Tomorrow looks to be the day that the credit rating downgrade inspired intensification of the U.S. credit crisis and the Italy inspired intensification of the eurozone credit crisis meet head-on. I have nothing further to add on our crisis, but, thanks to Zero Hedge (ZH), there is more to be said about the eurozone crisis.
Goldman Sachs is an adviser to the Italian government, among many others. Zero Hedge (ZH) has obtained the full text of a Goldman client note that, says ZH, is “a prompt” to European Central Bank President Jean Claude Trichet.
Here’s the client note, with my highlighting and my interspersed explanations and comments:
“Europe Should Say That BTPs Are ‘Cheap’”
Italy is now squarely at the centre of Euro-zone sovereign market pressures. The yield on two-year Italian government bonds (BTPs), which ended last week at around 4.4%, is trading at its highest relative to corresponding maturity LIBOR [The London Inter-Bank Overnight Rate, which can be thought of as the international equivalent of the Fed Funds Rate] in a number of decades. Similarly, the yield spread to German bonds across the yield curve has reached higher levels than in the early 1990s, when controlling for the FX regime. In some maturities, Italian government bonds now yield more than Spain’s.
Italy represents the second-largest EMU government bond market after Germany, and accounts for around a quarter of the Euro area’s sovereign debt stock, held mostly by resident financial institutions. A further escalation of the crisis would result in considerable capital shifts and welfare losses across the entire single currency area, and beyond. ["Beyond" must mean the U.S.]
In this note, we look at what could have triggered such acute tensions, and comment on their possible resolution. In our view, Italian government bonds are fundamentally attractive, but we have reached a point where only the European authorities can credibly signal this is the case. In the near term, secondary bond market purchases by the ECB would represent a much needed ‘circuit-breaker’.
2. In the Area of Self-Fulfilling Prophecies
Italy’s woes are partly the result of shifts in the outlook for the sovereign’s credit fundamentals. Darker clouds have gathered over the trajectory for global growth, as reflected in our downwardly revised forecasts on Friday August 5. This comes at a time when investors’ focus is shifting from the increase in public-sector liabilities—and the cost of bailing out the private sector—to how sovereigns will be able to grow out of indebtedness. [Austerity doesn't breed growth; it dampens it]
In this respect, Italy does not have a strong track-record (real GDP growth averaged around 1.5% in the period 1999-2007). And after a sizeable contraction during the crisis, real GDP growth has lagged that in the other large Euro-zone economies. Moreover, political risks and uncertainty have increased, and several observers have questioned the government’s resolve to push through structural reforms in key areas such as labour markets and the welfare state.[Sounds like S&P's rationale for downgrading our debt, doesn't it?]
But there are positive aspects too, which should not be forgotten. Italy already runs a non-interest budgetary surplus of close to 1% of GDP—the only country in the G-7 group to do so—and has maintained a prudent fiscal stance for years. And its debt stock, while high, is at the lowest level relative to Germany’s and France’s in several decades. In the period 1999-2007, its debt-to-GDP ratio fell by around ten percentage points to 103.6%, as even the modest growth it achieved outpaced the increase in liabilities.
As described in the Box on page 4, we look at Italian bond spreads over the past 20 years, comparing Italy’s fundamental performance with Germany’s both in isolation, and controlling for what has happened in other EMU countries. Our findings suggest that the yield spread between 10-yr Italian BTPs and German Bunds should be around 170-210bp based on current and prospective relative fundamentals. The current level of close to 400bp represents a multiple standard deviation event. [Or a "tail" event, to use the current financial parlance]
This can mean one of two things. Either we are experiencing an extreme situation, which enables investors to buy BTPs at severely distressed prices. Or the distribution of possible outcomes has changed substantially, as higher yield spreads negatively interact with fundamentals (think of the impact on commercial banks, for example), limiting the supply of credit and affecting spreads in a circular reference. There is an element of truth in both interpretations.
Upon joining the single currency, Italy lost control over monetary policy and with it the option to devalue. [As did every other member of the eurozone] As a ‘price taker’, it can pay its debt down by taxing wealth and income, grow out of it, or reduce the face value of its liabilities. To be sure, this has been true since EMU [European Monetary Union] inception and the logic could be extended to other sovereigns of the single currency area.
But Italy’s policy constraints have been brought to prominence lately by references to continued ‘market access’, cited by Moody’s as a justification for downgrading Italy’s rating outlook in the aftermath of Private Sector Involvement (PSI) for Greece. Investors have ‘discovered’ that debt restructurings [Reductions in principal values; in the vernacular, "haircuts"] are an option even in a highly advanced and financially integrated area such as the Euro-zone. And in a world of imperfect information, dominated by a great focus on capital preservation, they have started rationing credit to sovereign borrowers based on their cost of funds.
