Friday, February 8, 2019

The Italian Tragedy

Towards the end of 2018, Italy slipped into a (technical) recession. Italy's GDP growth was -0.2% in Q4 [1]. For several years now, Italy's economic position has been in a very fragile state. At present, its country's debt to GDP ratio stands at 132%. Although one measure makes the situation warrant concern, more worrisome is how the country has attempted to deal with the lofty sum.

Since 2015, the ECB has executed a QE program encouraging member central banks to purchase their own country's debt in proportion to the size of the country. In some cases, this has led to triangular transactions, in which the foreign sellers of Italian bonds will ask the ECB to credit the payment orders [2]. So, the Bundesbank has to credit not only the direct payment orders from the Italian government but also in the indirect orders resulting in the Bank of Italy's repurchases in third countries. Because of these transactions, the ECB has been the biggest buyer of Italian government debt. On behalf of the ECB, the Bank of Italy has bought more than $350 billion of multi-year treasury bonds since May 2015 [3]. The proportion of Italian gov. bonds held by the Bank of Italy since 2015 has grown from 5.8% of total outstanding debt to 19.3% [4]. The country itself has the highest proportion of debt held by residents and the lowest proportion held by foreigners.

Large foreign banking investors and institutions have continued to shed close to $69 billion (net) of Italian government debt. Since June 2019, capital flows have recovered somewhat [5]. Foreign direct investment, has also shown signs of substantial weakness since then [6]. The BTP 10-year spreads have been above 200 basis points for several months now, which (according to one source) can have spill-over effects into other EMU sovereigns [7]. Sharp moves in that spread, say an increase by 100 basis points, reduces the Common Equity Tier 1 capital of Italy's two largest banks by 35 basis points. The impact is nearly twice as large for mid-sized banks. Already we're beginning to see how fragile the Italian banking system is. Banca Carige recently received a $400 million emergency injection of cash to stay afloat after declaring bankruptcy [8].



Italy Capital Flows
Source: https://tradingeconomics.com/italy/capital-flows



Italy Foreign Direct Investment
Source: https://tradingeconomics.com/italy/foreign-direct-investment

A leading indicator of Italy's impending debt crisis can be observed through CDS spreads [9]. In 2015, ISDA introduced a new CDS contract to protect against euro area countries redenominating their debt into new national currencies. The spread between the new contract, and the old contract (2003) shows the potential for depreciation in the event of a redenomination. The only way that doesn't trigger a credit even is if Italy's debt is redenominated into a reserve currency, such as USD, CAD, the British pound, the yen, or the Swiss franc.


Source: https://ihsmarkit.com/research-analysis/cds-redenomination.html

As of February 7th, 2019, Italy's 5-year CDS rose to 232 basis point, UniCredit's 5-year CDS to 169 basis points, and Intesa Sanpaolo's 5-year CDS to 178 basis points [10].

If and when the debt crisis does play out, some economists at the Bundesbank have advocated for a national fund. The fund would be financed through "solidarity bonds" that Italian households would be forced to purchase according to a fixed proportion of their net wealth. As bleak as this may seem, it highlights the ignorance of economists refusing to acknowledge the problem itself: a common currency system within a network of nations who have vastly different fiscal and political systems.

With that, I'd like to end with two quotes from Friedrich Hayek's wonderful book, The Road to Serfdom:

"We are ready to accept almost any explanation of the present crisis of our civilization except one: that the present state of the world may be the result of genuine error on our part and that the pursuit of some of our most cherished ideals has apparently produced results utterly different from those which we expected."

"Only if we understand why and how certain kinds of economic controls tend to paralyze the driving forces of a free society, and which kinds of measures are particularly dangerous in this respect, can we hope that social experimentation will not lead us into situations none of us want."

Sources:
[1] https://www.zerohedge.com/news/2019-01-31/italy-officially-slides-recession-after-budget-battle-brussels
[2] https://moneymaven.io/mishtalk/economics/target2-and-secret-bailouts-will-germany-be-forced-into-a-fiscal-union-with-rest-of-eurozone-gkc4UP17RUyDbKp1LxkBfg/
[3] https://wolfstreet.com/2018/11/22/qe-created-dangerous-financial-dependence-italy-hooked-withdrawal-next-ecb-warns/
[4] http://bruegel.org/2018/11/the-consequences-of-italys-increasing-dependence-on-domestic-debt-holders/
[5] https://tradingeconomics.com/italy/capital-flows
[6] https://tradingeconomics.com/italy/foreign-direct-investment
[7] https://www.socialeurope.eu/italy-and-the-new-eurozone-risk-morphology
[8] https://www.cnbc.com/2019/01/02/reuters-america-update-2-ecb-appointed-administrators-step-in-to-manage-italys-banca-carige.html
[9] https://ftalphaville.ft.com/2017/03/06/2185614/guest-post-cds-markets-signal-rising-fear-of-euro-breakup/
[10] https://finance.yahoo.com/news/italian-sovereign-bank-cds-jump-155413997.html?.tsrc=rss