Tuesday, June 21, 2011
Markets and global economists are focused on Greece, where all the while there are growing non-Greek credit events lurking in the shadows. Specifically, recent news flow out of Italy ensures that the volatility in Europe will follow any near-term Greek resolution.
On Friday, Moody's placed Italy's Aa2 local and foreign currency bonds on negative outlook, citing a possible downgrade within 90 days. The drivers for the review are the following: (1) challenges to potential growth, (2) implementation risks surrounding fiscal consolidation efforts; and (3) risks posed by funding conditions for European sovereigns with high levels of debt.
Moody's states that the above are the 'main drivers' (no link); but how I've interpreted recent shifts in credit outlooks is that (2) above, via rising political risk, is the last straw. If the economic cyclical indicators become somewhat challenged, this would surely require further austerity measures in the case of European sovereigns; and if further austerity measures become less certain in expectation on rising political risk, then the country goes on 'review'.
The political risk has sharply increased in Italy as of late...
1. Local elections went against Berlusconi's coalition.
2. Then there was the vote against water privatization, further burdening Italian public finances.
3. And recently, previous political allies are pushing for tax cuts and new immigration rules.
...while Italy's cyclical outlook has worsened at the margin. In Q1 2011, Italy contributed just over 2% to Euro area quarterly GDP growth but is a massive 16% of of total GDP. Italy is lagging key core countries, like France and Germany.
And it's not just a relative decline. Italian GDP plunged 7% during the recession and recovered just 2% since its trough in Q2 2009: fall hard, rise slowly. When indexed to the GDP low in Q2 2009, imports have retraced the farthest with exports and gross fixed capital formation bouncing as well. But the real data are indexed to the cyclical lows following a 7% net decline in GDP. Better put, if I had indexed the data to before the recession, the recovery across GDP spending components would look much less buoyant.
I know that this is just one indicator; but higher frequency indicators are not looking good. Please see Edward Hugh's post at Roubini Global Economics for a nice review of Italian economic indicators.
Unless the economy picks up markedly, the government deficit is bound to surprise to the downside of official forecasts. Ultimately, this begs the question of how sustainable is Italy's debt burden, really? Is 189 basis points over German bunds (as of 6/20/11) a sufficient premium to warrant the credit risk?
Going forward, it wouldn't surprise me if Moody's did downgrade Italy unless the political situation improves markedly over the next 12 months. Italy's growth fundamentals are just too baked in for near-term change. (If you have a subscription to the Economist, please see the June 11-17th issue for a special report on Italy). Furthermore, I would expect the other rating agencies, S&P (A+u) and Fitch (AA-), to follow suit in either the outlook downgrade (S&P) or an outright rating downgrade (Fitch, possibly S&P).
Given Italy's high base of government debt, 119% of GDP in 2010, ratings downgrades that lead to shifts in real borrowing costs could have a profound impact on Italy's debt trajectory. Yes, this will be a problem in the world's third largest bond market - see the IMF GFSR 2009 data.
Greece is not the end game.