Eurozone debt crisis contagion spreads to Italy

On both sides of the Atlantic politicians are locked in crucial talks about how to address their respective debt positions that are an increasing threat to the global economic outlook. The stakes are high in both continents but whereas in the US there is a relatively simple decision to make (the two leading political parties need to agree to raise the government debt ceiling before the country technically defaults on 02 August), in Europe the situation is more complicated.

As we have commented before, the eleventh hour agreement to provide the necessary finance for Greece to service its debt over the next two months in exchange for the Greek government's acceptance of the renewed terms of the austerity package, has only bought time and solved nothing. Greece is in urgent need of a second bailout and the Eurozone ministers have yet to agree how to involve the private sector in such a rescue.

What has muddied the waters is whether a private sector initiative (PSI) would represent a default and, if there was a full or partial default, would the European Central Bank continue to accept Greek debt as collateral. At its monthly press conference last Wednesday the President of the ECB, Jean Claude Trichet, was asked what the position of the ECB was with regard to potential default. He responded in surprisingly unequivocal terms by saying that any form of default, however ‘partial', would render Greek debt as non-acceptable as collateral.

The ECB's stance has thrown the ball back into the court of the European Union to come up with a solution. The favoured French proposal of rolling over the majority of the debt is likely to be declared a default event according to S&P and this was less radical than the German plan to extend the maturities of the bonds. It is clear that if the Euro ministers want to involve the private sector in a second bailout they have to accept that it is likely to be classified as a 'credit event’.

The implications of this have become apparent over the last few days as further developments have added pressure on Eurozone finance ministers.

Contagion, far from being contained by the approval of the austerity programme by the Greek Parliament, has quickly spread to the larger periphery countries, Spain and, especially, Italy. The catalyst was the downgrade in Portuguese debt by the credit rating agency, Moody's, to junk level status that reminded markets that the problem of sovereign default goes beyond Greece.
 
The respective credit ratings for the periphery countries are as follows: Until the last few days Spain was viewed as the next domino likely to fall after the three smaller periphery countries that all required bailouts. Although Spanish 10 year yields are still slightly above those of Italy, it is in the latter country where bond yields and CDS have jumped the most in recent days.
 
On Friday the well regarded Italian finance minister, Giulio Tremonti, who is seen as a steady counterweight to the unpredictable and capricious Prime Minister, Berlusconi, was implicated in a corruption investigation involving a former aide. Whether or not he is forced to resign the loss of confidence quickly spread to the banking sector with some shares temporarily suspended as their prices fell heavily. There are growing concerns that some Italian banks will fail the stress tests for the  banks that are due to be published later this week.

In response to the growing contagion of the crisis the EC and ECB are holding an emergency meeting today that will include Italy on the agenda. This is ahead of a scheduled meeting of the Eurozone finance ministers to discuss the second bailout.
 
In the Financial Times and Wall Street Journal there are comments that suggest a shift in strategy following the developments of the last few days. It appears there had been belated acceptance that Greece should default on some of its bonds as part of a new bailout plan to include the private sector. The French and German proposals were self serving and did nothing to reduce the debt burden for Greece whereas, reports suggest, new plans will include some concessions to reduce Greek debt. This may include a reduced interest rate on the loans and/or a broad based buy out programme.

As contagion has spread to Italy it is clear that something has to give soon because the EU knows that the current bailout facility is not anywhere near big enough to provide for that country. The troika has been seeking to involve the private sector in contributing to the cost of a bailout while not triggering a default scenario but, as the rating agencies have made clear, it may not be possible to reconcile these twin objectives. In any event, such a ‘solution' would not help the solvency of the indebted nations and such subterfuge would be unlikely to placate markets.

Therefore, with the threat of Italian insolvency looming ever larger, it makes sense for the authorities to finally accept that it is necessary for Greece, and by implication other periphery countries where necessary, to default on part of its debt in helping the indebted nations overcome their predicament.

It will dawn on the collection of policy makers at meetings, if it has not already done so, that the outcome to this crisis is binary: either continue with the current policy of prevarication and risk disorderly default and financial chaos, or embrace closer financial and political union by taking a more radical approach that tackles the all consuming issue of solvency. There is no middle

This is a positive development if the reports in the FT and WSJ are to be believed but the devil is in the detail. It is how and when any such proposal comes into being that will determine its success. The rapid spread of contagion in the last two weeks have emphasised that the troika need to act fast but the details of any rescue plan has, also, to be credible unlike the aforesaid French and German proposals.

Essentially, to be successfully a rescue package has to embrace some sort of transfer union, however unpopular it is with the core countries, if it is to have a chance of prevailing against market forces. As a means of doing this the liquidity focused bailouts have not and will not work, and only defer the day or reckoning. Some debt relief needs to be given to the periphery countries while involving the private sector on a grand scale. The blueprint for this was the Brady plan for Latin America in the late 1980's and early 1990's. Trichet was involved with this and he should dust off his old notes and convince his colleagues of the way ahead.