4/6/18: Italy is a TBTF/TBTS Problem for ECB

In my previous post, I talked about the Too-Big-To-Fail Euro state, #Italy - a country with massive debt baggage that is systemic in nature.

Here is Project Syndicate view from Carmen Reinhart: https://www.project-syndicate.org/commentary/italy-sovereign-debt-restructuring-by-carmen-reinhart-2018-05.

An interesting graph, charting a combination of the official Government debt and Target 2 deficits accumulated by Italy:

Quote: "With many investors pulling out of Italian assets, capital flight in the more recent data is bound to show up as an even bigger Target2 hole. This debt, unlike pre-1999, pre-euro Italian debt, cannot be inflated away. In this regard, it is much like emerging markets’ dollar-denominated debts: it is either repaid or restructured."

The problem, of course, is the ECB position, as mentioned in my article linked above. It is more than a reputational issue. Restructuring central bank liabilities is easy and relatively painless when it comes to a one-off event within a large system, like the ECB. So no issue with simply ignoring these imbalances from the monetary policy perspective. However, the ECB is a creature of German comfort, and this makes any restructuring (or ignoring) of the Target 2 imbalances a tricky issue for ECB's ability to continue accumulating them vis-a-vis all other debtor states of the euro area. Should a new crisis emerge, the ECB needs stable (non-imploding) Target 2 balance sheet to continue making an argument for sustaining debtor nations. This means not ignoring Italian problem.

Here is the picture mapping out the problem:

Source: http://sdw.ecb.europa.eu/servlet/desis?node=1000004859

Reinhart warns, in my opinion correctly, "In the mildest of scenarios, only Italy’s official debt – held by other governments or international organizations – would be restructured, somewhat limiting the disruptions to financial markets. Yet restructuring official debt may not prove sufficient. Unlike Greece (post-2010), where official creditors held the lion’s share of the debt stock, domestic residents hold most of Italy’s public debt. This places a premium on a strategy that minimizes capital flight (which probably cannot be avoided altogether)."

In other words, as I noted years ago, Italy is a 'Too-Big-To-Fail' and a 'Too-Big-To-Save' or TBTF/TBTS problem for the euro area.

4/6/18: Italy's Problem is Europe's Problem

My article on Italian (and Spanish and Dutsche Bank) mess in Sunday Business Post: https://www.businesspost.ie/business/italys-problem-europes-problem-417945.

Unedited version of the article here:

This fortnight has been a real roller-coaster for the European markets and politics. Only two weeks ago, I wrote about the problems of rising political populism in Italy and Spain as the signals of a broader trend across the block’s member states. This week, in Spain a no confidence motion in Mariano Rajoy’s rule played a side show to Rome’s drama.

The timeline of events in Italy provides the background to this week’s lessons.

The country has been governed by a lame-duck executive since mid-2016. Fed up with Rome’s gridlock, in March 2018 general election, Italians endorsed a parliament split between the populist-Left M5S and the far-Right group of parties led by the League. Month and a half of League-M5S negotiations have produced a shared policies platform, replete with radical proposals for reshaping country’s Byzantine tax and social welfare systems. The platform also contained highly controversial proposals to force the ECB to write down EUR250 billion worth of Government debt, a plan for restructuring fiscal rules to allow the country to run larger fiscal deficits, and a call for immigration system reforms.

On Monday, the President of the Italian Republic, Sergio Mattarella, a loyal Euro supporter, vetoed the League-M5S candidate for the economy ministry, Eurosceptic Paolo Savona. The result was resignation of the League-M5S Prime Minister-designate, Giuseppe Conte, and a threat of an appointment of the unpopular technocrat, Carlo Cottarelli, an ex-IMF economist nicknamed Mr. Scissors for his staunch support for austerity, as a caretaker Prime Minister. By Thursday night, Conte was back in the saddle, with a new coalition Government agreed and set to be sworn in on Friday.

Crisis avoided? Not so fast.

Risk Blow Out

The markets followed the political turns and twists of the drama. On Tuesday, Italian bonds posted their worst daily performance in over 20 years. The spike in the 2-year bond yield was spectacular, going from 0.3 percent on Monday morning to 2.73 percent on Tuesday, before slipping back to 1.26 percent on Thursday. The 10-year Italian bond yield leaped from 2.37 percent to 3.18 percent within the first two days, falling to 2.84 percent a day after.

Source: FT

To put these bond yields’ movements into perspective, at the week’s peak yields, the cost of funding Italian EUR2.256 trillion mountain of Government debt would have risen by EUR45 billion per annum - more than the forecast deficit increases under the reforms proposed in the League-M5S programme.

Thus, despite the immediate crisis yielding to the new Coalition, a heavy cloud of uncertainty still hangs over the Euro area’s third largest member state. Should the new Government fail to deliver on a unified platform built by an inherently unstable coalition, the new election will be on offer. This will likely turn into a plebiscite on Italy’s membership in the Euro. And it will also raise a specter of another markets meltdown.


