Italy is Just the Tip of the Debt Iceberg

Italy has had a torrid time over the past month, yet over the past week its benchmark 10yr yield rose by just 9bps to 6.41% having reached a peak of 7.56% prior to the resignation of Prime Minister Berlusconi and passage of further draconian austerity measures. Over the week, Italian bonds outperformed French, Austrian and Belgium bonds as investors anticipated further sovereign downgrades to these countries, with France and Austria now likely to lose their all important triple AAA credit rating. The relief was based on the appointment of former EU Competition Commissioner Mario Monti with a mandate to pass sweeping structural reform. Changing the Prime Minister does not solve the crisis and 10yr yields are expected to remain in a broad range of 6.25-7.0%.

Sweeping structural reform is crucial in an economy where impediments to growth have resulted in negligible productivity growth over the past decade. Coupled with the ageing population this implies that the productive potential of the Italian economy is currently zero having slowed from an average of 1.0% during the nineties to just 0.6% per annum in the noughties.

However, the impact of this reform will take years to come to fruition. In the meantime, severe fiscal austerity over the next few years will lead to a sharp contraction of real GDP growth. Indeed, the economy is already in recession. The combination of declining activity, rising unemployment and high interest rates leaves Italy in a debt spiral with the primary budget surplus unable to compensate.

It is therefore extremely difficult to envisage a situation in which Italy can escape this debt trap through Teutonic austerity. We believe that this will lead to devaluation. Italy can either devalue inside or outside the single. Internal devaluation will involve writing off government debt. We believe that a 50% haircut is required to bring the debt to GDP down to the sustainable Maastricht level of 60%. The cost of a 50% haircut on Italy’s €1.9tr debt would be prohibitive in one go and this will have to be spread over a series of modest devaluations that represent controlled explosions.

The alternative would be for Italy to leave the single currency, but this is the nuclear option that would cause financial chaos with widespread, financial, consumer and corporate bankruptcies and consequently, while this prospect is no longer a black swan event, it is still a tail risk over the next few years.

The miracle solution that investors are praying for is also a low probability event, namely an announcement from the European Central Bank that it is willing to pursue unlimited quantitative easing. We believe that the ECB has neither the mandate, nor the imagination to pursue unlimited quantitative easing. European government, consumer and corporate debt is more than 300% of GDP and bank leverage is 400% of GDP.

The ECB has played the role of lender of cash resort over the past three years, providing unlimited term repo funding for the banks. In 2009 and to a lesser extent in 2010 after the first Greek bailout, banks recycled these funds into peripheral government bonds enjoying a massive carry trade. This trade worked as long as banks considered these peripheral governments as risk free. This is no longer the case and these bonds are considered credit, which in turn has accelerated the shift to triple AAA benchmarks in Europe.

The ECB cannot act as lender of last resort, because there is no government to lend to. Germany is trying to correct this anomaly through treaty changes, hoping to provide rules for greater economic governance. However, these changes will have to be passed by referendums in Germany, Netherlands, Finland, Slovakia, Ireland and Austria. Changes to the Lisbon Treaty took nine years.

In the meantime the ECB will continue expanding its balance sheet through provision of plentiful liquidity, expansion of its covered bond program and measured security market purchases. It has to continue the expansion of its balance sheet to compensate for the contraction of government, consumer, corporate and financial sector balance sheets. The key question is whether it will be enough to compensate for the contraction of these balance sheets.

We believe that aggressive QE in the UK and US will be enough to compensate and produce modest growth in these economies averaging 1-1.25%, but the ECB will follow the pattern set by the BOJ, where QE is insufficient to produce growth and the region will be plagued by recessions. Western European recessions will cause recessions in Eastern Europe, triggering the downgrade of Austria’s sovereign credit rating.  These recessions will force a more equitable sharing of the burden of adjustment between creditors and debtors.

This burden sharing through the DRM, debt reduction mechanism, will take place sooner in Europe than the rest of the world because of the straight jacket of the single currency. But there are similar and insurmountable imbalances in the rest of the world driven by excess global savings. These imbalances will drive down benchmark spot 10yr yields in the safe havens below 1% over the next few years.