On Italy’s (alleged) financial woes

My Facebook posting of a link to what I believe is one of the few well-balanced opinion articles about Italy’s financial situation (written by the Daily Telegraph’s Andrew Lilico) has sparked a very interesting discussion with a rather smart friend (whom I’ll call PK) from central Europe, in the day when Italian bond yields have reached Euro-time records.

I’ll report the debate with PK as it went, and you judge for yourself. Remember that only time will tell who’s right (and that’s usually me).

PK: Europe is a net exporter of capital. The reason that peripheral European governments cannot get financing is not because there is a lack of capital or liquidity problem but simply because their solvency is questioned by investors. They need someone foolish enough to lend money to countries that probably won’t repay. Look at Greece and talks 2-3 years ago about its “solvency” followed by bailout plans and today recent “voluntary” 50% haircut “so far” to private creditors.The confidence is lost by a lack of political will to tackle the problem and Italy seems to follow Greece footsteps. European major banks are keep selling south European sovereign governments bonds, including Italy since months. It is one of the reason Italian bond yields are rising sharply in spite of political hype about EFSF “rescue” fund. In the long term this situation is not sustainable. Italy alone has to roll over 300 billion euro just in 2012.. Who is going to buy it ? It was a very different situation back then in 90′s in Italy, so this article is missing a point to a large extent.

Mac: Italy will pay back even at 10% interest. Actually our finance is in better shape than France’s or in some respects even Germany’s in that our state income is largely independent of economic growth. The recent attack is simply France’s way to hide this. Unfortunately, our politicians seem to be unable to bring this clear and simple message out to the markets.

PK: I presume you mean recent France’s government deficit that indeed was considerably higher. However both France and Germany has a vital interest to keep Italy afloat, as their banks have a serious share of sovereign debt of Italy’s. In my view the question is not even whether Italy is willing to pay 10% interest, but whether in case of rising yield rates it will be able to finance its needs on the market = finding investors to whom they can sell bonds. If not – it will follow Greece, Portugal and Ireland shortly. In the longer term a main problem of Italy’s is not even high debt but progressive loss of its competitiveness since entering eurozone and one of the lowest economical growth amongst developed economies. It would be much easier if you have no euro and devaluate, but then you’d have other costs to bear. So in case of further worsening of market conditions Italy might be forced to get an official support from EFSF (ECB has already actively intervened). It can be a temporary fix within existing framework, but it always come at certain political costs and it might imply further loss of country’s credibility. That’s why it can’t be considered as a long term solution either. Italy’s debt is huge and it has relatively short maturity, so it could be potentially more vulnerable than other countries – especially in case of further deterioration of the market sentiment that cannot be ruled out. So far European policymakers are kicking a can down the road – buying more time and going deeper into debt. It will not work out forever…

Mac: Your point is valid, but the issue is all about speculation. In practice, I don’t deem possible a scenario in which Italy has to resort to foreign intervention to pay its debt (it’s happened recently but only in order to keep speculation astray). The Greek, Irish, Portuguese and even Spanish and French situation is far worse than ours. Your point on the economy is also only partially valid, as we do have growth, it just does not appear in the stats as the black market is huge.

PK: I agree that some other European countries have even bigger issues ahead (especially Greece that in fact has already bankrupted). However today it is Italy not without a reason in the foreground. I’d recommend to read a book written by Beth Simmons – “Who Adjusts” (check Amazon). There is a strong argument that one of the problems with a debt crisis is that when debt levels are perceived as being too high, major stakeholders are forced into behaving in ways that reinforce credit deterioration and exacerbate the debt problem. This is what happened to others and similiar case could be observed now in Italy. When adding low growth, significant size of underground economy (missing taxes and widening gap in social state revenues etc. = lost benefits for the state, it implies faster growth of debt) and declining competitveness – that’s a root cause of today Italy’s problems. Surely each trend is reversible, but not without pain. Take a look at the latest IMF report dated June 2011 about Italy’s economy. Let’s see how it will unravel in the coming months…

Mac: Our debt has been high (and stable with respect to GDP) since the early nineties. What’s changed recently? Moreover, the interest rates on our bonds has been much higher than today (check this graph). I am currently allocating a substantial part of my investment into Italian long-term bonds, and I’ll sleep tight knowing that my country will pay back. I have, however, sold all holdings in French banks. I’m not buying German bonds as the yield is lower than inflation, so I’d better keep my money in my bank (also being pretty sure it won’t collapse).

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