By Ambrose Evans-Pritchard | Telegraph
November 9 2011
It has taken three trading days since the failure of the G20 summit to detonate the explosive charge on Italy’s €1.9 trillion (£1.6 trillion) bond market, the world’s third-largest stock of public debt.
Europe’s purported “firewall” to safeguard Italy does not, in fact, exist. The EU’s vague plans to leverage its EFSF rescue fund to €1 trillion have come to nothing. Investors could see at once that plans to use the fund as a “first loss” bond insurer concentrates risk, dooming France’s AAA rating and accelerating contagion to the core.
The European Central Bank (ECB) has been buying Italian bonds, but too slowly to stop the debt spiral. The ECB’s new chief, Mario Draghi, kicked off his term with a blunt warning that it would be “pointless” for the bank to try to cap the yields of struggling debtors for long. It was an invitation for frightened investors to dump their bonds.
With almost nothing in place to halt contagion, the market verdict has been swift and brutal. Capital Economics said “the Rubicon may have been crossed” after yields on 10-year Italian bonds smashed through 7pc on Wednesday. Clearing house LCH.Clearnet has raised margin requirements once and will almost certainly do so again. Italy is effectively shut out of global capital markets.
Rome will not be able to roll over some €300bn in debt next year and will spiral into “disorderly default” unless EU authorities immediately face up to the enormity of the crisis.
“It is a panic. Rome is burning. Governments need to stop the fire spreading,” said Jennifer McKeown, the group’s Europe economist.
Wider contagion was alarmingly clear as yield spreads on French debt rose to a post-EMU record of 146 basis points over Bunds. French lenders have $416bn (£261bn) of exposure to Italian debt of various kinds. The two Latin nations are joined at the hip.
“It is obvious what needs to be done,” said Tim Congdon at International Monetary Research. “The ECB must engineer a ‘boomlet’ by purchasing €1 trillion of bonds – boosting the M3 money supply by 10pc – to end all the agony. This means that Germany must put up with 4pc to 5pc inflation for while, but is that such a disaster? If they want to save the euro, they have to give some hope to the peripheral countries.”
Hans Redeker from Morgan Stanley said the ECB must cap yields at 6.5pc by soaking up an “unlimited supply” of Italian bonds if necessary. “At the end of the day, we all know what the ultimate solution is going to be. They are going to have to monetise,” he said.
This does not seem likely yet. On Tuesday, Germany’s two ECB members warned that the bank must not stray into debt monetisation or start quantitative easing, though there are at last signs that parts of the German establishment are starting to think creatively. The heads of the country’s five top institutes – the “Five Wise Men” – have together called for a debt pact to break the “vicious circle of an intertwined sovereign debt crisis and a banking crisis”. The radical plan proposes a €2.3 trillion fund to enable joint bond issuance on a chunk of debt. This is a bitter pill for Germany but is the only way to avoid an “uncontrolled collapse of monetary union” or recourse to the “sin” of unlimited debt purchases by the ECB.
The Wise Men said their idea is a “very different animal” from eurobonds – anathema to the Bundestag – because the shrinking fund would be wound down gradually. It would not be a form of fiscal union. Chancellor Angela Merkel shot down the idea, warning it would require an EU treaty change and amendments to the German constitution. She stuck to her mantra that the solution is for Italy to carry out reforms and meet its austerity target.
The European Commission stepped up its surveillance demands, calling for a list of state assets to be sold and “additional measures” to balance the budget by 2013 if the economy goes into a deeper downturn.
Italy is now being forced to tighten fiscal policy into a deepening recession – against the advice of the International Monetary Fund – repeating the formula that has failed in Greece and closely resembles the final debacle of the 1930s Gold Standard.
The country is almost certainly in recession already, the result of combined monetary and fiscal tightening across the eurozone earlier this year. Real M1 deposits turned negative for the whole region over the summer, with dire rates of contraction in Italy and Club Med.
Milan consultants Ref Ricerche believe Italy’s economy will shrink all through 2012 and 2013 in what amounts to a full-blown depression. This will itself cause debt dynamics to metastasize.
The strange feature of the crisis is that Italy is not fundamentally insolvent. Public debt has been stable for several years at about 120pc of GDP. The country has a primary budget surplus. Household debt is low at 42pc of GDP. Net household wealth is €2.3 trillion, higher in per capita terms than in Germany. Combined public and private debt is under 260pc, lower than in Holland, France, Britain, the US and Japan. The core problem is not Italy’s debts but the 40pc loss of labour competitiveness against Germany over the past 15 years. This has left the country trapped inside EMU with misaligned currency, choking growth.
It is hard to see how the resignation of Silvio Berlusconi makes any difference. He has run one of Italy’s most stable post-war governments. Elections are likely to throw up a splintered political mix, with gains for the Left but no one bloc able to put together a strong coalition. The nation remains bitterly divided on redundancy law and “firm-level” wage bargaining. The trade unions remain militant.
Stephen Lewis from Monument Securities said the search for some sort of “Grand Plan” or mega-fund to save the euro is an evasion of the North-South intra-EMU currency misalignment corroding the whole project. “Whatever they do, the underyling economic divergence will still exist. It may be that there is no solution and that it would be better to finance an orderly break-up of the euro,” he said.
There are already hints of this comimg from Brussels, with reports of “intense consultations” between German and French officials on reshaping or “pruning” the currency bloc, reducing it to a manageable core.
“You’ll still call it the euro, but there will be fewer countries,” said a German official. Veteran EU watchers say the leaks appear to be a heavy-handed attempt from certain quarters in Berlin to force austerity compliance in southern Europe.
Such forms of diplomacy usually blow up in the face of the authors.