The fate of the euro and the fate of Italy are now intertwined. The euro will not survive if Italy is forced to default because its government can no longer refinance the part of its €1.5 trillion debt coming due every year. The firepower of the European Financial Stability Facility would not be sufficient to safeguard Italy, even if the IMF were to provide a couple of hundreds of billions of additional funding.
In short, Italy is too big to fail, but also too big to save. Can Italy save itself? Some analysts are pessimistic but I believe there still is a path to success.
The Italian government is currently pushing a strong and credible fiscal adjustment through Parliament. But this might not be enough to prevent another sell-off in the Italian bond market. Experience has shown that spikes in the risk premia lead to a self-reinforcing negative spiral under which higher interest rates put into doubt the solvency of the government, and threaten the survival of the Italian banking system which gets cut off from the normal interbank (and other) cross-border financing channels. However this vicious circle can be broken to allow the Italian government to survive a substantial period of high interest rates – as it did in the 1990s when interest rates were in the double digits for several years. (See my analysis of this period and what is different today.)
The distribution of tasks should be simple:
– Italian households should finance their own government by buying its debt, and
– The ECB should prevent a collapse of the Italian banking system.
A first, key element of survival is thus that the new high-cost debt should be sold mostly to Italians. In this way the higher cost of debt service will not be a burden on the country, but just a redistribution of income between savers and taxpayers.
To the extent that the new, high cost debt instruments are sold to foreign investors they constitute a burden on the entire economy because they lead to a deterioration in the current account. This should be avoided by using regulatory and other levers to entice Italian savers to shift to Italian government debt (typically short-term 'Buoni Ordinari del Tesoro', with maturities up to 365 days, and Treasury issued 'Buoni del Tesoro Poliennali', with maturities of three, five, 10, 15 and 30 years).
At present about one half of all Italian public debt is held in Italy. If the proportion of new debt bought by domestic savers could be increased to at least three quarters, the negative feedback loop mentioned above could already be much reduced. There would then be much less need for the ECB to buy more Italian public debt.
Experience has shown the importance of a domestic investor base in times of crisis. During the 1990s the interest burden for the government was much higher. But this was sustainable because most of the debt was held by residents (the famous ‘BOT people’). If domestic savings are redirected towards purchases of domestic government debt this leaves an ‘external financing gap’ given that Italy still runs a moderate current account deficit of about 3 per cent of GDP, somewhat under €50 billion per annum. If foreign investors also refuse to finance Italian private sector borrowers, Italian banks would need to obtain more funds from the ECB.
In an ideal world it is clearly not the task of a central bank to finance regional current-account imbalances. But it would still be preferable for the ECB to provide the Italian banking system with continuing access to its normal monetary policy operations to the tune of €50 billion annually, rather than buying hundreds of billions worth of government debt.
The stability of the Italian banking system now seems assured given that the ECB has made three-year funding available (important given that supervisors will not allow Italian banks to give medium-term credits to small and medium enterprises if they refinance themselves only with short-term funding). The relaxation of the collateral requirements the ECB has also announced recently is even more important. Banks can now use any performing loan to obtain funding. This is crucial for a banking system which has conservatively stuck to its basic business of lending to the real economy and thus until recently had more difficulties finding eligible collateral on its balance sheet.
All in all it seems that Italy should now have a good chance to survive even a prolonged period of high risk premia if it can mobilise its domestic savings. Knowledge that this is the case should already lower the tension in financial markets. Moreover, Italy will soon be one of the few countries to satisfy the rule of the new eurozone ‘fiscal compact’ (cyclically adjusted deficit should be well below 0.5 per cent of GDP in 2013). This should also contribute to lower tensions (and increase the readiness of Germany to agree to measures to support the Italian bond market should tensions return anyway).
Of course, this survival strategy makes sense only if the long-term adjustment is also taken care of. On the fiscal front this seems to be the case. What has to start yet is to make the Italian economy competitive again by reducing labour costs. It took even Germany the better part of a decade before it could make up for the overvaluation with which it had entered the eurozone. But the process of reducing wage costs must now start to convince financial markets that Italy will be able to grow again on the back of growing exports, as it did in the 1990s.
Provided the real sector of the economy can be shielded from the worst effects of the financial storm the country should have enough time for the real adjustment to bear its first fruits.
Originally published on www.VoxEU.org. Reproduced with permission.