With no solution to Italy’s problems in sight, the country can continue to raise money from the markets at high interest rates whilst the ECB can continue to buy Italian debt and try to cap yields. However, neither is sustainable….
Keith Wade, Chief Economist & Strategist
– Thinking through these scenarios should make euro policymakers redouble their efforts to find a solution: make the EFSF fly or get external help. QE is probably the lesser of two evils when compared to euro break up, but recognising that the ship is currently headed for the rocks should spur a change of course.
The arrival of a new government in Italy has been warmly welcomed by the markets, but the challenges facing the country remain great. Although Italian yields have fallen back from the 7% level seen last week, at 6.7%, they are unsustainable for a country with a debt to GDP ratio of 120% and a growth rate of less than 2%. On our calculations an interest rate of 4% is closer to what Italy can afford over the long run, some way from current levels.
The most benign outcome would be that market confidence returns, yields fall, and the market’s focus moves on. Perhaps the combination of a credible Italian government, and financial support from Germany and France alongside the IMF, will convince investors that the country is on a sustainable footing.
Such a package might already be on its way given rumours at the G-20 meeting in Cannes that the IMF had offered €50 billion to Italy.
However, the problem for Italy is its size. Fifty billion does not go very far against a funding requirement of €275 billion for 2012 alone. Italy, the third biggest economy in the euro area with one of the largest bond markets in the world, requires something more significant.
The hope had been that the European Financial Stability Facility (EFSF), otherwise known as the eurozone’s bailout fund, would provide that support. Unfortunately, plans to increase it to €1 trillion, as promised at the Brussels summit, appear to have stalled. There are doubts over the insurance scheme which would have allowed the fund to be leveraged four or five times, and
external investors such as China appear reluctant to get involved. At present the fund has just €250 billion – less if we exclude Italy’s contribution.
Without an adequate bailout fund, the eurozone has to fall back on the European Central Bank (ECB). The central bank has been buying increasing amounts of bonds as part of its Securities Market Programme and can buy more. So far though this has failed to bring Italian yields down. Furthermore, investors doubt the ECB’s ability to keep buying bonds on concerns about risking its own solvency as its balance sheet swells with peripheral debt.
Many see the solution as allowing the ECB to buy peripheral bonds with printed money, effectively quantitative easing (QE). This would provide the firepower to defeat the markets; however Germany fears the inflationary implications and remains opposed to any form of printing money.
Pulling this together, Italy can continue to raise money from the markets at high interest rates whilst the ECB can continue to buy Italian debt and try to cap yields. However, neither is sustainable, meaning that we are headed for an almighty crunch. Either we continue along the current path (where Italy is likely to run out of funding options), or Germany has to give way on QE.
The former would probably mean a default by Italy in order to bring its debt down to sustainable levels. The result, from say a 50% haircut, would be significant losses for the European and global banking systems and a very deep recession across the continent. The euro could in theory limp on, but is more likely to break up with the weaker members leaving.
Alternatively, the ECB starts printing money, funding costs come down and the euro survives. Or does it? Such a move would not be without repercussions as the risk of future inflation will be very unpopular in Germany, with the result that the single currency’s largest economy might decide to leave. How can the euro ever achieve fiscal discipline if it resorts to such measures? From this perspective, the recent departures of Axel Weber and Jürgen Stark may be a precursor of a wider German withdrawal from the single currency.
Which path do we see as most likely? Thinking through these scenarios should make euro policymakers redouble their efforts to find a solution: make the EFSF fly or get external help. QE is probably the lesser of two evils when compared to euro break up, but recognising that the ship
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Source: ETFWorld – Schroders