Italy Attack Tests Euro Defenses

Rise in Italian bond yields calls into question Europe's ability to resolve crisis.

The euro region’s defenses are being breached.

Investors yesterday propelled Italy’s 10-year bond yield to close at a euro-era high of 7.25 percent after the promised exit of Prime Minister Silvio Berlusconi failed to convince them that his country can slash Europe’s second-largest debt burden.

The biggest signal yet that the single currency’s third-largest economy is falling prey to its two-year debt crisis forces German Chancellor Angela Merkel, European Central Bank President Mario Draghi and their peers to decide just how far they’re willing to go to defend the euro.

“The market is testing the commitment of the euro zone’s stewards,” said Eric Chaney, Paris-based chief economist at insurer AXA SA and a former official in the French Finance Ministry. “Italy is the real crisis battleground.”

The euro strengthened against the dollar today, after earlier reaching a one month low, and traded at $1.3565 as of 9:22 a.m. in London.

Italian 10-year bonds rebounded from declines as the ECB bought the country’s debt, according to three people familiar with the transactions, who declined to be identified because the deals are confidential. The 10-year yield slipped to 7.1 percent, still at a level which previously drove Greece, Ireland and Portugal to seek bailouts.

At 1.9 trillion euros ($2.6 trillion), Italy’s debt exceeds that of Greece, Spain, Portugal and Ireland combined, though unlike those nations, it has systemic importance as the world’s third-largest bond market and eighth-biggest economy.

Berlusconi’s offer to quit has still left his nation struggling to produce a government stable enough to deliver austerity after LCH Clearnet SA raised the deposit it demands for trading Italian securities. Investor sentiment will be tested today as Italy sells 5 billion euros ($6.8 billion) of one-year bills.

“While Italy is considered too big to fail, she may be too big to save unless there is a major change of attitude towards resolving the crisis,” said John Higgins, an economist at Capital Economics Ltd. in London. “Things could be about to turn very ugly.”


 
Pressure Builds

Investors want “a signal that Italy has taken control of its accounts and is increasing the competitiveness of the system,” Marco Tronchetti Provera, Chairman of Pirelli & C. SpA, Europe’s third-biggest maker of tires, told reporters in London yesterday. “Parliament has to take action soon.”

Global pressure on Rome is building days after Group of 20 leaders decried the inability of European counterparts to defeat a crisis now in its third year and threatening global growth.

Deputy finance ministers meeting at the Asia-Pacific Economic Cooperation forum in Honolulu today expressed concern over the danger Europe poses to the world economy. U.S. Treasury Undersecretary for International Affairs Lael Brainard said yesterday that European officials must speed up construction of a “firewall” to protect countries that have sound policies.

International Monetary Fund fiscal monitors are due to visit the Italian capital, and European Union Economic and Monetary Affairs Commissioner Olli Rehn says he wants answers to “very specific questions” on economic pledges by the weekend. U.K. Prime Minister David Cameron yesterday said Italian interest rates are “getting to a totally unsustainable level.”

“This is a form of meltdown,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London. “I would imagine the telephones between international finance ministries and central banks are in danger of running so hot they’ll melt down themselves.”

Spooked by the investor selloff, Italy’s Senate rushed to set up a vote tomorrow on a package of debt-reduction measures which should pave the way for a Nov. 12 vote in the Chamber of Deputies and then Berlusconi’s departure. The premier is still seeking elections which may delay further reforms.

Failure to restore order may leave Italy joining Greece, Portugal and Ireland in seeking outside help. The first port of call would likely be the 440-billion euro European Financial Stability Facility. A country can now tap a precautionary promise of support of up to 10 percent of its gross domestic product -- about 160 billion euros in Italy’s case.

German Finance Minister Wolfgang Schaeuble yesterday told lawmakers that Italy should request aid from the EFSF if it needs it, two people present at the Berlin meeting said.


 
EFSF Backstop

Higgins at Capital Economics said Italy needs about 650 billion euros to keep out of markets for the next three years, rising to 700 billion euros with support for its banks. Another alternative is the EFSF buys Italian bonds in markets, he said.

A problem is that the rescue fund has about 270 billion euros left after subtracting commitments to Greece, Portugal and Ireland. Governments also have yet to flesh out last month’s promise to boost its spending power to 1 trillion euros. With Italy facing bond maturities of about 475 billion euros in the next three years, Citigroup Inc. and Royal Bank of Scotland Group Plc are among those saying the fund needs at least double that amount to insulate Italy and Spain.

“It’s hard to see that Europe would have the resources to take a country the size of Italy into the bailout program,” Finnish Prime Minister Jyrki Katainen said this week.

Such dilemmas could push Italy into the arms of the IMF, days after Berlusconi said he turned down a credit line with the Washington-based lender. With G-20 leaders debating whether and how to boost the IMF’s $391 billion war chest to assist Europe’s crisis-fighting, Managing Director Christine Lagarde yesterday warned of a potential “lost decade” for the world economy.

“The bazooka approach would be an IMF-led solution backed by the U.S., China and others,” said Fredrik Erixon, head of the European Centre for International Political Economy in Brussels.

There is mounting pressure on the Frankfurt-based ECB --now helmed by the Italian Draghi -- to bolster a bond-buying program which it deployed as recently as yesterday to ease Italy’s strains. Another proposal is for the central bank to provide an unlimited guarantee of Italy’s debt in the hope that would remind investors it’s struggling with liquidity not insolvency and to buy it time to pass debt-reducing policies.

“The house is on fire,” said Dante Roscini, a lecturer at Harvard Business School and former chief executive officer of Morgan Stanley in Italy. “The ECB needs to print money and buy Italian bonds, it’s the only way to put the fire out.”

The time may still not have come for the ECB to power up, given central bankers would first want Italy to earn support by showing how it will eventually deliver budget discipline, said Ken Wattret, chief euro-zone market economist at BNP Paribas SA.


 
‘Limited’ Intervention

“The ECB will only intervene in a limited way when there’s a clearer path towards a more fundamental overhaul of the economy,” he said.

Internal politics and ideology may stay the ECB’s hand permanently despite its prior willingness to rewrite its rulebook. Since May 2010 the ECB has limited its bond buying to 183 billion, and Bundesbank President Jens Weidmann this week said the central bank cannot bail governments out, citing Germany’s experience of hyperinflation after World War I.

“The only thing that would be a real game changer would be if the ECB were to take up this idea of being a lender of last resort to governments, but printing money is against the ECB’s religion,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam.

If the central bankers do eventually turn to the printing press it may be part of a broader strategic effort to finally conquer the turmoil which includes Greece being ejected from the euro area, said Eoin Fahy, chief economist at Kleinwort Benson Investors in Dublin. Merkel and French President Nicolas Sarkozy said last week for the first time that a country could leave the euro area if it fails to live by its rules.

“Eventually they’ll get to that point where they have to press ‘print,’” Fahy said. “The question is, do they throw Greece to the wolves first?”

Italy may still not need saving. IHS Global Insight economist Raj Badiani says the government can survive “several quarters of expensive debt auctions” thanks to positive cash flow and relatively low levels of private debt. BlackRock Inc., the world’s biggest money manager, said yesterday it’s “comfortable” holding intermediate Italian bonds.

Andrew Bosomworth, a senior portfolio manager at Pacific Investment Management Co. in Munich, senses a “watershed moment.” With Italy all but locked out of markets, European officials may have to jettison their short-term firefighting and pick between a smaller, stronger euro zone or a federalist structure with greater cross-border support.

“What is happening is what they’ve been trying to stop,” said Bosomworth, a former ECB economist.



Bloomberg News

 

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