Italy Needs EU Bonds And It Needs Them Now!

You see, this isn’t a brainstorming session — it’s a collision of fundamentally incompatible world views.
Paul Krugman

As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?
Paul Krugman

First, focus all attention on reversing the collapse in demand now, rather than on the global architecture. Second, employ overwhelming force. The time for “shock and awe” in economic policymaking is now.
Martin Wolf

OK, I think no regular reader of this blog could seriously suggest I have much sympathy for the sort of views you normally find being propagated by Italy's Finance Minister Guilio Tremonti, but when he starts to send out the kind of red warning light danger signals that he has been doing over recent days, then I think we should all be taking note, and when the republic is in danger, then its all hands to the pumps, regardless of who is sounding the alert. This is not a brainstorming session, it is a real flesh and blood crisis.

Perhaps few of you will have noticed it, but our erstwhile logician has been getting extremely nervous in recent days, and most notably chose his visit to Davos to indicate that he personally would look extraordinarily favourably on any move to inititiate the creation of EU bonds (for a brief explanation of why these are important, see Wolfgang Munchau's argument in favour of such bonds here. (Or the longer version here)

Italy's Finance Minister Giulio Tremonti has said he favoured the issuance of government debt by the European Union. "Now my feeling -- I am speaking of a political issue not an economic issue -- is ... now we need a union bond," Tremonti said at the World Economic Forum in Davos. Countries in the euro zone currently issue sovereign debt in their own name, rather than regionally. Bond traders concerned about the mounting public debt of Italy, Greece and Ireland have pushed down the value of their government bonds, sparking speculation they might be driven out of the euro zone.

Now why would he be arguing this? Well the state of Italy's own banking sector would be one part of the explanation, and the fact that the Italian government is in no position to mount a rescue operation on its own given the size of its existing debt to GDP commitment, would be another. In particular, and as I have been arguing, Unicredit - and its Eastern Europe exposure - is a huge worry.

Indeed the situation is now so delicate, that according to this Reuters report last week, Unicredit really doesn't know which government to turn to. The Italian one perhaps, or the Polish one, or "it could consider doing it in Austria".

Italian bank UniCredit is considering requesting state support in Italy and Poland, a source close to the bank told Reuters on Thursday. "The bank does not exclude possible state support in Italy and Poland," the source said on condition of anonymity. In an extract of an interview to be published in Germany's Handelsblatt newspaper on Friday, UniCredit Chief Executive Alessandro Profumo said the bank could consider "state support as insurance against unpredictable events." If the bank does seek state aid, it could consider doing it in Austria, for example, he added.

UniCredit SpA is considering asking for government capital amid the credit crunch, Chief Executive Officer Alessandro Profumo said. “State support as insurance for unforeseeable events” is conceivable, Profumo told Handelsblatt newspaper in an interview at the World Economic Forum in Davos, Switzerland. A UniCredit official confirmed the comments to Bloomberg. Italy’s top bankers met with central bank Governor Mario Draghi last week to discuss the financial crisis, which has caused bankruptcies and government bailouts across the world, while stocks have plunged and credit markets have seized up. UniCredit and some of its rivals have tumbled in Milan since the start of 2008 amid concern about the strength of their finances.
Bloomberg 29 January 2009

The announcement that Unicredit was seeking state aid came on the same day that the bank admitted that investors had placed orders for only 0.5 percent of the shares they were offering in a rights issue. The bank received orders for a mere 14.3 million euros of stock out of a total of 3 billion euros, and the plan was to sell leftover stock in the form of convertible bonds, but even this hit a snag, as

