No time for Mr Monti: Italy will have to restructure its debt

Luminarie Italia
2 Febbraio Feb 2012 1209 02 febbraio 2012

Prime Minister Mario Monti has wasted no time in trying to revive Italy’s economic prospects. A €20 billion fiscal consolidation package was agreed before Christmas and efforts have begun to open up Italy’s notoriously rigid labour and product markets. However, the Italian still economy faces severe headwinds. Ultimately we do not believe Italy will manage to return to growth in time to avoid losing market access, restructure its debt and ultimately potentially exit the eurozone.

The political instability that that was the hallmark of Silvio Berlusconi’s last years in office has receded rapidly now that Mr Monti is in place as prime minister. Italian policymakers are welcome again at the EU’s top table, and the country wields influence in Brussels it hasn’t enjoyed since the 1980s. It now rivals France as Germany’s most significant interlocutor.

These improvements in Italy’s political standing have coincided with a period of relative financial calm. While it appeared possible that Italian debt might suffer a buyers’ strike in mid-November, improved market sentiment in early 2012 has seen Italian borrowing costs fall steadily during a series of well subscribed sovereign debt auctions. This is largely owing to the ECB’s three-year long-term liquidity operation (LTRO), which some Italian banks have used to purchase domestic sovereign debt.

These developments are undoubtedly positive, but Italy is by no means out of the woods. The fiscal austerity measures Mr Monti announced upon taking office will undermine growth. His structural reform agenda also involves large up-front costs—including lower wages and higher unemployment—that will exert a drag on the economy. Nor is the ECB’s LTRO likely to boost Italy’s growth prospects significantly. If Italian banks are uncertain about the credit-worthiness of potential borrowers, they will not lend even when awash with liquidity.

These factors are likely to see Italy’s GDP contract during 2012-13, leading to an increase in the country’s debt-to-GDP ratio , which will exacerbate investors’ concerns about Italy’s solvency. We therefore expect Italy’s borrowing costs to soar once again, and that the country will be forced to request a bailout. The point of such a bailout would be to buy enough time for Italy to return to growth so that it could reenter the markets without official support when the bailout funds run out. What are the chances of this strategy succeeding? Not high, we’re afraid.
By combining IMF money with funds from the European Financial Stability Facility (EFSF) and the European Financial Stability Mechanism (ESM), EU leaders might be able to create a EUR1trn firewall for the peripheral countries in the eurozone. Considering the financing needs of Greece, Portugal, Ireland, Spain and Italy over the next few years, this firewall would be sufficient to cover Italy’s debt servicing costs and budget deficit for roughly 18-24 months.

This is unlikely to be enough time for Mr Monti’s structural reforms to start delivering growth. When the bailout funding runs out, therefore, we expect Italy will be unable to return to the markets. At that point, the country will either need to seek a further bailout or to restructure its debt. Given that it is difficult to see where new bailout funding might be found, a debt restructuring is more likely.

However, even if there is a debt restructuring, it will only address Italy’s existing stock of debt. It would not fix its debt flow problem; that requires increased competitiveness and growth. With opposition to structural reforms high and GDP contracting, there is a risk the Italian government will eventually decide that, rather than continuing down a path of prolonged austerity and recession, it would rather exit the eurozone. This would allow for a currency devaluation and a much swifter return to growth.

The easing of bond yields in the early weeks of 2012 has lifted some of the pressure on EU leaders to find an immediate resolution to the eurozone crisis. But the fundamentals have not changed. It is only a matter of time before Italy’s economic performance causes investors to question the country’s solvency once again. The only way to ensure Italy’s future in the eurozone is for Italy to return to growth, but it is unlikely that EU leaders will be able to buy enough time for this to happen.

*senior economist for Western Europe and the eurozone at Roubini Global Economics

Twitter: @economistmeg