Italy Update

The revelations about Greece's currency swap, fuller details are expected in the coming days, have raised questions about Italy.

First, there was some concern that Italy Central Bank Governor Draghi may have involved with the swaps with Greece when he worked for the US investment house that has been linked to the transactions. The Bank of Italy formally denied this.

Second, there is some concern that Italy may have used similar tactics to dress up its accounts. Reports indicate that Italy did in fact use derivatives to lower its deficit to meet the Maastricht requirements to join EMU. Swaps were apparently used to temporarily reduce the amount of interest paid and lower the 1997 deficit. The European Commission had reportedly reviewed and approved the transaction. Yesterday Finance Minister Tremonti hinted that the technical issues--like the existence of the Italian lira and budget figures kept in lira, prevented the swap from being identified as a way to mask the size of the deficit.

On different front, the Italian Banking Association reports that Italian banks are awash with cash (deposits and new bond issuance), but like banks elsewhere, they are not lending. Specifically, the banking association figures indicate that the claims of Italian banks (assets) rose by 9.0% in Jan (year-over-year), but that loans to households and non-financial businesses rose only 0.1%.

Italian banks hold about 454 bln euros worth of bonds, including government bonds in January. This represents a 30% increase from a year ago. However, the Italian Banking Association notes that households are not buying government bonds (like American households appear to be). The most recent data is for Q3 09 and then Italian households held about 13% fewer government bonds. However, Italian households appear to have shifted from government bonds to the bank bonds.

Elsewhere, note that one of Italy's leading economic think tanks, ISAE updated forecasts now has the Italian economy growing about 1% this year, which is sightly above the Bloomberg consensus as is next year's forecast of 1.4% growth. It sees net exports as contributing to growth, but overall sees growth led by domestic consumption. Investment is expected to be sluggish. It anticipates the budget deficit to fall to a little more than 5% of GDP this year and 4.6% next year.

Lastly, we note that the Italian-German 10-year bond spread stands at at about 82 bp. This represents an 7 bp widening year-to-date. To put this in perspective note that the French-German spread has widened 8 bp this year. Greece has widened by 93 bp. Spain has widened by 21 bp and Portugal by 52 bp. The esteemed Robert Mundell claimed in a Bloomberg interview yesterday that Italy was the real challenge in the euro zone. While we see some pressures emanating more from its debt/gdp ratio more so than its current deficit, we do not see Italy on the front edge of the European storm. Italy's banks have thus far avoided the need for extensive government support and do not appear to have the exposures to the weaker European credits as do German, French, British and Swiss banks.