Got questions? Goldman has answers.
The calamari bank — like most of the market — turned its attention to Italy late last week. In particular, economist Lasse Holboell Nielsen took some time to answer 10 “key questions” on the Italian situation.
Here they are:
1. Why has the crisis spread to Italy?
This is not entirely clear, nor is it clear why the sell-off has occurred now.
External risks facing Italy appeared to have eased with the adoption of additional austerity measures in Greece, and after the Euro-group and the IMF signed off on a fifth tranche of financial aid to Greece last week. However, this was offset by a number of factors, which probably exacerbated negative investor sentiment: (i) concerns over a lack of agreement on a new support package for Greece, and in particular the role of private-sector involvement, (ii) the likelihood that rating agencies would treat any private-sector involvement in a Greek debt restructuring as tantamount to a selective default, (iii) related to this, the ECB’s continued opposition to private-sector involvement and its refusal to repo collateral with a selective default rating, and (iv) the severe downgrading of Portuguese sovereign debt, driven largely by concerns over private-sector involvement and its implication for Portugal’s future market access.
Although Italy had, until recently, been relatively insulated from concerns over the debt crisis in Greece, specific Italian factors are likely accountable for the timing of the recent market sell-off. The Italian government’s potential inability to deliver necessary budget cuts added to concerns over the back-loading of austerity measures under the current budget. On top of this, Italy’s composite PMI for June dipped below 50 last week (indicative of a contraction in output), while official Italian industrial production printed a 0.6%mom decline in May.
A combination of these factors caused the spread of the Italian 10-yr government bond to the German bund to widen by around 80bp between Friday July 8 and Monday July 11. While spreads have since come off those highs, they remain elevated (Chart 1) and on an asset-swapped basis (controlling for the FX regime), they are above early 1990s levels, when public finances were much more distressed.
2. What is the extent of the planned fiscal consolidation in Italy?
Italy’s latest Stability Program lays out fairly ambitious plans for the medium term. If these targets are met, the budget deficit would fall below 3% by 2012 and a balanced budget would be delivered by 2014 … The debt dynamics associated with this fiscal tightening imply the debt-to-GDP ratio will peak this year at 120% and decline by some 8ppt over three years. That said, these targets assume a change to budget laws allowing the implementation of the required spending cuts. It is important to bear in mind, too, that the largest budget improvements are back-loaded, occurring after 2011 …
3. At what level would Italian yields become unsustainable?
Yields at somewhere around 7% are likely to become problematic, but this depends critically on our assumptions.
If the current rise in bond spreads is sustained and subsequent debt is issued at higher yields, the Italian government’s debt servicing cost will increase. While it would take a number of years for costs to rise (as debt is rolled-over), current yield increases would add to investor concerns that levels of public debt in Italy may not be sustainable. Theoretically, there is a threshold level for bond yields at which such worries over debt sustainability become self-fulfilling …
4. What is the likely impact of rising yields on financial conditions and GDP growth in Italy?
Higher interest rates and a falling stock market have tightened financial conditions by around 40bp in the past two weeks, adding downside risk to the Italian growth outlook.
We gauge the tightness of financial conditions in Italy by tracking four variables (the Italian 3-month interbank interest rate, the 10-year government bond yield, the trade-weighted currency and an aggregate stock market index) and assigning each a weight based on its relative importance in explaining future year-on-year GDP growth.
On this metric, financial conditions in Italy have tightened sharply in recent months—by around 130bp from their average in Q1 to their current level in mid-July. A substantial part (around 40bp) of this move has occurred in the past two weeks, as Italian short-term interbank rates have risen, long-term bond yields have hit post-Euro-zone highs, and the Italian stock market has fallen by some 7%. The Euro has depreciated—providing an offset to the tightening in conditions—but given Italy’s high degree of intra-Euro-zone trade, the weight of the currency in our measure is relatively low. In comparison, given the limited outflow of capital from the Euro-zone as a whole, yields have eased for less risky Euro-zone assets and our Euro-FCI is down about 30bp since the end of June.
On past correlations, if higher spreads are sustained and the stock market fails to recover, the negative impact of this sharp tightening in financial conditions on Italian GDP growth could be significant. There is a risk that annual GDP growth could fall from +1.0%yoy in Q1 into negative territory …
5. Who owns Italian debt and what would be the consequence of a sovereign restructuring for European banks?
A little more than half of Italy’s outstanding government debt (about €1,800bn) is owned by non-residents.
Domestically, Italian households hold about 15% of the debt stock, while Banca d’Italia holds another 5% or so. The remaining debt is held by Italian banks and other financial institutions (each holds about 15%).
Given the amount of public debt outstanding in Italy, and the high foreign ownership ratio, any debt restructuring would have major implications for European banks …
6. What scope does the EFSF have to fund Italy?
Some assistance is feasible, but a full three-year program is unachievable with the funds currently available …
7. What are the implications for Spain?
The risks of contagion from Italy to Spain are considerable. Compared with Italy, Spanish public debt is considerably lower, but the government deficit is higher and bank losses from non-performing mortgages greater …
8. Would EFSF bond purchases in the secondary market alleviate the current situation?
This seems highly likely.
Secondary purchases by any official institution (the ECB or the EFSF) could potentially change the direction of market pricing. If both a ‘good’ and a ‘bad’ equilibrium (where high yields become self-fulfilling) do exist, official sector market intervention has merit.
While the current rules under the EFSF do not allow for secondary market purchases, the ECB would in principle be able to intervene under the Securities Market Program (SMP) should systemic risk increase sufficiently.
Recent comments from last Monday’s meeting of Euro-group finance minsters suggest that increased EFSF flexibility is possible, including allowing for purchases in the secondary market …
9. What happens if the ECB suffers losses from the sovereign debt crisis on its balance sheet?
Its capital reserves would diminish … While the ECB and the Euro-system seem to be well-capitalised, when including the revaluation account, a full-blown sovereign debt crisis in Europe could create a need for recapitalising the central bank. In principle, a central bank could function with negative equity, but the Euro-system would likely need to be recapitalised in such a scenario by national Euro-zone governments. In the case of a Greek government default alone, the ECB would likely remain well-capitalised.
10. Does private-sector involvement (PSI) need to be abandoned to stabilise the market?
Not necessarily, but a shift in that direction would certainly help.
Concerns over private-sector involvement (PSI) have contributed to the escalation of the debt crisis in recent weeks. As the actual amounts obtained in such an exercise are likely to be fairly limited, the main justification of PSI seems political. The abandonment of any PSI proposal—given that private-sector involvement would trigger a rating downgrade to selective default status—would likely go a long way to alleviating market tensions.
That said, it remains possible that a PSI scheme that is both truly voluntary and avoids triggering a selective default rating could be implemented …
Make of that what you will — though we think the points made in question three and four are worth lingering over.
A switch from positive GDP growth to negative in such a short space of time really smacks of reflexivity. Or as George Soros put it more forcefully; “a self-fulfilling death spiral financing-feedback loop.”
Related links:
Eurozone CDO – it’s triple-A time - FT Alphaville
Italy left winded by rollercoaster bond ride – FT
Buiter says ECB will revive bond bond-buying – Bloomberg