Is Greece Italy's Future?

Currency in Crisis

This seems to be the question on nearly every one's mind today, with Italian 10-year yields rocketing through the 7% threshold and a vicious cycle of rising yields, triggering more sales, leading to margin increases, spurring more sales. Does Italy now need to go to the EU and IMF with hat in hand?

Italian mythology borrowed much from ancient Greece, but that was then than this is now. Greece is not the future of Italy. The scale of the Italian challenge is far greater than Greece's as Italy's sovereign debt is bigger than Greece, Ireland, Spain and Portugal's put together. Greece has, prior to the coming haircuts, about 350 bln euros of debt. Italy has to roll over about 300 bln euros in debt next year and another 200 bln in 2013. Together this is about 25% of Italy's debt and about 30% of GDP.

If Italy is locked out of the capital markets, as other peripheral countries have been, neither the IMF nor EU (through the EFSF) have yet to marshal the resources to fund Italy for even next year. In fact, Italy still needs to raise around another 30 bln euros this year to cover the 15.5 bln in redemptions and raise new money.

Italy is not nearly in as bad of a situation as some observers may suspect, looking the 10-year yield well above levels that appeared to trigger assistance for Greece, Ireland and Portugal.

Italy's average debt maturity is a little above 7 year and is among the longest in the euro zone. This coupled with its large stock of existing debt means the rise in yields will take some time to filter through into Italy's debt burden.

The 2012 budget assumes Italy's debt servicing costs of about 85 bln euros. As a thought experiment, if Italy were to pay 7% on all its nearly 2 trillion euro in debt it would cost about 140 bln euros. Italy projects collecting 500 bln in taxes in 2012. This still leaves quite a cushion if the debt servicing estimate is low and the tax collection is high.

Many investors are focusing exclusively on the sovereign debt, but this seems to be misleading, especially given the linkages, between public and private debt. If one were to combine public and private debt, Italy's overall debt is among the lowest in the OECD.

Moreover, Italian households are relatively wealthy. Household debt in Italy is about 40% of GDP. This compares with an European average of closer to 75%. In the US, household debt is near 90% of GDP, having peaking just shy of 100% in Q1 09. Italy's government debt is about a quarter of the household net wealth.

Some observers talk about the sharp drop in US nominal yields, pushing real yields well below zero as a form of financial repression. This is nothing compared to the financial repression that is possible in Italy. Domestic accounts own about 55% of Italy's government debt. Bond swaps can be foisted on domestic institutions. Domestic institutions can be required to hold more government bonds in say pension portfolios.

Italy also has other sources of wealth. Consider its gold reserves, which are the fourth highest in the world (behind the US, Germany and IMF) at about 2,450 tonnes, according to the World Gold Council, worth about $141 bln.

Non-residents have been selling Italian paper since the first quarter. Recent bank earnings reports suggest that numerous European banks have sold peripheral sovereign bonds, including Italian bonds, as one of the ways that capital ratios will be raised.

This is generally true of Europe as a whole. There is great wealth. There is sufficient wealth in Europe in general and Italy in particular to address the debt crisis. Chinese money or BRIC funds, or foreign vulture funds are not needed, if European will was greater.

Italy's problem is primarily one of confidence not solvency. Its debt/GDP was over 100% when the lira was exchanged for euros. The slow growth rather than a housing market bubble or some other kind of speculative mania is the source of the gradual creep higher of Italy's debt. The political breakdown and loss of credibility appears to have sparked the debt crisis.

Given the obvious contagion, there will be great pressure brought to bear for Italy to move shore up the political situation. Berlusconi was as much the result of a dysfunctional political order as the cause. This is only now becoming clear to observers. A policy response must be forthcoming in short order or the contagion will overwhelm everything else.