The shares were offered at 3.083 euros apiece, or over twice what they were trading for in Milan at the time (around 1.408 euros). Shareholders, including Allianz SE and the Central Bank of Libya, are among those who agreed to buy the convertible bonds, according to the bank offer document. Shares of UniCredit have dropped 54 percent since October, when the rights offering was announced, amid concern the capital raising won’t be sufficient. But even the bonds issue is running into trouble, since Il Sole 24 Ore reported that Unicredit may raise only 2.5 billion euros rather than the full 3 billion euros because because investor Fondazione CariVerona, which holds a 5 percent stake in the bank, reportedly hasn’t received approval from the government to buy the securities, however, the reason they have not received approval may well be that they have not yet applied since the Italian Treasury, in what is a rather unusual step, said on Thursday announced that they had yet to receive a request from CariVerona to sign up for the bond issue. All this suggests, of course, that Tremonti's warning about an imminent bailout could be a piece of brinksmanship, designed to presssure CariVerona to stop playing "positioning" games and come up with the money, but irrespective of whether or not this is the case, some sort of rescue operation for Unicredit surely cannot be far away at this point.

And the fact that Bulgaria's Finance Minister Plamen Oresharski was running around last week assuring everyone that Bulgaria's banks have not asked for state rescue aid so far, and that the government is not worried about the banking system's health for now, is hardly helping to calm already troubled nerves. About 80 percent of the 29 commercial banks operating in Bulgaria are foreign-owned, with the biggest lenders being run by Italy's UniCredit, Hungary's OTP Bank, Greece's National Bank of Greece and Austria's Raiffeisen.

And only today Tremonti has warned that the announcement of more EU bank bailouts is imminent, and maybe as early as this weekend.

European governments may have to bail out more banks as soon as “this weekend,” Italian Finance Minister Giulio Tremonti said today. “So far in Europe there have been more than 30 bank bailouts and I can’t rule out that there will be more this week- end,” Tremonti said, speaking at a press conference after today’s Cabinet meeting in Rome.

So how should we address this danger, imminent or otherwise? At this point in time I have four proposals:

a) The creation of EU bonds
b) The introduction of quantitative easing by the ECB (quantitative easing is the monetary policy which is currently being applied in both the US and Japan, and probably soon in the UK too).
c) Letting those members of the East who want to join the eurozone immediately do so.
d) A new "pact" - one which would be much, much stronger than the old Stability and Growth Pact - to be signed by all countries who enter the EU bond system, a pact which gives direct fiscal remedies to Brussels in the event of non-compliance together with a substantial dose of effective control over the economies of individual countries - since nothing, Mr Sr. Tremonti, ever comes completely for free.

Obviously all of this is quite radical, and indeed fraught with danger, but these are hardly normal times. In all of this (d) is obviously the most important part, as any protection given to EU member economies by the Union must be credible and serious. So no country could or should be forced in, but it should also be pointed out to those who chose sovereignty and remaining on the fringes to participation that they would run an enormous risk. Since almost all EU economies seem vulnerable at this point, anyone staying outside could rapidly see themselves exposed to the risk of forced default, since lack of protection is simply an invitation to attack. Letting ourselves get picked off one by one is not an appetising prospect (Latvia, Hungary, Greece, Austria, Italy, Spain, Ireland, the UK, Romania, Bulgaria.........).

Clearly those who wish to remain "dissenters" should have the liberty to do so, but they should bear well in mind that should they do so they could very easily end up in a group - possibly lead by Diego Armando Maradona - together with Yulia Timoshenko (Ukraine), Cristina Fernadez (Argentina), Rafael Correa (Ecuador) and (possibly) whoever is the new prime minister in Iceland, bankrupt, and without the aid of international financial support to help deal with their mess.

Perhaps readers may think I am being rather shrill here, and perhaps at this point Tremonti (for whom I have no afinity, elective or otherwise, see linked post above) is only playing brinksmanship, but if he isn't, and Unicredit is about to need bailing out, then push does quickly come to shove, since the EU leaders agreed on October 12 in Paris to bail out systemic banks, and Unicredit is a systemic bank. So will will need to know how they plan to stand by their commitment, and if they don't, well then everyone of us stands exposed, since credibility rapidly falls towards zero.

Maybe this is a false alarm situation, and Unicredit will not need bailing out this weekend, or the next one, but one day it will, and one day Spain's huge non performing loan and household debt default problem is going to need sorting out. So I think this is a line in the sand situation, and we are much nearer to having to make up our minds which side of the line we are on than many seem think.

