It Was Never Destined to Work …
The markets have given Italy's debt the benefit of the doubt based on the ECB's OMT promise, but the basic problem still awaits resolution. In the past, Italy would have simply devalued the lira, confiscating its citizenry's vast savings with the hidden inflation tax and devaluing the government's outstanding debt. This time it had to implement 'reform', but the man chosen to do that was a typical EU approved bureaucrat, someone who knows absolutely nothing about the daily struggle producers of wealth face in the marketplace. And so Mr. Monti did what a statist bureaucrat is wont to do: he raised a plethora of taxes, severely restricted the use of cash and ordered the tax bureau to go on a hugely repressive hunt for all sorts of perceived tax cheats, down to the pensioners who help with olive tree maintenance to supplement their meager incomes in order not to starve. The openly declared goal of these activities was to intimidate the citizenry. We're not just making this up – this is what they said they wanted to achieve, even if their actions were to weigh on the economy. We have detailed some of the methods employed in a past write-up.
As Italy's tax payer association remarked last year: “Monti's reform has consisted of introducing new taxes and nothing else”.
Not surprisingly, the underlying problems therefore remain firmly in place. The government's outstanding stock of debt has continued to rise (at a rate of almost €75 billion per year), the economy has tanked and the citizenry has been terrorized. Good job.
Now the bond market's equanimity can apparently no longer be counted on, although this is of course currently not a matter confined to Italy – bond yields have been surging worldwide. The problem for Italy is that if bond yields continue to rise, unstoppable debt spiral dynamics will reassert themselves. Moreover, the banking system will be in even bigger trouble than it already is, as the banks are up to their eyebrows in Italian government bonds.
Solvency Risk on Yellow Alert
Mediobanca has constructed a 'solvency risk' indicator that is lately giving alarm signals. This is an ominous development, especially as the governing coalition is under strain. According to a recent Telegraph report, Italy may require a rescue within six months unless a miracle happens. It looks like Super-Mario's OMT promises will be tested after all:
“Mediobanca, Italy’s second biggest bank, said its “index of solvency risk” for Italy was already flashing warning signs as the worldwide bond rout continued into a second week, pushing up borrowing costs.
“Time is running out fast,” said Mediobanca’s top analyst, Antonio Guglielmi, in a confidential client note. “The Italian macro situation has not improved over the last quarter, rather the contrary. Some 160 large corporates in Italy are now in special crisis administration.”
The report warned that Italy will “inevitably end up in an EU bail-out request” over the next six months, unless it can count on low borrowing costs and a broader recovery.
Emphasising the gravity of the situation, it compared the crisis with when the country was blown out of the Exchange Rate Mechanism in 1992 despite drastic austerity measures. Italy’s €2.1 trillion (£1.8 trillion) debt is the world’s third largest after the US and Japan. Any serious stress in its debt markets threatens to reignite the eurozone crisis. This may already have begun after the US Federal Reserve signaled last week that it will begin to drain dollar liquidity from the global system.”
Sovereign debt strategist Nicolas Spiro said “taper terror” is jolting eurozone investors out of their complacency, though safe-haven Swiss and German bonds have also sold off sharply in the rout. Yields on 10-year UK Gilts closed at a two-year high of 2.53pc.
Yields punched to 5.1pc in Spain, and 6.7pc in Portugal. This is sending a secondary shock wave through their corporate debt markets, choking recovery.
“The European Central Bank needs to take very aggressive steps to offset this,” said Marchel Alexandrovich from Jefferies Fixed Income. “We have a sell-off across the board. If the ECB doesn’t act, it could see all the gains of the past nine months vanish in two weeks, taking the eurozone back to square one.”
Borrowing costs of 5pc could prove crippling for Spain and Italy, both suffering from contraction of nominal GDP.
Mediobanca said the trigger for a blow-up in Italy could be a bail-out crisis for Slovenia or an ugly turn of events in Argentina, which has close links to Italian business. “Argentina in particular worries us, as a new default seems likely.”
So the cries for more central bank intervention are already going up – no surprise there. We found the tidbit about Argentina potentially becoming a trigger for a crisis in Italy interesting – we were unaware of the strong economic ties mentioned by Mediobanca.
Shady Derivatives Deals Helped to Hide Debt
In the meantime it has also turned out that just like Greece, Italy used complex derivatives deals to lie about the size of its debt prior to its accession to the euro (readers may recall that we have mentioned in the past that all governments lied about their debt in some shape or form at the time – now it is finally officially admitted, bit by bit). While this has a surprise coefficient of exactly zero, the admission means that there will likely be an immediate hit to the budget, euro. And guess who was one of the Italian officials deeply involved at the time with the country's debt and deficit accounting? The man who presumably helped with cooking up this scheme? It was none other a certain rather well-known Goldman Sachs alumnus who currently runs the ECB (this was shortly before he joined GS by the way).
