The road to Rome

by Economist

In the first of three articles on the worsening debt crisis, we examine the spread of contagion to Italy

EVER since Europe’s sovereign-debt saga began, euro-area policymakers have feared that the turmoil afflicting first Greece, and then Ireland and Portugal, would engulf larger economies. Most attention had focused on Spain, a country that remains in peril. This week, however, contagion spread to another and even more alarming place: Italy.

Starting on July 8th bond markets staged an unexpected buyers’ strike, driving yields on Italian debt to their highest levels in a decade. These violent moves were mirrored by sharp falls in the shares of Italian banks. Markets calmed in mid-week amid talk that the European Central Bank had started buying peripheral debt. But the psychological damage has been done. The possibility that Italy, the euro area’s third-largest economy and the world’s third-biggest issuer of government bonds, might be sucked into the debt crisis cannot now be denied.

The sell-off was in many respects overdone. Italy’s gross debt-to-GDP ratio is large, at 120%, and the country has a chronic growth problem, but it is not insolvent. Its primary balance (ie, excluding interest payments) is in surplus and the average maturity of its debt is a reasonable seven years. Plenty of other countries have debt profiles that are just as worrying (see table). Italy has a vibrant export sector that could thrive further if the country were more competitive.

That does not necessarily mean the markets were being irrational. Were Italy to be frozen out of the bond markets, let alone default, the effects would be enormous. Italy owes about a quarter of all government debt in the euro zone. Its bonds are held by banks and insurers across the region. Stress tests of Europe’s biggest banks are due to be released on July 15th and are expected to show that the region’s banking system could absorb the losses from a Greek default with only a dozen or so banks having to raise extra capital. Losses from Ireland or Portugal could similarly be contained. But steep falls in the value of Italian or Spanish government debt risk a wave of bank failures.

French banks held almost $100 billion of Italian sovereign debt at the end of last year (and had total exposures to Italy that were about four times larger), according to the Bank for International Settlements. That is more than their combined exposure to Greece, Ireland, Portugal and Spain. “If the crisis reaches Italy, which I don’t think it will, then France will probably be part of the hurricane,” says a senior Italian banker. American money-market funds, a big source of short-term funding for European banks, are already said to be trimming their exposures to French banks.

The immediate cause of the sharp fall in bond prices seems to have been rooted in the byzantine world of Italian politics, and in particular, an acrimonious spat between Silvio Berlusconi, the prime minister, and Giulio Tremonti, the finance minister, over provisions in an emergency budget. Mr Berlusconi ridiculed Mr Tremonti, who is trusted by markets, as someone who “thinks he’s a genius and believes that everyone else is a cretin”.

Other domestic factors also fed the sell-off. One is an imminent surge in bond redemptions: €175 billion ($247 billion) in Italian government paper (11% of total marketable debt) comes due in the second half of this year. Another was the fact that Mr Tremonti’s budget package was less austere than initially billed: of €40 billion in deficit-cutting measures, €34 billion were put off until 2013 and 2014, by which time a new government will be in office. Lots of cuts were short on detail. A provision in the budget to increase the flat-rate stamp duty on government bonds, rendering them considerably less appealing to retail investors, did not help.

Events abroad played their part, too. Signals that the endless fumbling over Greece’s second bail-out will end in debt restructuring prompted investor flight from core euro-zone countries as well as peripheral ones. Long-term buyers of government bonds such as pension funds and insurers held back, leading to an almost total closure of the Italian bond market. “If Greece is going to become disorderly then you don’t want to be overweight Italy,” says Andrew Balls of PIMCO, the world’s largest bond investor.

This downward spiral may have been exacerbated by Europe’s efforts to cut the value of Greek sovereign debt without triggering a payout on credit-default-swap contracts. That would leave many holders of Greek debt without protection from losses, encouraging them to hedge their risk by betting against other euro-denominated debt like Italy’s. It also encourages holders of Italian debt to sell bonds rather than insure them with policies that may not pay out. Government pressure on banks to maintain their holdings in Greece may also have prompted concern that similar coercion could emerge elsewhere. A downgrade of Irish debt by Moody’s, a ratings agency, added to the nervousness.

Be afraid, don’t panic

The prospect of Italy being sucked into a debt trap in which it has to borrow more simply to service existing debt is, for the moment, remote. Most of the country’s debt need not be refinanced for years, so it would take a while before higher rates fed through. Analysts at UBS reckon that even if ten-year interest rates were to spike to 10% on Italian debt—they briefly topped 6% on July 12th—its average borrowing costs would rise by only 0.5 percentage points a year over the next four years.

Explore our interactive guide to Europe's troubled economies

Its banking system is also relatively insulated from turmoil in bond markets, with more than 90% of loans funded by retail deposits. Many of its biggest banks have stocked up on excess liquidity. “The Italian banks are much stronger than they look,” says Paolo Bordogna of Bain & Co, a consultancy that has worked with several. “They typically have strong retail franchises with loyal customers.”

Italy has also moved swiftly to shore up confidence, fast-tracking a vote on the budget as well as proposals to privatise state-owned assets. Italy’s deficit, already among the smallest in the euro zone, is set to shrink further. By 2014 Italy expects to be paying down its debt. Senior Italian figures are also pressing for more fundamental changes to free up a moribund economy and spur growth. “Italy only reacts under an emergency,” says the boss of an Italian financial institution. “Now there is one.”

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