To paraphrase Paul Krugman again, in flirting with the idea of whether the first to default should be Greece, or Hungary, we truly are flirting with disaster.

You are independent of all logic Giulio Tremonti!

Italian Finance Minister Giulio Tremonti is a strange and controversial figure.The peculiar phrase in the title to this post in fact came out of the very mouth of Tremonti himself, though they were addressed to an astounded, if now world famous, US economist, Nouriel Roubini, in front of an equally amazed and bemused Davos audience. Since in these kind of matters it is normally better to watch what it is you actually say, just in case in the fullness of time your own words come back to haunt you - as the famous “If you don’t fully understand an instrument, don’t buy it” ones of Santader Bank chief Emilio Botin just did in the Madoff affair - I simply can't resist pointing out how lacking in logic the present Italian Finance Minister is himself at times.

This post came into my head on reading a report in the Financial Times, about a plan which Italy, currently the revolving (how appropriate this word is here) president of the G7, wishes to present to that august body, with the apparent intention of promoting all that much needed reform in the financial system. I was almost moved to tears by the elquoence and idealism of his words, and of his determination to get to grips with all those horrid "rogue economies".

We need a new global order,” (Tremonti) told the Financial Times in an interview. “We want to present a new icon – the legal standard – just as once there was the gold standard" A briefing paper he showed the FT begins: “The ‘Legal Standard’ could contain the minimum basic set of rules on propriety of international activities and transparency which the whole international community is expected to respect.” A mix of voluntary and binding codes would be closely monitored with a wide range of tools, including peer review, naming and shaming, indicators and “black listing ... for ‘rogue’ economies”.

But then I put my emotions to one side, and thought cooly and calmly for a moment: coming from a minister whose country ranking in the World Economic Forum Global Competitiveness Report lies somewhere near to that of Botswana (with all due respect to Botswana) this does seem all to be rather rich to me, my, my, it really does.

But then I read a report of an interview Tremonti gave last week to the French newspaper Les Echos:

Finance Minister Giulio Tremonti told French newspaper Les Echos in a Jan. 12 interview that Italy may not be faring as badly as GDP figures suggest because they don’t include the so-called black economy, worth about 17 percent of overall economic output, according government estimates.

And I thought to myself, mightn't an economy where the Finance Minister brazenly proclaims that 17% of output is to be found in the informal economy......well mightn't someone think that a country whose minister cited this fact as evidence for not doing too badly was itself one of those "irregular" economies that Tremonti wants to set us all so hard to work on "blacklisting". But then I read the latest utterance from his Prime Minister Silvio Berlusconi, and I understood what not faring badly actually means in a country whose politicians' grasp of the complexities of modern logical thinking leaves me just astounded:

Italian Prime Minister Silvio Berlusconi said the economy isn’t in “such bad shape” even after the European Commission and the country’s central bank predicted the worst annual contraction in more than 30 years. “It means we will go back by two years,” Berlusconi told reporters today in Rome, referring to the value of nominal gross domestic product. “That doesn’t seem so bad.”

Indeed, Giulio Tremonti does have this much in his favour, he never flinches in the face of having to change his mind. Only today he came out and abandoned his forecast (yes, only today) that the Italian economy would expand in 2009 and informed us that it is about to have the worst contraction in more than 30 years. Of course, it is just mere coincidence that the European Commission yesterday forecast a contraction of a similar order.

Interestingly here, Tremonti came out on 18 December and explicitly attacked the Financial Stability Forum, a group of regulators chaired by Bank of Italy Governor Mario Draghi. In comments to reporters at the European finance ministers and central bankers held in Paris, he insisted it would be “stupid to listen or take lessons from people who don’t understand anything” of the credit crisis. Ironically, one of these people - Mario Draghi - who apparently didn't understand anything had already forecast on January 15 that the Italian economy would contract by 2% this year (at the time Tremonti was predicting 0.5% growth). When question by reporters about the apparent disparity he limited himself to saying that The Bank of Italy forecast seemed “realistic”, but that the government’s own predictions were not yet ready. I mean, I know Liebniz and Newton did reputedly discover the mathematical calculus separately, but it is curious how the Bank of Italy, the EU Commission and the the Italian Government all come out with exactly the same number within a matter of days. Could this be another example of multiple scientific discovery, or is it just that they are using the same computer software and model.

