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Wednesday, July 06, 2011

Offhand, I'd Say This Is Serious

It's not Portugal, but Italy.

Italian services PMI contracted in June (47.4). Given the overall situation in Europe and the world, and given that Italy cannot possibly get its Debt/GDP ratio below 116% within a couple of years, this raises the spector of something more like 130%. Italy's economy is heavily service-weighted, so a contracting services sector should mean a contracting economy, lower taxes and higher unemployment over the next six months.

Italy is on negative outlook/review, and ten year yields crossed the 5% mark today. It's not hard to understand the uneasiness - after all, a service-weighted economy is very sensitive to austerity programs, but yet Italy cannot continue running a deficit and hope to repay its debt over the longer run. This is not going to be good for Italian banks, which have a lot of Italian sovereigns and are also dependent on the government continuing to spend.

For example, earlier attempts to cut back some of the alternative energy subsidies were quashed by Italian banks, who truthfully told the government that cutting the subsidies would impair their finances. They had done a lot of lending on systems which depended on the government revenue flow for repayment. This has been going on for over eighteen months, and each time the Italian government looked to cut subsidies, the banks intervened. Now it looks like the cuts for new systems are going to take effect this summer - and the banks are worried. This alone might have had an impact on services PMI, but the fact that this is such an issue exemplifies the difficulty of trying to adjust such an economy to be less dependent on the government sector.

So now what? The US 6 month is at six friggin' basis points. The four-week auction Wednesday had a bid/cover ratio of 4.79 and an award rate of 0 basis points. Bloomberg. The six-month on Tuesday had a bid/cover of 5.46 and an award rate of 8 basis points. This does look a lot like severe angst, and again, it is understandable. It's not that the US economy looks so good - it's that the situation in Europe, especially, looks so bad.

We've got Greece, and the likely final haircut just gets higher and higher there. Ireland, well, Ireland is coming back but it's anyone's guess as to the final tariff and who will pay it. Portugal, well, better countries have had to default; Portugal is locked out of the private market and the EU will have to cover its needs. Given the extreme draws on the finances of other governments, it is not feasible to think that Italy can be bailed out by Germany. Italy is too large. This then must put many Italian banks in an unfortunate position.

Last year, the big Italian banks did not come off too well in the European banking stress tests. You remember, the stress tests that passed all the Irish banks? Those stress tests? The five Italian biggies that got special treatment brushed a little close to the margin, which led to the Italian government reopening a program whereby these banks could raise money by taking up bonds issued by the Italian government (Tremonti bonds, the Italian version of TARP in 2008). Well, this year we have more stress tests, and they are expected to be a little harsher this time, given with the embarrassing collapse of the Irish banking system right after it got the all clear. It's a good guess that several of these banks may need to use the Tremontis. However, such a facility increases Italian government debt.

I'm guessing that the E-bond proposal may show up this summer. It's the one way to prevent a cascading system of defaults that I can see. The details are quite knotty, though - who pays for what? The solvent partners are guaranteeing the locked-outs. It is true that the situation of the locked-outs would improve, because they would be paying lower costs to roll over debt, but if the locked-outs aren't going to make it in the long run, it's just going to eventually tip the solvents into a France-like situation. On the other hand, the E-bond proposal is a way to create a pooled facility which would eventually allow mutual debt writeoffs, and writing off debt is the only real way out of this mess. The "voluntary" deal being imposed on the Greek creditors isn't that far from the write-offs that would eventually have to come out of an E-bond proposal.

This is the reason I thought the whole Greece deal was so iffy in the first place. The E-bond proposal can only work if the total amount of E-bonds is plausible for the EU as a whole. Rolling over ever higher amounts has inflated the Greek debt and surely we are close to the point at which the size of the necessary facility would begin to make investors demand higher E-bond yields? There isn't much time left. On the 24th of June, Italian bank stocks took a hit and trading was suspended. Nothing about the current news improves these banks' general position, and the continued pressure is going to have an impact.

Comments:
Europe's problems are, what's the 2007 phrase, oh yes, "well contained."
 
I mean that of course in the most sarcastic, snarky way possible. Can't let Mark have all the snarky fun!
 
This is gonna be epic. Overnight the spread between the Italian 10 year and the German 10 year hit 225 basis points (2.25%). Since the Euro, it has never gone that high.

Italy is in a very tight place, and that means the Euro is as also.

France's position has improved - the energy follies of most of the rest of Europe have provided it a good relative advantage and additional revenue.

But Germany's retail sales fell again quite significantly this spring, and retail sales in Italy aren't doing well either.
 
Eventually the music stops and everyone races for
a chair. When that begins, the euro as we know it, and open borders for trade end.
Sporkfed
 
Spork is probably right. But what will wind up happening is that winners and losers will be chosen. I'm afraid the losers will be doing the choosing.
 
Spork - I'm thinking about your comment. I would have guessed that everyone would want to keep the Zollverein - why do you think they won't? Some of these countries could exit the Euro without reimposing trade barriers. They have a lot to lose!
 
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