Contagio

by Andrew Stuttaford

He may sometimes (sometimes?) seem like the fifth horseman of the apocalypse, but the Daily Telegraph’s Ambrose Evans-Pritchard is right to be worried about Italy:

Italy’s 10-year yields spiked through 6pc in wild trading [on Monday] and hit a record post-EMU spread over German Bunds [government bonds], snuffing out a brief relief rally following Washington’s debt deal. Spain’s yields once again flirted with danger at 6.2pc.

“The markets know that the EU’s bail-out fund (EFSF) won’t be able to buy Italian and Spanish bonds on the secondary market for another three or four months because the deal has to be ratified by national parliaments,” said David Owen from Jefferies Fixed Income.

The summit accord did not increase the EFSF’s firepower above €440bn (£380bn), leaving it unclear how EU leaders expect to cope as contagion engulfs the eurozone’s bigger players. The fund has just €275bn left after pledges to Greece, Ireland, and Portugal. City analysts say it may take €2 trillion and a clearer German commitment to halt the panic.

Good luck with explaining that to your voters, Chancellor Merkel. Meanwhile:

JP Morgan warned clients that Italy has a thin margin of safety and risks running out of cash to cover spending as soon as September. “Italy and Spain will run out of cash in September and February respectively, if they lose access to funding markets,” said the bank’s fixed income team of Pavan Wadhwa and Gianluca Salford. Worries about Italy’s immediate cash level risks leading to “a self-fulfilling negative spiral.”

It’s that spiral that is the thing to watch out for. It was described best by Belgian economist Paul de Grauwe in a paper that I linked to here back in May. The following passage (which uses Spain as an example) is key to understanding why membership of a currency union has left Italy so vulnerable to a run:

Suppose that investors fear a default by the Spanish government. As a result, they sell Spanish government bonds, raising the interest rate. So far, we have the same effects as in the case of the UK. The rest is very different. The investors who have acquired euros are [in the absence of a truly dramatic increase in Spanish interest rates] likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. There is no foreign exchange market, nor a flexible exchange rate to stop this. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB [European Central Bank] can provide all the liquidity of the world, but the Spanish government does not control that institution. The liquidity crisis, if strong enough can force the Spanish government into default. Financial markets know this and will test the Spanish government when budget deficits deteriorate. Thus, in a monetary union, financial markets acquire tremendous power and can force any member country on its knees…

In some respects, Italy’s underlying financial position is more favorable than is frequently thought, but as one Eurozone domino tumbles after another, investors can hardly be blamed if they decide that that is not a hypothesis they want to put to the test.

And then there’s this:

Monetary tightening by the European Central Bank has compounded the problem, triggering a collapse of all key measures of the Italian money supply.

One size still does not fit all.