and Brazil?” To which the only half-joking answer was “about nine months.”

We bring that bit of crisis history up because Barclays Capital does, in a note out on Thursday.

In it emerging markets specialists Michael Gavin and Piero Ghezzi explore the ‘why? question by making a comparison between Italy and Japan. Both countries have been plagued by relatively high levels of debt for years, yet only one has caught the attention of markets recently. In fact, Japan’s debt-to-GDP ratios stands at a whopping 230 per cent — almost twice Italy’s 120 per cent.

Here’s a summarised explanation from BarCap:

We argue that the absence of market anxiety about Japanese public debt sustainability has plausible explanations: the country’s strong external position means that Japanese bonds are owned almost entirely by domestic investors who tend to be (rightly or wrongly) less prone to panic than external bondholders. Control over monetary policy is another key difference: the extreme tail risk of a default event caused by the government’s running out of the currency that it owes to bondholders simply does not exist for Japan, as it does for the Italian government.

Which seems fair enough. But you could also stretch the question to other G7 nations, as Bank of America Merrill Lynch economists have done. According to them, the risks to Italian debt seem roughly balanced over the next decade or so. Unlike say, in the US, where fiscal scenarios are more stressed.

Anyway, none of that really answers what caused recent Italian contagion.

We’d point out, as we’ve done before, that all of these latent financial problems — be it Japan’s massive indebtedness or Australian bank funding — tend to be fine as long as the market feels they are fine.

A truism for sure, but one that really sums up the self-reflexive nature of markets.

So what kicked off Italy? Here’s a stab from BarCap:

In our view, the doubts that entered investors’ minds had less to do with developments within Italy than with the development of the euro area fiscal support mechanisms, where questions about the role of private sector involvement in support programs may have created just enough room for concern to raise the possibility of such a downward spiral. The support mechanisms were supposed to force the market away from the bad equilibrium and into the no-default equilibrium by providing an international backstop for fiscally stressed euro area governments. But for some time at least, they seemed to have become a default machine instead.

Here is how we think this happened. As it became apparent that the initial program of Greek fiscal adjustment and official financial support would not bring about market access as quickly as originally planned, a revised program with additional financial support had to be designed. Private sector involvement was demanded by European countries, not because the problem could not be solved without it, but as a matter of realpolitik in the creditor countries. After wandering down some blind alleys, it gradually became apparent to investors and European policymakers alike that meaningful PSI implies what most investors (and most rating agencies) would call default or restructuring.

The rating agencies and the market concluded that Ireland and Portugal would follow Greece; it is a near certainty that these programs will sooner or later have to be revised and extended because it seems highly unlikely that either country will be able to return to markets as early as had been assumed in the initial program; until last week, nothing had been said or done to dispel the impression that PSI would need to be part of these program extensions as well. Hence, among other things, Moody’s 3-notch downgrades and quadruple-digit CDS spreads for Ireland and Portugal.

Which means, BarCap says, that all those European financial support mechanisms — the EFSF, ESM and the like — simply morphed into giant default machines, at least in the eyes of the market. Every time a new country entered the bailout programme, it had just been placed on a long road to default or restructuring. EU ‘support’ became a way of managing defaults, and not necessarily avoiding them.

What’s more, we would add, the long road to default is creating massive contingent liabilities for the countries that have so far escaped it — places like Italy, and even France and Germany. It’s actually a terrible half-way house between outright restructuring and a string of publicly-funded bailouts.

All of which rather begs the question of whether Europe’s lumbering default machine has been successfully dismantled in the latest iteration of eurozone bailout policies, as announced last week. Note that while EU authorities were at pains to point out that the programme was for Greece and Greece alone, investors have reacted in a nervous manner, with Italian and Spanish bond yields rising again.

Clearly the market still feels something is wrong.

Related links:
The same crisis again and again – FT Alphaville
Euro area faces breakpoint – lessons learned and policy options – The Long Room