Go Back To Turkey!

Moving back now to Nouriel Roubini and the Davos Meeting of 2005, I think I'll let Nouriel himself develop the point. As he put it on his blog at the time:

On Friday I was in Davos in a panel on the "Ups and Downs of EMU" (European Monetary Union) where ECB head Trichet, Italian Economy Minister Tremonti, a few other EU officials and myself were supposed to discuss the following questions: Will EMU collapse in the future? Which country will exit first? What will be the consequences of a break-up of EMU? How to avoid that? And what are the prospects for the Growth and Stability Pact? Unlike the other panelists that ignored the topic and spoke instead about all the good things allegedly associated with EMU, I took the questions seriously by considering some of the problems and risks faced by EMU and the risks of a break-up, especially for the case of Italy.

My remarks caused a stir with Minister Tremonti who interrupted me in the middle of my remarks, went into a temper tantrum and shouted - to the consternation of all participants - to me: "Go Back to Turkey!!". I happen to have been born in Istanbul.....I politely replied that I was an independent academic thinker being paid to present sensible analyses and arguments. And I also pointed out that Prime Minister Berlusconi, the boss of Mr. Tremonti, had declared in public that the "Euro has been a disaster for Italy". At which the minister rudely interrupted me again shouting: "You are independent of logic". At that point I decided to ignore him and finished my remarks. The only additional observation I can make now is that the minister did not just personally and rudely insulted me; he also insulted Turkey and the Turks, a civilized country that is following much more radical fiscal policies and economic reforms than Italy in order to join the EU. Moreover, such a public temper tantrum by the deputy prime minister of Italy - something apparently common to him as the italian press has reported - is a major embarrassment for Italy; Italy deserves better in terms of who should lead its economy and represent him in international public forums. As many members in the audience expressed their solidarity to me and their scorn of the minister tantrum after the end of the panel, this sad episode is a reflection of the sadder state of economic policy in Italy. And the Italian press, starting with the respected Corriere della Sera, has now reported this sad incident and scorned the minister for publicly embarassing Italy in a major international forum. Hopefully, since Italy and Italians deserve better rulers than this buffoon that made a fool of himself in public and embarrassed his own entire country, in April they will vote into the dustbin of history this mediocre individual and his entire administration. Certainly with pathetic rulers such himself Italy would be certainly bound to face economic disaster and eventually be forced to ignominiously exit EMU. Italy and Italians deserve better.

But such volte face from GuilioTremonti are nothing new. Take his new found enthusiasm for the euro, for example - in fact only this week he decried his own Prime Minister's earlier view that the Euro was a disaster, and asserted that in his opinion the euro project was a “totally sustainable” one. A conviction which now stands in somewhat strange contrast with the large queues which developed outside banks and ATMs in Italy during the first days of the new currency's existence since due to his then "eurosceptic stance" as economy minister there were marked delays in the introduction of the currency and a huge row about who was to blame in the Italian cabinet. In fact the row lead to the abrupt exit stage left from the Italian government of Foreign Minister Renato Ruggiero who was strongly critical of Tremonti's antics, antics which were implicitly defended by Prime Minister Berlusconi himself in allowing Ruggiero to be ousted.

And I could go on and on, citing, for example, his recent statements to the effect that further stimulus packages have no point since they simply don't work, an attitude which looks rather less the standpoint of a man of principle, and rather more like sour grapes from the Finance Minister of a country which quite simply can't afford any more stimulus due to the imminent threat of credit rating downgrades. The Europen Commission has said it expects Italy’s public debt to rise to 109.3 per cent of GDP this year, up from around 105% next year. This is what happens when you get a 2% contraction, and if we get deflation (falling prices) then things will get even worse without any increase in the actual deficit, and let's try not to think about what the rising cost of borrowing indicated by the credit spreads will mean.