3. Maintaining Market Access
A forward-looking analysis would indicate that Italy’s funding terms are still within the limits of affordability.
We projected Italy’s gross government debt-to-GDP-ratio from 2011 to 2030, under a set of different working assumptions. The primary surplus increases from around 0.1% of GDP in 2010 to 2.9% in 2013, as targeted in the old Italian Stability Program (this is roughly 1ppt below what was announced by the Italian government this past Friday). We also use the Stability Program’s assumption for nominal GDP growth over 2011-2014 (around 3.0%-3.5%). As the interest rate on the public debt, we use the current effective servicing costs and simulate the implied increase from any given market rate using the current debt maturity profile.
The two tables to the right [not shown here] show the level of Italian debt in 2030, assuming various combinations of nominal growth and roll-over cost from 2015 onwards, as well as a fixed primary balance of 3.5% or 1.5ppt below the current projections in the Stability Program. As can be seen, Italy’s debt-to-GDP-ratio decreases for a wide combination of nominal growth and interest rate assumptions.
All else equal, this indicates that Italy’s debt dynamics are fairly sustainable—even when subjecting them to relatively large increases in debt servicing costs, as well as decreases in trend nominal growth. Increasing the primary balance [by excluding interest payments] to 5%, as currently projected by the government, would lead to decreases in Italy’s debt-to-GDP-ratio even with permanent debt servicing costs as high as 7%-8% and trend nominal growth at 3.5%.
The limitations of this analysis are twofold. Firstly, the interplay between the three control variables—nominal growth, the primary balance and funding costs—is much more complex than illustrated here, and expectations play a large role. Secondly, it assumes investors will be willing to extend credit to the sovereign smoothly and continuously as yields increase. The risk is that, if tensions escalate, Italy could instead find itself credit constrained.
4. Greater Risk-Sharing Needed
There is growing evidence to suggest that the price action is becoming self-reinforcing, and is disregarding economic fundamentals. [This is the feedback loop to doomsday] Italy has tried to signal that the current borrowing prices are unattractive by cancelling scheduled issuance. But debt amortization requirements are large, and this cannot last for long: the Italian Treasury needs to roll over around EUR400bn of maturing debt over the coming 16 months.
As we noted in European Weekly Analyst 11/25, in a situation where a ‘good’ and a ‘bad’ equilibrium (high yields become self-fulfilling) co-exist, the official sector can play a role. We see three interconnected stages of policy:
In the short term: As Dirk Schumacher and others have commented this past week, the ECB should act as a circuit-breaker at this juncture, interrupting the unfolding speculative dynamic in order to safeguard the transmission of monetary policy. [Short-circuit the feedback loop] The central bank is the only institution that can act quickly, and without a budget constraint. As in the case of FX [foreign exchange] interventions, in order to be fully effective, ECB purchases in the secondary bond market should be coordinated, i.e., involve all Euro-zone central banks, or at a minimum receive the endorsement (even tacit) of all countries. Ideally, greater coordination with the fiscal authorities could be sought, whereby the EFSF [European Financial Stability Fund] makes use of its newly extended powers and pledges to swap back part of the bonds that the ECB has bought. If the Euro-zone governments want to credibly convince private lenders that Italian bond yields have overshot their fundamentals, they should be prepared to take that risk themselves. [Put up or shut up!]
Over the medium term, Italy’s credit fundamentals need to be further reinforced. As our empirical analysis implies, fitted bond spreads have moved up lately and, based on IMF forecasts for GDP growth, the deficit and debt, they are forecast to move broadly sideways at around 150-200bp. On Friday, the Italian government made a commitment to bring the non-interest balance to a surplus of 5% already by 2013, from 1% now, and to ‘tie its hands’ through a German-style ‘balanced budget rule’ requiring a modification of Art.81 of the Italian Constitution. The government also promised more on the liberalization front (starting with changing Art.41 of the Constitution to say that all economic activities that are not explicitly prohibited are allowed), and on labour market reforms. More information on both fronts should transpire this coming week.
And, in the medium to long term, a deeper discussion should take place on Euro-zone trend growth dynamics and policy management. The Pact for the Euro—underwritten last March—envisages that all countries should reach a balanced budget over the next couple of years, and should continue to reduce public debt as a percentage to GDP under a formulaic rule. Structural reforms should help raise the growth potential, but are unlikely to boost economic activity while they are carried out (Germany’s adjustments over the past year weighed on domestic demand). [Structural reforms is a euphemism for austerity] Against this backdrop, running countercyclical policy at this juncture will fall more heavily on the ECB, as our new forecasts indicate. going ahead, a gradual pooling of at least some Euro area wide fiscal policies (and funding) may be required.