Italy's Challenges Mount

One of our thematic points has been that Italy is emerging as arguably the weak link in EMU.  Italy faces two immediate challenges--one political and one financial--and neither is expected to be resolved immediately.  At best, together and separately risk the under performance of Italian assets.  At worst, a crisis in Italy could renew the broader tensions in the monetary union. 

The first issue is Berlusconi.  In particular the parliamentary commission begins its hearing today on whether to enforce the ban for political office that the former prime minister's tax fraud conviction entails.  The anti-corruption law, under which the ban would take place, was passed in 2012.  The crime Berlusconi was found guilty of took place prior and his allies are using this as a reason for arguing that it should not apply (ex post facto).

Berlusconi and his allies have threatened to pull support from the fragile Letta government if the center-left moves against its coalition partner.  That, they say, is the real rupture and resignations by the center-right ministers simply recognizes that. Over the weekend, Berlusconi's lawyers have filed a motion before the European Court of Human Rights, seeking to a ruling prior to the Senate vote, which was expected to take place before the end of the month. 

Time, though, seems to be working against Berlusconi.  The appeal process of his conviction for paying for sex with a minor and abusing his office continues and that too threatens the Berlusconi's political future.   As reluctant as he may be, Berlusconi appears to be preparing for this eventuality by re-launching his political party and there is speculation that his daughter Marina, who has taken the reins of the businesses, will also be heir to his party Forza Italia. 

The financial issue seems just as intractable.  It involves Monte dei Pashi's need for more capital.  Over the weekend the EU indicated that the bank needs to raise 2.5 bln euros, which is about the market cap of the oldest bank in the world.  This is twice the amount that was initially identified.

If Monte dei Pashi fails to raise the sum, the government would have to convert is debt holdings to equity and take control of the bank.  This is important because it would likely trigger the new EU bank aid rules that went into effect on August 1 that require a so-called "bail-in" of subordinated debt holders. 

This in turn could undermine what increasingly appears as a fragile banking system.  Earlier today the Bank of Italy reported that as of July, bad loans had risen a little more than 22% from a year ago.  This, coupled with the continued contraction of the economy, to dissuade Italian banks from making fresh loans.  Private sector loans are 3.3% less than last July's.  On the other hand, private sector deposits are up almost 6% from a year ago.

Italian banks do not appear to have returned much of their LTRO borrowings from the ECB.  Italian banks, among others, appear to be pressing for another LTRO before the end of the year.  Several large investment houses anticipate a new 2-year LTRO in Q4.  This would effectively extend the current 3-year LTRO for another year. 

For its part, the Letta government is pressing ahead with its limited agenda.  The labor minister has indicated that employment taxes will be cut next year and the cabinet met earlier today to discuss a decree on education funding.  The Letta government is also preparing a plan that is expected to be ready later this month on the selling of state assets.  The government has extensive corporate holdings and these are what is being targeted. 

The weakness of the Italian economy and the concerns sketched here have prompted the under-performance of  Italian bonds relative to Spain.  Over the past month, the spread has narrowed by 32 bp to about a single basis point today.  Italy's 10-year yield is set to rise above Spain's for the first time since early 2012.  The cost of insuring Italian debt (5-year CDS) has been trending gently higher over the past month, but has been more expensive than Spain for the better part of two months.