November 9, 2011 6:54 pm
What happens next? The scenarios for Italy
Markets have pushed Italy and the eurozone towards what many investors see as a tipping point, but European Union officials on Wednesday said they were waiting for Italy to decide on a new government rather than planning emergency measures to turn the tide.
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The decision to stand firm appeared both a measure of the eurozone’s continued belief that only Italy itself can now change market sentiment – and a tacit acknowledgement the tools in the international arsenal have become increasingly limited.
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.The prospect of a technocratic government taking over quickly from a teetering Silvio Berlusconi to push through long-demanded economic reforms – coupled with returning order to Greece and beefing up their €440bn rescue fund – presented the best hope for turning around a darkening crisis.“There is nothing that the European [leaders] can effectively do at this point,” said Sony Kapoor, head of the economic consultancy Re-Define. “They have to let events happen in Italy.”
But if current plans do not work, the scenarios quickly become far more complicated:
1. The current plan: cut debt and spur growth now
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EU officials and the majority of independent analysts agree that Italy’s economic fundamentals, while not rosy, are far better than those of Greece or other eurozone countries in full-scale bail-outs. Italy’s debt levels are high, but its annual deficits are small, its banking sector is sound, and its overall economy big and diversified.
As a result, reforms that can immediately cut the country’s debt burden and spur economic growth could have a powerful effect on its ability to dig out of the current hole. Making sure Italy moves forward on plans to do both is the reason officials pushed Rome to accept both EU and International Monetary Fund monitors.
Mujtaba Rahman, an analyst at the Eurasia Group, said the Italian panic had been made worse by Greece and fights over reforming the rescue fund, the European financial stability facility. “Focusing on addressing those pieces may be enough to massage sentiment in the right direction ... in combination with more technical oversight from the IMF to address Italy’s internal issues.”.
A letter sent by EU inspectors ahead of their arrival Wednesday, and obtained by the Financial Times, shows their mission intends to be intrusive. Brussels is asking for a specific list of state-owned assets Rome can sell in order to raise €5bn per year for debt reduction. The letter also asks for measures “over and above” the privatisation plan.
Potentially more contentious, inspectors wrote that they believe Italy would no longer hit budget targets for 2012 and 2013 and asked for Rome to come up with “additional measures” to balance its budget by 2013.
EU officials have reason to hope such measures can work. Ireland, which had solid economic fundamentals before a banking crisis dragged it into a €85bn bail-out last year, has seen its bond yields cut almost in half – from above 14 per cent in July to close to 7.6 per cent earlier this week – after two quarters of better-than-expected export growth.
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2. Provide a precautionary line of credit
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This was offered to Mr Berlusconi at the Group of 20 summit in Cannes last week, but was turned down. Such a line of credit would likely come from the IMF, something it does with regularity for countries that are solvent but struggling to raise cash. Last month, the EFSF was given similar powers and there is now talk it could step into the breach.
Essentially, the EFSF or IMF would give Italy a limited amount of credit – anywhere from €50bn to €80bn – with a firm set of conditions attached. Doing so would lend credibility to the Italian reform plan and solve the most immediate problem: Italy’s inability to borrow money at sustainable rates.
But the move could further spook investors, convincing them Italy’s problems were worse than originally believed. In addition, even at eye-popping levels, the aid may not be enough. Italy must raise €300bn next year. “That €50bn will get used up in three months or so,” said Mr Kapoor. “Then what?”
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3. If all else fails: a full-scale bail-out
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If Italy proves unable to return to the public markets with a credit line, the next step would be a bail-out that would take Rome out of the bond market altogether.
If such a plan were to follow previous models, it would be a three-year programme where EU and IMF lenders would carry the weight of Italian debt payments until confidence returned so Italy could service its own debts.
The problem is Italy’s size. While a small country like Greece needs about €130bn to cover borrowing needs for three years, Italy would need that much to cover just six months.
All told, the EFSF, which started with €440bn, now only has about €250bn left to lend – a number that in an Italian bail-out suddenly gets cut to €110bn, since Italy contributes €139bn to the fund.
Italy would therefore have to rely heavily on the IMF. But IMF officials said they only had about $400bn on hand – or about €300bn – barely enough to last Italy through next year. Developing countries such as Brazil would undoubtedly object if the IMF dedicated that much money to another eurozone rescue.
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4. Or, a takeover by the European Central Bank
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Some eurozone governments, led by France, have argued that the ECB must become the zone’s lender of last resort in order to stop the run on peripheral sovereign bonds. If it were to guarantee all Italian debt, the ECB’s unlimited firepower – it can literally print money – could give it the power to buy every Italian bond and ensure Rome could borrow at low rates for the foreseeable future.
Central banks in the US and Britain already do this routinely. But Germany has long objected to so-called “monetary financing” – using central banks to fund government spending – and ensured it was prohibited in the Lisbon Treaty, which governs EU institutions.
Leading voices in Berlin, including the German president, have already objected to limited ECB bond purchases, and there has been no sign Berlin would back down. But because Germany has only two votes on the ECB board, German opposition could be overcome.
“You could end up with a divided ECB with the majority saying we’re facing an existential crisis,” said Mr Kapoor.
But some worry that even the bottomless pockets of the ECB may not be enough to stop the panic if it were to grip the €1,900bn Italian bond market by the throat.
“The situation has deteriorated so dramatically a large-scale asset buying by the ECB would not necessarily be a panacea,” RBS analyst Alberto Gallo said in a conference call with investors on Wednesday. “I do not think the ECB on its own could bring back the market to the point before Italy succumbed.”
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Additional reporting by Rachel Sanderson in Milan
Copyright The Financial Times Limited 2011.
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