Italy, Lebanon, and the sovereign outer limits | FT Alphaville

Italy, Lebanon, and the sovereign outer limits

Something’s wrong with this picture… (chart via Exotix):

(An older version of the same chart from Exotix can be found here)

It’s Italy, whose government bonds trade with a wider zero-volatility spread to Lebanon, despite being placed eleven notches higher by the ratings agencies. Helps to put Italy’s latest S&P one-notch rating cut in perspective… even if it’s necessarily an extremely broad comparison. (Spain’s just below Lebanon’s spread. Argentina hides behind Bosnia within this chart but it’s tighter than Portugal, though with less of a ratings gulf.)

Choosing between Italy and Lebanon is obviously not an investment decision that a bonds portfolio manager is going to make, ever. Probably. Gabriel Sterne, economist at Exotix, makes a poignant connection though, between two indebted sovereigns:

During the mid-2000s, Lebanon was the ultimate imminent crisis that never materialised. Italy is looking increasingly like the crisis that could never materialise but is now imminent.

Which we think is a really good summation of the single point of failure problem facing Italy. In other words, Italy’s former strengths — it was the biggest sovereign issuing liquid debt in euro — are now weaknesses. Indeed the very size of Italy’s debt stock now makes it un-bailable.

After all there’s not much favouring Lebanon apart from that on a straight economic basis, as Sterne writes:

In our opinion, the most incredible aspect is that [Lebanon’s] outperformance comes in spite of it performing worse on virtually all conventional vulnerability metrics… According to IMF projections for 2011 (from the April WEO), Lebanon’s public debt at 134% of GDP, is higher than Italy’s (120%); as are its fiscal deficit (10.5% of GDP versus 4.3%); its current account deficit (12.9% versus 3.4%); and its inflation rate (5.5% versus 2%), while its GDP per capita is 25% that of Italy’s. Furthermore, Lebanon’s ethnic tensions and social divisions are far greater and its institutional rankings much weaker. Neither country can devalue or deflate away the problem, Italy for obvious reasons and Lebanon, because much of bank lending and 40% of public debt is dollarised; abandoning the exchange rate peg is not a remotely palatable option.

But standing against all of that, Sterne argues, is that everyone knows Lebanon has a long history of undergoing sovereign crises (as in actual wars and revolutions) and getting through them in one piece somehow.

Italy has never been tested with a systemic event (such as a currency break-up) in the same way really. It’s certainly not the kind of bet that many holders of Italian government bonds had imagined they might be forced to make, since the euro’s inception.

Seems an obvious point when it’s made… but everyone seems to miss this big picture.

There’s an interesting footnote here, in terms of what counts as “good” volatility in financial markets, and the sovereign risk that feeds back into those markets. It includes whether suppressing volatility is bad.

Nassim Taleb and Mark Blyth co-wrote a piece in Foreign Affairs a while back arguing that suppression is indeed a terrible idea over the long run, and that the Arab Spring showed this up. That is, by attempting to suppress volatility in the name of stability, one moves potential outcomes (or “blow-ups” in the parlance) into the distributional tails where Taleb’s much-loved swans reside.

Much better to embrace the “chaotic” but flexible revolving-door political systems of Lebanon… and Italy, Taleb and Blyth argued.

Italy’s subsequent troubles don’t make them wrong. In fact, it shows why the eurozone’s current obsession with using austerity to reboot Italian interest rates is wrong. Very wrong. Suddenly Italian politics becomes the thing everyone relies on (a fresh eurozone single point of failure, if you will) when its very lack of reliability is its main feature.

And that, in short, is the kind of superior statesmanship that leaves Italian debt half-way seriously comparable with Lebanon. The outer limits have been reached, indeed.

Related links:
The new Big Short – EM debt, not so safe – Bond Vigilantes
A slippery slope – Buttonwood