“It’s not right to support demand by raising debt,” Tremonti said in a news conference in Rome. “The economic trend can’t be turned around with stimulus packages. Judging from the U.S., they have worked very little.”

As I said, I could go on and on, but at this point my head is simply spinning with this whirling-dervish-like crasp of the niceties of logical reasoning, so I think I'll leave it there. After all, we do have a crisis out there which we need to make the time to think about.

Italy Slips Slowly But Steadily Into Its Worst Recession In Over 30 Years

The Italian economy continued to contract sharply in the third quarter of 2008 as exports fell sharply - declining at the fastest rate in three years - under the impact of a global slump which weighed down on foreign demand for Italian products, and pushed the Italian economy into its worst recession since at least 1975. Sales of Italian goods abroad fell 1.6 percent from the previous quarter, their biggest decline since 2005.

Pressure is of course on the government to offer a fiscal reponse to the problem, but given Italy's outstanding debt issues and the fact that a large part of the problem is long term structural and not cyclical it is hard to see much of note happening, and indeed Finance Minister Giulio Tremonti's statement this week that additional stimulus packages were pretty pointless could be read as more of an admission of impotence than anything else. What'smore the Italian government announced this week that its budget deficit for 2008 will be 52.9 billion euros, somewhat above the government’s earlier estimate which forecast a gap of 45.2 billion euros. It is not clear yet how this deficit overrun will actually affect the final % of GDP number for the deficit, since we still do not have an accurate 2008 GDP number for Italy yet. In any event speculation is rife about the future of the Italian bond spread and the danger of a credit rating downgrade. The Italian government went to market this week and sold 6.949 billion euros of five-, 20- and 30-year bonds. The 10-year Italian BTP/Bund spread was trading at around 144 basis points after Thursdays auctions compared with 141 basis points the day before.

Severe Limits On Stimulus Packages and Bank Bailouts

This week the government did approve a further 16.6 billion euros in public works investments to try to boost economic growth, but little of this actually represents new spending. The projects include an additional 7.3 billion euros in public spending, together with 9.3 billion euros in private investment. Among other infrastructural works some of the additional funding will go toward building the “Moses” retractable dams that are designed to protect the city of Venice from flooding.

This infrastructure package is in addition to the 5 billion euro stimulus package to help poor families, small businesses and boost bank capital that was agreed to by the Italian parliament earlier in the week. Under the bill a sum of around 2.4 billion euros will be used to help Italy’s poorest families and pensioners, including some one-off cash payments. Highway tolls will be frozen until April 30 and low-income Italians will benefit from tax breaks on utility bills. Small businesses will get a 10 percent break on a regional tax on condition they are already paying a national corporate income tax.

Following warnings to a number of Eurozone government's over credit downgrades from rating agency Standard and Poor's this week Finance Minister Giulio Trementi said on Thursday that Italy won’t follow up its existing stimulus package with more cash injections . Italy currently has the highest debt level in the European Union, which was running over 105 percent of gross domestic product in 2008, according to a Bank of Italy statement today.

Italy’s bank bailout is likely also to be pretty modest in comparison with what is going on elsewhere. The 20 billion-euro bank recapitalization plan will probably start operating next week, according to the news source Il Sole/24 Ore, but details are not available since the Finance Ministry is still “perfecting” the rules and regulations that go with it.

Bleak GDP Growth Outlook In The Short, Medium and Long Term

Italy's economy is expected to shrink by 2 percent this year, making the present contraction the worst in more than three decades, according to the latest forecast from the Bank of Italy. “Taking into account the government measures .... the economy will shrink by 2 percent and then expand 0.5 percent in 2010". The economy’s last annual contraction on this scale was in 1975.

These central bank predictions are the worst to have come out on Italy to date, and significantly above the 1.3 percent contraction being forecast by employers organisation Confindustria and minus 0.6 percent prediction from retail lobby group Confcommercio. It is also a substantial downward revision since only six months ago the central bank was predicting growth of 0.4 percent. Ominously Confcommercio added that “Should the employment situation worsen, we will have to cut these estimates”. Clearly one of the big dangers with the current contraction in the industrial sector is that it lead to large a scale industrial layoffs, and that this then feed back pushing demand downwards.

