Why Italy

There is a perverse logic unfolding.  Spain is the fourth of the euro zone members to require external assistance.  Cyprus is likely to be next, especially if Russia does not come to its aid as it did last year with a $2.5 bln loan.

That leaves Italy as the last of southern debtor countries to be standing on its own in the face of the end of a global credit cycle.  Italy’s problem is not a deficit.  It is likely to be near 4% this year.  It is also the only debtor to be running a primary budget (excluding debt servicing costs) surplus.

The challenge stems from the accumulation of prior deficits.  It debt is approximately 2 trillion euros.  The refinancing costs require it to borrow something on the scale of 35 bln euros a month by selling bonds and bills.  The market’s appetite is waning and even the head of Debt Agency warned last week that foreign investors are pulling back from the auctions.

Ironically, Italian banks appear to have accumulated Italian bonds faster than the government has been issuing, suggesting they are also absorbing foreign sales.  Italy holds a bill sale on Wednesday and a bond sale on Thursday.  Yields have backed up sharply in recent days, but it is unlikely to be sufficient to appease international investors given the current environment and ahead of the Greek elections.

The initial momentum of technocrat prime minister Monti has faded.  He secured 20 bln euros in savings quickly, but his reforms in pensions, services and labor markets appear to have been diluted.  There is no doubt he has helped shift the agenda in Europe towards both more growth measures and greater integration.  However important he is on the European stage, his ability to shape the post-Berlusconi Italy appears limited.

There is little room to maneuver.  The ECB’s monetary policy is too tight for a country that contracted, as Italy did by 0.8% in Q1.  That is an annualized pace of greater than 3%  Households cut spending by 1% and exports fell 0.6%.  More recent data from Q2 shows the contraction shows no signs of abating.  And interest rates are rising to boot.  Italian yields have actually risen more than Spanish yields over the past week and month.

Italy did not experience a housing market bubble, like Spain and Ireland.  Besides its past deficits (can we call them legacy costs?) Italy is weighed down by, Italy’s ultimate problem is simply its lack of economic vigor.  Its growth has trailed the European Union average for the past decade.   It does have an significant industrial sector that generates a third the country’s GDP, but the incentive structures are so tilted toward rent-seeking behavior that it squeezes out the space for profit-seeking entrepreneurs.

Unlike in Spain and Ireland, where the private debts (banks) becoming public, in Italy’s case, the public debt  appears to be the major drag on the banks.  In Italy’s case the LTRO increased the exposure of vulnerable banks to a vulnerable sovereign.

At the start of the year, I had anticipated Spain taking over the role of lightening rod from Italy, which had served the role in the second half of 2011.  I am concerned now that even if the deal with Spain is insufficient, that rubicon has been, or will be shortly crossed.    Italy will come under closer scrutiny.