Italy--Still Part of the Periphery

Many have long suspected that Greece, Ireland and Portugal are ultimately manageable given the relatively small size relative to the euro zone GDP and institutional capacity of the EFSF. Spain was the real challenge. Yet the price action in recent days warns that beyond Spain, Italy looms even larger.

Over the past five sessions, Italian bonds have under-performed their Spanish counterparts. The current 10-year Italian bond yield has risen 14 bp to Spain's 1 bp. Until now, the Italian and Spanish bonds had performed roughly equally over the past year. The market still see Spain as a bigger risk but than Italy, but the difference is narrowing. Spain is paying 48 bp more Italy on 10-year bonds and 31 bp more on 2-year borrowing. Spain's 5-year CDS is quoted just above 301 while Italy is near 215.

Yet if a threat (risk) is a function of credibility and capability, the magnitude of Italy's debt in absolute and relative terms is significant. The ECB expects Italy's debt/GDP to reach 120% this year and only ease be a few percentage points in the coming years. Its debt is over $2 trillion. It is bigger, to help put it in perspective, the UK's annual GDP.

Its saving grace has been that, like Japan, the bulk of the debt is owned by domestic institutions. However, there are some reports suggesting some domestic institutions are turning more cautious. A test on their resolve and commitment will be forthcoming. Italy has around 175 bln euros of bills and bonds that are maturing in H2 and another 245 bln euros of maturing instruments next year.

The maturing debt needs to be refinanced and, given recent developments, means that Italy will have to pay higher yields. Moral hazard implies the likelihood of regulatory forbearance, but losses on Italian bond holdings may temper the appetite going forward. However, the more important implication may be on the fiscal front.

Italy is aiming at a 4% budget deficit this year after about a 5% shortfall last year. The deficit in Q1 was near 7.7%. The government has unveiled a 47 bln euro savings plan, but has had to be modified when it was revealed that it contained a clause that would have allowed a Berlusconi owned company to at least temporarily avoid a heavy fine in a larger legal dispute.

The narrative that the ECB and Germany often tell is one of profligate states leaving beyond their means. While striking a responsive chord among many investors, that story only really applies to Greece. In Ireland, the sovereign was not the problem until it provided an unlimited guarantee to the senior bank bond holders and nationalized the banks. Portugal's sovereign debt was not a problem until the financial crisis hit. The real problem in Portugal is not the sovereign but the private sector.

And while so many are focused on the debt-centric narrative, one theme we return to from time to time, is the competitive deficiency. The periphery is growth challenged and this applies to Italy. Italy has recorded average annual growth of less than 0.25% over the past decade. Comparable growth in the euro zone as a whole is 1.1%.

In Q1 Italy barely expanded (0.1%), while the euro zone expanded by 0.8%. The second quarter does not look better. In fact with the June manufacturing and service sector PMIs below the 50 boom/bust threshold, the risk is the Italy's economy contracted in Q2.

This is not to argue that Italy is about to leap frog over Spain and see international assistance. Indeed, part of the argument is that the kind of sums Italy would need would far surpass the EFSF/EU and IMF capacity. The point is that Europe's challenges are much greater than Greece. In fact, in none of the aid packages has Europe managed to contain the situation. It is not just contagion, but there are multiple threats. As we have seen recently, an apparent resolution of one, may offer a brief relief for the others, but as Moody's decision on Portugal illustrates, a resolution of one can have negative implications for others.

We have been closely monitoring the firewall that has appeared to protect Spain from the other Portugal (Ireland and Greece). Recent developments appear to be weakening that firewall and pressure is mounting on Italy now as well. It is still in the early days for Italy, but the situation requires closer monitoring that had been the case.