The Italian Contagion Problem

The lessons from this week’s spike in political uncertainty are three-fold. All are bad for Italy and for the entire euro area. Firstly, after years of QE-induced amnesia, the investment markets are now ready to force huge volatility and rapid risk-repricing into sovereign bonds valuations. Secondly, despite all the talk in Brussels and Rome about the robustness of post-2011 reforms, the Italian economy remains stagnant, incapable of withstanding any significant uptick in the historically-low borrowing costs that prevailed over recent years, with its financial system still vulnerable to shocks. Thirdly, the feared contagion from Italy to the rest of the Eurozone is not a distant echo of the crises past, but a very present danger.

Italy’s debt mountain is the powder keg, ready to explode. The IMF forecasts from April this year envision Italian debt-to-GDP ratio dropping from 131.5 percent at the end of 2017 to 116.6 percent in 2023. However, should the average cost of debt rise just 200 basis points on IMF’s central scenario, hitting 4 percent, the debt ratio is set to rise to 137 percent. This Wednesday bond auction achieved a gross yield of 3 percent on 10-year bonds. In other words, Italy’s fiscal and economic dynamics are unsustainable under a combination of higher risk premia, and the ECB monetary policy normalisation. The risk of the former was playing out this week and will remain in place into 2019. The latter is expected to start around November-December and accelerate thereafter.

With the government crisis unfolding, the probability of Italy leaving the Euro within 12 months, measured by Sentix Italexit index jumped from 3.6 percent at the end of the last week to 12.3 percent this Tuesday before moderating to 11 percent at the end of Thursday. This puts at risk not only Italian Government bonds, but the private sector debt as well, amounting to close to EUR2 trillion. A rise in the cost of this debt, in line with Government debt risk scenarios, will literally sink economy into a recession.

As Italian Government bonds spreads shot up, other European markets started feeling the pain. Based on the data from Deutsche Bank Research, at the start of 2018, foreign banks, non-bank investors and official sector, including the Euro system, held ca 48 percent of the Italian Government debt.  In Spain and Portugal, this number was closer to 65 percent. In other words, the risk of falling bonds prices is both material and broadly distributed across the European financial system for all ‘peripheral’ Euro states.

Source: DB Research

As a part of its quantitative easing program, the ECB has purchased some EUR250 billion worth of Italian bonds. A significant uptick in risk of Italy’s default on these bonds will put political pressure on ECB. Going forward, Frankfurt will face greater political uncertainty in dealing with the future financial and fiscal crises.

Research from the Bank for International Settlements puts Italian banks’ holdings of Government bonds at roughly EUR 450 billion. Ten largest Italian banks have sovereign-debt exposures that exceed their Tier-1 capital. As the value of these bonds plunges, the solvency risks rise too. Not surprisingly, over the last two weeks, shares of the large Italian banks fell 10-20 percent. These declines in equity prices, in turn, are driving solvency risks even higher.

Beyond the Italian banks, French financial institutions held some EUR44 billion worth of Italian bonds, while Spanish banks were exposed to EUR29 billion, according to the European Banking Authority.

The second order effects of the Italian risk contagion play through the other ‘peripheral’ euro area bonds. As events of this week unfolded, in line with Italy, Spain, Portugal and Greece have experienced relatively sharp drops in their bonds values. All three are also subject to elevated political uncertainty at home, made more robust by the Italian crisis.

Thus, if the Italian government bond yields head up, banks’ balance sheets risks mount through both, direct exposures to the Italian Government bonds, and indirect effects from Italian contagion on the broader government debt markets, as well as to the private sector lending.

At the end of this week, all indication are that the Italian contagion crisis is receding. The new risk triggers are shifting out into late 2018 and early 2019. The uneasy coalition between two populist moments, the M5S and the League, is unlikely to survive the onslaught of voter dissatisfaction with the state of the economy and continued immigration crisis. At the same time, the coalition will be facing a highly skeptical EU, hell-bent on assuring that M5S-League Government does not achieve much progress on its reforms. All in, the new Government has between six and twelve months to run before we see a new election looming on the horizon.

The Italian crisis might be easing, but it is not going away any time soon. Neither the Spanish one. Oh, and with a major credit downgrade from the Standard & Poor’s and the U.S. Fed, here goes the systemic behemoth of European finance, the Deutsche Bank.

29/6/2013: Banks-Sovereign Contagion: It's Getting Worse in Europe

Two revealing charts from Ioan Smith @moved_average (h/t to @russian_market ): Government bonds volumes held by Italian and Spanish banks:

Combined:

• Italy EUR404bn (26% of 2013 GDP) up on EUR177bn at the end of 2008
• Spain EUR303bn (29% of 2013 GDP) up on EUR107bn at the end of 2008

Now, recall that over the last few years:

• European authorities and nation states have pushed for banks to 'play a greater role' in 'supporting recovery' - euphemism for forcing or incentivising (or both) banks to buy more Government debt to fund fiscal deficits (gross effect: increase holdings of Government by the banks, making banks even more too-big/important-to-fail); 
• European authorities and nation states have pushed for separating the banks-sovereign contagion links, primarily by loading more contingent liabilities in the case of insolvency on investors, lenders and depositors (gross effect: attempting to decrease potential call on sovereigns from the defaulting banks);
• European authorities and nation states have continued to treat Government bonds as zero risk-weighted 'safe' assets, while pushing for banks to hold more capital (the twin effect is the direct incentive for banks to increase, not decrease, their direct links to the states via bond holdings).

