Ever since Greece requested its first European Union/International Monetary Fund rescue package in May 2010, this crisis has been brewing and spreading. We've witnessed sovereign debt problems in Ireland in the fall of 2010 and Portugal this past spring. This summer, we are experiencing another one. Italy is the latest victim.
ITALY
Italy has the third largest bond market in the world after the US and Japan. The country has €1.6 trillion in debt outstanding, equivalent to 119% of Italian GDP. There is not enough money in the €440 billion European Financial Stabilization Fund (EFSF) to finance Italian debt if the country loses access to the capital markets. Italy has approximately €300 billion in interest and principal coming due in 2012 alone. This crisis is big and fast approaching.
In June, rumors spread that Italian Finance Minister Giulio Tremonti would resign due to corruption. This rumor created the first wave of fear. Tremonti is the key architect in maintaining the Italian debt program. He first became Finance Minster in 1995 when Italian debt was at 121% of GDP. Debt to GDP had been driven down to 103%. However, the global crisis of 2008 drove it back to 119% of GDP. Via Tremonti, Italy was able to maintain debt stability through a tight fiscal policy. It takes a strong hand to maintain fiscal discipline, so Tremonti's potential resignation spooked markets.
EUROPEAN CENTRAL BANK
European Central Bank (ECB) has not helped the situation. The ECB has made it clear that it dislikes buying government bonds in the open market. The ECB does not want to be perceived as rewarding reckless fiscal spending. However, it is critical that the ECB be the "lender of last resort." Central banks are established to provide liquidity in times of market panics or bank runs. A bank run will likely stop if the market has confidence that the lender of last resort will respond by providing sufficient liquidity. The ECB has been very slow to respond and has appeared like most of Europe to be on "vacation". Given the ECB's laissez-faire attitude, investors are alarmed.
Global markets have been dumping Italian bonds, along with bank securities. Market pressure has become very intense in August as equity prices are plunging around the world. This sell-off has forced the ECB to act by reinstating a bond buy-back program. The ECB has been buying billions of Italian bonds. Unfortunately, no one knows how committed the ECB is with their bond buy-back program. This lack of clarity on the ECB's buying operations has led to further negative speculation.
EUROPEAN BANKS
Sovereign bonds fears have spread to the European banking system. European banks have significant exposure to these sovereign bonds. From a quality perspective, we believe the major European banks look healthy enough to weather the current market stresses. However, we are not so sure about the entire European banking system. Smaller banks are not as well prepared, and many may become "toast".
SUMMARY
At the end of the day, it comes down to debt sustainability. Can Italy (or any troubled European country) pay back their debts? Are the debts sustainable? Lowering debt is an obvious solution; another is economic growth. Countries need revenue from growth to lower their debt-to-GDP ratio. This current soft patch of economic activity is crushing. Growth is an essential elixir. Without growth, debt sustainability is not achievable without debt restructuring or worse: DEFAULT.
We believe the European debt crisis will be secular. Like the "Big Dig Tunnel," new problems will keep popping up, and these events are likely to cause market volatility.
Special thanks to Loomis Sayles & Co. who has had great market coverage on this issue.
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