The Bank of Italy forecast was described as “realistic” by Finance Minister Giulio Tremonti even though his current government forecasts are for an economic expansion of 0.5 percent in 2009. These differences in forecasts are in fact very important, since the government budget is evidently anticipating far higher revenue levels and far lower social expenditure (on unemployment etc) than is likely to be the case.

Fourth Recession In Seven Years

The last GDP report from Italy's statistics office (ISTAT) confirmed that the euro-region’s third-biggest economy slipped into its fourth recession in seven years in Q3 2008. The economy shrank 0.5 percent in the three months through September after contracting 0.4 percent in the previous three months. Imports in Germany and France, Italy’s largest trading partners, declined in October, and the German import decline of 5.6% in November over October (following a decline of 3.7% in October over September) was the biggest slide in almost four years. As a result Italian year-on-year GDP shrank 0.9 percent in the third quarter.

Italian imports fell 0.5 percent in the third quarter while consumer spending barely grew, increasing 0.1 percent in the quarter. Year on year household spending was down 0.6%.


Gross fixed capital formation was down 1.9% on the year - with the machinery and equipment component down 3.5%. Exports fell 3.1% on the year in price adjusted terms.




Manufacturing Contraction


And as we look forward all the short term data is deteriorating. Industrial production fell yet again in November with output dropping a seasonally adjusted 2.3 percent from October, while production adjusted for working days fell 9.7 percent when compared with November 2007, the biggest drop since 1991.


And if we look at the index, we can see that output has now been trending down since the end of 2006.




And survey data from December suggest the Italian manufacturing sector remained mired in recession as output, new orders, new export orders, backlogs, employment and purchasing activity all contracted. The headline seasonally adjusted Markit/ADACI Purchasing Managers’ Index (PMI) came in at 35.5 in December. Even though this was marginally up from the 34.9 recorded in November, it was the still second-lowest reading recorded in the history of the survey.


And it was the ninth consecutive monthly contraction in production volumes. In their report Markit state that the continued downturn in new business appeared to be the key driver, as firms reduced output in line with falling demand. Steep falls were reported in new business from both domestic and foreign markets. Overall, new order books fell for a 12th successive month, albeit at a slightly weaker rate than November’s series record. And perhaps most worryingly given Italy's need to export, new orders from export markets fell at the fastest pace in the survey history.

Protracted falls in incoming work and production volumes resulted in a further month of job-shedding in December. Moreover, the rate of job losses was the fastest in the history of the series. There was also some evidence from those interviewed that redundancy programs had been implemented over the month and that the non-essential workforce had been reduced.

Commenting on the Italy Manufacturing PMI survey data, Andrew Self, economist at Markit Economics, said: “While December’s fall in output was less pronounced
than November’s series record, the rate at which the manufacturing economy has
contracted throughout Q4 is alarming. Italian manufacturers will hope that the
fiscal packages announced throughout Europe in December will mark the turning
point of the recession. However, with new orders still falling in domestic and
foreign markets the downturn looks set to continue into 2009.”

The Services Sector Also Continues to Contract

Italy's service sector also contracted sharply in December (for the 13th consecutive month), although as with manufacturing the rate was marginally slower rate than the record low hit in November, and the Markit Purchasing Managers Index edged up to 40.3 from 39.5 in November. Again this was still the second lowest level in the survey's 11-year history and well below the 50 divide between growth and contraction.

The index has now not been above the 50 mark that separates growth from contraction since November 2007 and the latest survey, like its companion PMI for the manufacturing sector, offered no evidence whatsoever of recovery.

"December ... painted a gloomy picture of the Italian services economy as,
throughout the final quarter of 2008, activity contracted at rates unprecedented
in the 11-year survey history," said Andrew Self, economist at Markit Economics.

Retail Sales Contract For The 22nd Consecutive Month

Italian retail sales contracted for a 22nd month in December as the Bloomberg retail sales PMI rose slightlly - to 31.9 from 28.5 .The index, based on a survey of 440 executives prepared by Markit Economics, also showed annual sales fell at the fastest pace in the near five-year history of the data.