“Italy risks potential losses of billions of euros on derivatives contracts it restructured at the height of the euro zone crisis, according to a confidential report by the Rome Treasury that sheds more light on the financial tactics that enabled the debt-laden country to enter the euro in 1999.
A 29-page report by the Treasury, obtained by the Financial Times, details Italy's debt transactions and exposure in the first half of 2012, including the restructuring of eight derivatives contracts with foreign banks with a total notional value of €31.7 billion.
While the report leaves out crucial details and appears intended not to give a full picture of Italy's potential losses, experts who examined it told the Financial Times the restructuring allowed the cash-strapped Treasury to stagger payments owed to foreign banks over a longer period but, in some cases, at more disadvantageous terms for Italy.
The report does not name the banks or give details of the original contracts – questions that worried the state auditors – but the experts said they appeared to date back to the period in the late 1990s. At that time, before and just after Italy entered the euro, Rome was flattering its accounts by taking upfront payments from banks in order to meet the deficit targets set by the EU for joining the first wave of 11 countries that adopted the euro in 1999.
Italy had a budget deficit of 7.7 percent in 1995. By 1998, the crucial year for approval of its euro membership, this had been reduced to 2.7 percent, by far the largest drop among the Euro 11.”
Mario Draghi, now head of the European Central Bank, was director-general of the Italian Treasury at the time, working with Vincenzo La Via, then head of the debt department, and Ms Cannata, then a senior official involved with debt and deficit accounting.”
It is quite ironic that Mario Draghi may now well end up as the person imposing 'conditionality' (read: severe austerity measures) on Italy when its government finally comes to the ECB, hat in hand. As an aside, the € 8 billion figure is an estimate, as Italy of course does not fully disclose the extent of its derivatives losses. The ECB is rather tight-lipped about the involvement of its boss as well:
“An ECB spokesman declined to comment on the bank's knowledge of Italy's potential exposure to derivatives losses or on Mr Draghi's role in approving derivatives contracts in the 1990s before he joined Goldman Sachs International in 2002.”
Again, surprise factor zero. Very likely it will all be swept under the rug. The main thing is to keep the Italian population properly terrorized after all, not going after those who are actually responsible for the mess the country is in.
Lastly, there has been a surprising spike in successful prosecutions of former prime minister Berlusconi in the meantime. He was just convicted for the third time in a row, this time of allegedly 'paying a minor for sex'.
Berlusconi himself of course maintains that what is going on is a political witch hunt. It is probably true that he has done all sorts of legally dubious things in the course of his career – how else would he ever have become prime minister of Italy as well as a billionaire media mogul in a high tax regulatory democracy? No-one who actually hews 100% to the rules and regulations of the modern-day 'free' economic tyrannies can ever hope to accumulate such a huge amount of capital. However, that means that Berlusconi is probably no worse than others in similar positions. In that sense he is probably correct: if not for the fact that powerful forces within the EU want to get rid of him, he simply wouldn't be successfully prosecuted. Note that Berlusconi wants to roll back the worst excesses of Monti's so-called 'reforms'. He is therefore seen as a danger to the EU centralization project – a thorn in the side of the socialist super-state. Here are two brief quotes from the Bloomberg article on the conviction:
“The verdict “confirms the intention to eliminate Prime Minister Berlusconi from the political scene,” Paolo Bonaiuti, a senator and spokesman for Berlusconi, said in an e-mailed statement.
Berlusconi’s trials may pose a greater threat to his political career than to his freedom, given Italy’s flexible sentencing and indulgence toward convicts over the age of 70.”
Regardless though of the motives and the question of Berlusconi's guilt or innocence, the immediate effect will be that the coalition government will find it harder to introduce new reform measures. Prime minister Letta's latest plans require the support of Berlusconi's party. As one observer remarked:
“Letta’s going to have to fight very hard to keep his boat on course,” said James Walston, a professor at the American University in Rome. The verdict “makes the Berlusconi supporters all the more hyped up and angry, and they’re going to be a lot tougher on completely irrelevant issues.”
One bone of contention is Letta's plan to increase VAT, which Berlusconi opposes. It is conceivable, although most observers don't think it is likely at the moment, that the coalition will split up again. In that case, new elections will have to be held.
Meanwhile, the Milan Stock Index (MIB) looks quite wobbly as well of late:
Italy may soon be making its way back to page 1 from page 16. It remains the euro area's most worrisome problem, given the huge size of its outstanding debt (Italy's government debt stock is the third largest in the world). A renewed flaring up of the crisis with a focus on Italy is the eurocracy's worst nightmare. It is a good bet that if it happens, it will happen at an extremely inopportune moment. Right now everybody is hoping and praying that nothing untoward occurs prior to Germany's election – but no-one knows if the markets will comply with such wishes. If the recent massacre in international bond markets continues, there will be nothing that can be done to keep the Italian debt problem from resurfacing with a vengeance.
Charts by: BigCharts
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