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Kash Mansori: Thoughts on Italy's Little Debt Problem




Kash Mansori is an economist and author of the popular blog The Street Light. He authored an article in the New Republic this week discussing Italy's debt woes and possible solutions to the problem. We spoke with him on Benzinga Radio to get his thoughts on the developing situation in Italy and systemic risk in the eurozone.

At what point do liquidity issues in Italy turn into solvency issues?

Liquidity and solvency are very closely related. Having liquidity problems can make you insolvent, and I think that is exactly what is happening with Italy. The problem with Italy is not that they have huge, out of control budget deficits, like a Greece, for example. Actually, Italy's public finances are in better shape than countries like France or the U.K.

The problem Italy has is that they have so much debt left over from previous years and decades that any time their borrowing costs go up, then the interest payments they have to make will balloon, and that is what will get them into trouble. That is what people are worrying about could eventually make Italy insolvent. It's really directly caused by a spike in borrowing costs in the first place, not their particular budget problems.

How big a deal are increased borrowing costs for Italy?

Well, it takes a couple of years for higher borrowing costs to filter through because they don't roll over all of their debt every year. But, if you give it a couple of years of high interest rates, say at 7 or 8 percent, then you could see their borrowing costs go up by 50 billion--or even 75 billion--euro a year, which is several percent of their GDP.

So, all of the sudden, a deficit that looked manageable at a couple of percent of GDP becomes more like a 10 percent-of-GDP deficit after a couple of years of that. That is when the alarm bells go off, and you start thinking that this is not sustainable.

What of the dichotomy between austerity and growth policies in the eurozone?

That's exactly where the problem lies for Italy here. Yes, one way to address this medium to long-term budget problem they have is to get their public finances in better shape and to cut spending or increase revenue--one way or another--to try and increase their primary budget surplus. On the other hand, in the short term, they need economic growth.

Italy was one of the hardest-hit countries by the most recent recession and has not really started recovering as far as economic growth goes. What Italy really needs right now is some economic growth. So, you have this tension. In the medium term and in the long term, they need austerity and some budget retrenchment. In the short term, they need growth, and austerity contradicts, or even sabotages, that growth in the short term.

Italy has a notoriously dysfunctional political system. One of Berlusconi's unusual achievements is that he's actually been able to hold together a government for more than one year. Italian governments have this incredibly short lifespan, typically. Even with such a dysfunctional political system, really, for the last 15-20 years, Italy has been a fairly fiscally responsible country. It has not been a crazy, deficit-spending country, like a Greece, for example.

So, I think the Italian political system probably will be able to come through and figure something out, but that doesn't get around the problem that austerity alone is not going to fix the short-term budget problem that Italy is facing, thanks to this crisis spreading.

How did Italy pile on so much debt?

They got there mostly in the 70s and 80s, when they had terrible, chronic deficit spending. They have had over 100 percent debt-to-GDP ratio since the early 90s, and since then, it's been pretty much stable. True, they haven't been great at bringing it down, but it's been over 100 percent for 20 years now.

Just having that debt-to-GDP ratio over 100 percent doesn't necessarily mean that they are insolvent, and for the last 20 years, nobody has thought that Italy was insolvent with such a high debt-to-GDP ratio.

The conversation is markedly shifting toward ECB involvement in containing the spread of contagion to Italy.

It's a process of elimination that people are coming to the ECB as the final solution because everything else seems to be either not sufficiently powerful enough or not politically workable. The EFSF is not big enough and has its own problems. There is no other way to bring liquidity to the market. Austerity is good for the medium and long term but it is not going to solve the problem in the short term.

The only option that seems to be left that has enough firepower to deal with this is the European Central Bank. The advantage that they have is that they, of course, can provide unlimited amounts of liquidity. There is no end to how many euro they can create, simply because they are a central bank.

If they really set their minds to it, they could provide all of the liquidity that the market needs to bring interest rates down and cause the crisis, basically, to be over. Now, of course, there are huge political problems with that, and there is a lot of reluctance for the ECB to do that, but I think it's worth keeping in mind that traditionally, central banks have actually taken on that function.

Central banks for the last 200 years have stepped in to provide liquidity to governments when they have run into trouble like this. In the UK, in the US, and in a lot of other countries, this has been a traditional role for central banks. The ECB has not taken on that role for a variety of reasons, but it is something that we've seen at many times in history.

What of their Securities Markets Programme? Aren't they essentially already doing that?

