Markets Prepare for an Italian Size Problem

Italy was tested this week as bondholders sent yields rising near 7%, increasing the cost of borrowing for the country. The timing was perfect as the markets realized the growing risk of an Italian size problem for the Euro zone. We realized that the European Central Bank (ECB) is not capable of artificially buying enough Italian debt to push yields down, thus decreasing Italy's borrowing costs despite market based movements. We also saw a win situation for investors as they were able to use their selling power to force the incompetent Prime Minister of Italy, Silvio Berlusconi, to pledge his resignation after a budget bill is passed, paving the way for structural reform and cooperation with the ECB over debt issues.

It all started when two major European clearinghouses raised collateral amounts for investors wanting to borrow Italian bonds. By doing so, the clearinghouses sent a message that Italian debt is deemed too risky, and therefore requires more money up front to protect against losses while dealing with Italy. Not wanting to take on the extra costs while anticipating a sell-off, more banks began reducing exposure to Italy. This lead to the sell-off that sent yields rising near 7%, the dreadful levels reached by Greece, Ireland, and Portugal during the height of their debt panic. The Financial Select Sector SPDR Fund dropped 5.4% on Wednesday - further proof of the sell-off by banks with exposure to Italian debt.

The worry is whether or not Italy can sustain the high cost of borrowing. If not, will the country be on a path to default? Not quite.

Again, the timing is perfect. Italy has time to make the necessary reforms. If it does not, it will certainly be a major blow to the region, causing an eventual break-up or break-down of the Euro zone. With Greek troubles, Spanish structural issues, and Germany becoming financially exhausted, economic leaders are not prepared to tackle another problem. Not to mention that nothing has been solved for the current mess that's becoming worse, except mere agreements among leaders to meet.

The scariest part of this situation is that the ECB does not have enough market power to artificially decrease yields. The Central Bank desperately tried to purchase Italian debt to decrease the burden on the country's borrowing, but this hardly placed a dent in the sell-off.

Italy can get this right, and Berlusconi made the right decision to resign as the markets pressured him out of his role as Prime Minister. Now the hope is that the Italian Senate approves the budget deal (which it did) so that Berlusconi will officially resign, and the new government under Mario Monti, the man touted as the next Prime Minister, will move forward with reforms.

The Italian government will need to implement the budget plans which includes spending cuts and tax increases, but must also focus on growth.

In a world of high growth or high inflation, those interest costs would be manageable. Either income covers the outlay or inflation erodes the debt burden.
But Italy has neither to look forward to. The International Monetary Fund forecasts Italy to grow by less than 1% a year over the coming three years and for Italian prices to rise by little more than 1% over the same period. -WSJ

This will result from incentives for investments and productivity; the economy needs to produce enough revenue to pay the increasing costs of debt accumulation. Investors particularly find Italian debt  attractive because it is very liquid. Italy is the world's fourth largest borrower, and is a magnet for European bondholders. This is why Italian leaders must present a plan that focuses on growth in order to calm the markets and eventually send yields lower to comfortable levels. Even if the plan is not implemented properly, at least borrowing costs will be lowered so that the expectations for economic growth are reasonable.

The political shake-up in Greece and Italy are good first steps to calming the markets. Getting rid of incompetent leaders is always reassuring. It is not a complete reset though - this will only come in the form of default and a completely new government. Realistically speaking, new politics and budget plans have already proven to calm markets in the short term. The Euro currency and US stock markets gained some ground after Berlusconi made his pledge to resign, and the Italian Senate approved the budget bill on Friday.

Don't think Europe is off the hook yet. There still needs to be drastic changes. Getting rid of incompetent leaders is only the start.