Italy is bound to default

August 4, 2011

Realistically, Italy is bound to default, but Spain may just get away without having to do so

The failure of the European leaders to sort out their economic problems before going away for August has left Italy and Spain in the lurch. Prime Minister Zapatero has cancelled his summer holiday; Prime Minister Berlusconi, whose everyday life resembles a Club 18-30 holiday, has not actually given up his own summer plan but is making an unusual address to the Italian Parliament today (Wednesday).


It is important to understand the different dynamics of the Italian and Spanish situations. We have modelled a ‘good’ outcome and a ‘bad outcome’ for both to see if they are likely to be able to stave off default, flexing growth rates and borrowing costs.


For Spain, even the bad outcome has the debt GDP ratio remaining no higher than 75%. This depends, though, on the banks not being forced to take major capital losses on their property portfolios and therefore no additional financing of the banking sector by the government. They have got away with it so far. The key to Spain is that their exports remain fairly successful despite the strength of the euro, and most of those owning empty property are middle class families who have not yet dumped it on the market. Fingers crossed but there is a real chance that Spain may avoid default and debt restructuring unless it gets dragged down by contagion.


For Italy, the calculations are different. The starting debt position is much worse at 128%. Although Mr. Berlusconi has actually managed to run a tight budget, it is still not tight enough. And if the markets continue to force on them borrowing costs at around 6% and growth stays close to zero, our calculations show the debt GDP ratio rising gradually to over 150% by 2017. Even if the cost of borrowing goes back down to 4%, their growth rate is so anaemic that we see the debt GDP ratio remaining at 123% in 2018.


This is purely mathematical. Because the bond market has assumed optimistic growth rates, it believes that the critical bond yield above which a debt position is unsustainable is about 7%. Actually, with the very sluggish growth in Southern Europe as a result of the competitive hits that the countries have taken from staying in the euro, the maximum sustainable bond yield is nearer to 4-5%.


The bond market has not sufficiently factored in the importance of export growth in determining the plausibility of different countries’ prospects. Ireland – provided it does not get hit by contagion – should be able to export its way out of trouble fairly easily because of its tremendous exporting success, though it will take a 10 year hit on living standards. Spain is in a less strong export situation but has a smaller debt ratio (though it has a weak banking sector) and with some luck can survive.
But Greece cannot sort out its debt problem and realistically the same is the case for Italy. Portugal is nearer to Italy, though its position is only about 85% as bad.


However, these distinctions based on economics and mathematics may not matter. If one Eurozone country defaults, the markets are likely to put pressure on the other weak economies and push up bond yields. This will in turn drag them down, making devaluating and thus leaving the euro increasingly attractive, which is why we are pessimistic about the chances of the euro holding together.

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