The net result: the contagion risk conduit is now bigger than ever, while the customer/investor security in the banking system is now weaker than ever. If someone wanted to purposefully design a system to destroy the European banking, they couldn't have dreamt up a better one than that...

22/4/2012: Irish Crisis Requires Drastic Action, but Not a Euro Exit

In light of Prof Paul Krugman's comments concerning the desirability of the GIIPS remaining in the euro earlier this week, the Sunday Independent has asked myself (amongst other commentators) to provide my opinion on Prof Krugman's proposed solution. Here is the link to the published article and below is an unedited version of my comment:

In his article, Paul Krugman puts forward what he terms an alternative solution to the current course of policies, chosen by the EU in dealing with the Sovereign debt and financial sector crises. The core of his argument boils down to the need for the EU ‘peripheral’ states, notably Greece, Spain, Portugal, and potentially Ireland, to exit the euro and restore national currencies.

In my view, such a course, undertaken in cooperation with the EU member states and the ECB is a correct one for Greece, and possibly Portugal, but is not an option for Ireland, and the rest of the periphery. The reason for this is that unlike Greece and Portugal, Spain and Ireland are suffering not so much from the Sovereign debt overhang, but from a private and banking debts crisis. Resolution of these latter crises will not be sufficiently helped by an exit from the euro, primarily because private debt deflation will not be feasible for debts already denominated in euro. In addition, exiting the euro will entail significant economic and reputational costs to an extremely open economy, like Ireland, reliant on FDI and high value-added euro-related services, such as IFSC.

Two years ago, prior to the completion of the contagion from banking debts to Sovereign debt, exiting the euro was a workable solution, albeit a disruptive and a costly one for Ireland. Today, such an exit will require default – most likely an unstructured and disorderly – on both Sovereign and private debts, with simultaneous collapsing of the Exchequer funding and the banking sector. This will lead, in my opinion, to a disorderly unwinding of the entire economy of Ireland.

Professor Krugman is correct in his analysis that “continuing on the present course, imposing ever-harsher austerity on countries that are already suffering depression-era unemployment, is what’s truly inconceivable”. He is also correct in stating, that, “if European leaders wanted to save the euro they would be looking for an alternative course.”

The new course that the European and Irish leaders must adopt is the course that will preserve and strengthen Irish participation in the Euro zone economy, not push Ireland out of the common currency. This course requires a number of steps to be taken by Irish and European authorities in close cooperation with each other.

The first step is to recognize that Ireland’s economy is suffering from a private (namely household) debt overhang and the incomplete nature of the banking sector restructuring here. This means making a choice: either Ireland continues down the current path, with economic adjustments to the crisis stretched over decades of pain, or we jointly, with our European ‘partners’, take real charge of the economic restructuring. The former path implies that Ireland will be sapping Euro area monetary and fiscal resources for many years to come, while being unable to implement deep reforms due to the lack of supportive economic growth and facing continued risks of a Sovereign default. The latter path means that we take a quick, sharp correction in our private debts and get back onto the growth path.

The second step is to devise a solution – most likely via the ECB (to avoid placing burden of our adjustment on European taxpayers) – to write down significant proportion of Irish mortgages and other household debts while simultaneously allowing the banks to deleverage out of the household debts. This can and should be achieved by the ECB canceling all of the Central Bank of Ireland ELA and a part of Irish banks borrowing from the ECB itself and using these cancellation proceeds to write down household debt. Delivering such a deleveraging will open up room for stabilizing Government finances, as reduced debt burden on private balancesheets will allow Ireland to divert resources to paying down Sovereign debt, while a new cycle of domestic investment and growth can commence, allowing for structural reforms in the economy (covering both private and public sectors).

The third step is to create a long-term warehousing facility – within the ESM – to roll over existent Government debt so Ireland will have a period of 10-15 years within which this debt can be reduced without the need to face uncertainty of market funding. This would be primarily a cash flow management exercise. ESM lending rates should be set around funding cost plus administrative margin, or in current terms around 3.0-3.2% per annum, saving Irish Exchequer up to €3.4 billion annually in interest repayments, which can be diverted to more rapid paying down of the national debt. Hardly a chop-change, under conservative assumptions, this approach will allow Ireland to save over €27 billion in funds from 2013 through 2020, reducing overall nominal debt levels by 11.6% by 2020 compared to status quo scenario.

Combined, these policy steps will be able to put Irish economy and Exchequer finances on the security platform from which structural and longer-term reforms can take place without undermining economic growth potential. In addition, good will extended by the EU to Ireland under such a co-operative and coordinated approach to the crisis will assure continued Irish support and participation within the EU. This, in turn, will assure that Ireland can play an active and positive role in the Euro area growth and sustainable development in years to come. Exiting the euro today is neither necessary, nor sufficient for restoring Irish economy to growth. Resolving our debt crisis is both feasible and the least-costly part of the solution to the broader Euro area crises.