They have done that to a limited degree, but the problem is that they've done it in such a way that it's almost been counterproductive. They have been stepping in and buying some Italian bonds, and they don't really make it public or easy to find out how much they are doing that or when they will do that, and why on some days they will step into the market and buy while other days they won't.

So, people don't really know how much intervention the ECB is providing, and as a result, people don't really pay that much attention to it.

On the other hand, if the ECB made a public declaration saying, "This is our policy. We are going to step and do this much intervention. We are going to make sure interest rates don't rise above this level." All of the sudden, the dynamics of the market would be shifted. Everybody would recognize that, "Oh, ok, there is no way I'm going to be able to profit by dumping these Italian bonds at this price, so I might as well hold on to them."

What are your thoughts on IMF involvement in Italy?

The IMF is another source of funding, but I think the problem with looking to the IMF to save things is that the IMF is not going to take steps or do anything to contribute money to the problem unless they get the green light from Germany and France. Germany and France are going to continue to call the shots there. The IMF could be brought in as backup, but the shots are still clearly going to be called by the Europeans themselves.

You still are in a situation where you need the political leaders in Europe to decide how they want to deal with this. That is the part that people are waiting for, right? There doesn't seem to be any clear decision or leadership about what the final solution to this problem is going to look like.

It really is, as far as I'm concerned, almost completely about market psychology at this point. So, you need to address that problem before you can even get to the longer-term budget issues that a lot of these European countries face.

Now, they are running the risk of it spreading even to France, because France has quite a bit worse budget deficit problem than Italy does. People are starting to catch on to this, and if there is no solution coming forward for Italy, people are going to start wondering, "Well, what about France? What about Belgium and some of these other countries?"

Why has an Italian debt restructuring entered the conversation being conducted in the market?

That is everybody's nightmare, right? If there is a real restructuring--a haircut, or something like that--on Italian debt, then all bets are off as far as the European banking system goes. There is just so much exposure to Italy that it is hard to imagine what that would look like if that were to happen.

So, we're all really hoping that it doesn't get to that point. It's almost hard to believe that the European political leadership will let it get to that point because you're facing the prospect of the entire banking system of the entire continent shutting down. If that happens, it is certainly going to have impacts across the world, because, for example, the United States banking system is very intimately connected to the European banking system now.

That is everybody's worst-case scenario. We really don't want to go there. We really hope something happens in a positive direction that cuts off all contemplation of a haircut on Italian debt.

If there is an Italian debt restructuring and the European banking system shuts down, or goes on holiday for a couple of months, that means real businesses have to shut down, because businesses that are not in the financial industry are very dependent on the regular and smooth flow of credit. So, if the banking system gets hit, the rest of the economy gets hit.

My additional worry is that equity markets will also get hit if there is a serious push for austerity across the continent. Growth rates in Europe are now teetering; they were just revised down from around 2 percent to around 0.5 percent for the next year, and that's even before any significant austerity measures have been passed.

If you start having countries like Italy and France doing major cutbacks in government spending or major tax increases, that growth is going to turn negative. We are going to have another recession in Europe, and that's definitely not good for equities.

What are your thoughts on credit default swaps not triggering in the event of a Greek debt restructuring?

That's a little bit of an unknown, because again, we are in uncharted territories with this. We've never had to deal with possible CDS triggers on any sort of scale like this before. Nobody really has a great idea of how this is going to shake out as far as Greece is concerned, and then what the implications might be for the other markets.

Some people are saying, "Well, if this doesn't trigger CDS contracts to go into force for Greece, why should we believe they have any value for other countries?" All of the sudden, you throw the whole CDS market into question--whether it's a worthwhile piece of paper.

It's really hard to tell what the net exposure is as far as the CDS guarantees go. The BIS data has some suggestive data, and you can make some inferences from it, but it's very difficult to read anything concrete into it. There are some estimates that say net CDS exposure across all of Europe is only a few billion dollars, which seems a little bit hard to believe--that you have this multi-trillion dollar market, and the net exposures are that small--but there is just no way to know for sure.

That's another black box we are dealing with here. We just don't know how it's going to shake out if and when these things are actually triggered.

It's a fairly loosely regulated market. I don't think that regulators actually have a much better grasp on what the net exposures are than they release in the public data. I don't think they keep a lot of secret data hidden from the public, as far as this goes.

It's just not that closely regulated, so I don't think anybody has that great of an idea, other than banks, which will certainly keep track of what their net exposures are, but they aren't going to tell. So, it's hard to know what the aggregate picture is.


 

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