The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world’s 8th largest economy and 3rd largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn’t clear, but it’s unlikely to be pretty.
Can this cycle be interrupted? I think so. I think that an ECB guarantee to backstop sovereign debt, coupled with massive purchases to establish credibility and a substantial easing in monetary policy, could change the dynamic, particularly if quickly followed up with a major fiscal commitment from core economies to support bail-out efforts and invest in peripheral economies while peripheral economies focus on substantial labour market, public-sector, and tax reforms. How likely does all of that sound? Could the ECB even commit to the above bold actions without facing debilitating criticism, and perhaps intervention, from national governments?
And little of this analysis from IHS Global insight will make him or you feel any better (bold is mine.):
1. We continue to assume there is no bailout for Italy because of its size. But we argue Italy appears to be less vulnerable than Portugal and Ireland before they admitted defeat and asked for financial assistance.
2. We believe Italy has more time and can endure several quarters of expensive debt auctions. However, we accept the risks to solvency have risen appreciably since the focus switched to Italy in early July.
3. Although rising bond yields will not affect Italy’s current debt structure as most of the public debt is held under fixed interest rates, it will be an increasing burden on the economy with Italy facing a prolonged period of heavy financing needs as its public debt ratio peaks at just over 120 percent of GDP. Given that the average yield on current government debt stands at 4.125 percent, bond yields higher than 7 percent would present a significant jump in the cost of rolling over sovereign debt in the next few years.
4. The outlook for Italy has worsened steadily, with the latest economic data and survey evidence suggesting the economy is sliding towards a recession in early 2012. Therefore, real GDP is projected to grow by just 0.6 percent in 2011 before contracting by 0.5 percent (revised down from a drop of 0.2 percent) in 2012 in the yet to be released November forecast. The more challenging economic backdrop is a significant risk to the government’s flagship goal of eradicating the public-sector budget deficit by 2013, especially with the official fiscal projections based on seemingly optimistic real GDP growth forecasts of 0.7 percent in 2011 and 0.6 percent in 2012.
5. A key risk is that the government expects a marked improvement in the primary budget surplus (general government budget balance minus interest expenditure) in 2012/13, with modest but continued growth helping to reinforce the impact of latest fiscal tightening measures. According to the Ministry of Economy and Finance, the primary budget surplus is expected to grow from an estimated 0.9 percent of GDP in 2011 to 3.7 percent in 2012 and 5.4 percent in 2013, which could be derailed should a stalled economic recovery strangle the projected growth in tax receipts.
6. Italian financial investors, who under normal circumstances are the main buyers of Italian government debt, are under pressure to limit their exposure, which could contribute to the vacuum in which bond yields have risen (bond prices have fallen). This can ignite a dangerous downward cycle of deteriorating sovereign and bank credit quality. The Bank of Italy reports that 33 percent of Italian government debt was held by Italian financial institutions in the first quarter of 2011, with roughly 18 percent held by domestic banks and the remaining 15 percent in the hands of the other financial institutions.
7. Clearly, bond yields need to fall to more sustainable levels, but this will require Italy launching an aggressive growth-boosting reform agenda. … However, the political outlook remains confused. After appearing to lose his parliamentary majority, Berlusconi has agreed to stand down after introducing structural economic reforms to parliament in mid-November. However, the danger of course is the potential for weeks of dysfunctional politics that settles nothing before elections are forced in February. In that worst-case scenario the elections could return a weak coalition government that will then have to tackle entrenched trade unions to implement austerity measures.