Declining sales prompted retailers to cut staff for a 12th consecutive month, the report also said, and the rate at which staff numbers were reduced was the fastest since Markit first compiled the data in January 2004. In the third quarter the number of Italians out of work rose and the unemployment rate held at two-year high of 6.7 percent. Joblessness will rise to 6.9 percent in 2008, the highest in three years, from 6.2 percent in 2007, the Organization for Economic Cooperation and Development estimated on Nov. 25.


Falling Consumer and Business Confidence

Italian business confidence fell to a record low in December, and the Isae Institute’s business confidence index dropped to 66.6 from a revised 71.6 in November.

“These figures are consistent with the picture of a deep recession in
manufacturing industry,” said Paolo Mameli, an economist at Intesa Sanpaolo in
Milan. “As there is usually a three-month gap between this data and the
industrial production, we forecast that the economy will contract further next
year and won’t resume growing anyway until the last quarter of 2009.”

About 13 percent of Italian companies trying to get loans don't receive them, either because banks refuse to lend to them or because the costs involved are considered excessive by the company, Isae say in data which accompanies this months report.


Italian consumer confidence also fell in December its level in four months on concern that the recession and the decline in industrial activity would increase unemployment, with the Isae Institute’s consumer confidence index falling to 99.6 from 100.4 in November.




Inflation Falling Back But No Sign Of Deflation Yet

Italy’s inflation rate fell to its lowest level in 14 months in December, as energy costs fell sharply and the recession made it harder for retailers to raise prices. Consumer prices as measured by the EU's HICP rose 2.3 percent from a year earlier, compared with a 2.7 percent rise in November. When compared with November prices were down 0.2 percent.

So Where Does That Leave US - With Very Little (If Any) Growth In the Future, That's Where It Leaves Us!


Unlike many other Eurozone economies, Italy's current contraction in activity is not a simple result of the global economic slowdown. Itay's problems are endemic, and ongoing: hence the four recessions in seven years. Trend growth in Italy has been slowing over the last few decades, and must now be near to zero. Which raises the question as to whether in the coming decade Italy's trend growth could turn negative, with GDP simply contracting from one year to the next.
Obviously this possibility is only a theoretical one at the present time, but it is one which cannot be entirely included, especially when we look at how - despite all the promises that things would change - trend growth has steadily drifted to zero. Ceratinly also there are reasons to imagine that the productive capacity of the Italian population could drop as median population rises. Italy is currently among the three oldest societies on the globe - with median age of 43, and Germany and Japan being the other two - and as we saw at the start of this post, Italy has not been able to raise its export prowess in the way the other two have. And if it hasn't been able to do this over the last 15 years or so, what good reasons are there for thinking that Italy may start now?



S&P and Fitch last reduced Italy's credit rating in October 2006, with S&P reducing the rating to A+ (with negative outlook), the third-lowest of the eurozone countries after Greece and Slovakia, while Fitch dropped it to AA- from AA. Moody’s Investors Service rates Italian debt Aa2, with a “stable” outlook. In November 2005 the ECB announced that would not accept government paper (bonds) in the future from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies. Which means of course that Greek sovereign bonds are now very vulnerable to losing acceptable asset status in the longer run, but that Italy is not far behind.

In fact back in October last year, the ECB announced that the Eurosystem would lower the credit threshold for marketable and non-marketable assets from A- to BBB-, with the exception of asset-backed securities (ABS), and impose a haircut add-on of 5% on all assets rated BBB-. But it is important to bear in mind that this expansion of eligible collateral is temporary: “The list of assets eligible as collateral in Eurosystem credit operations will be expanded as set out below, with this expansion remaining into force until the end of 2009.” While it is perfectly possible that the ECB will extend this temporary relaxation of credit thresholds for the duration of the current crisis, the problem of default risk in the most vulnerable economies is likely to outlive the current crisis, and the ECB relaxation is unlikely to last indefinitely.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has now ballooned to the widest since before they joined the euro. In the graph below you can see ten year bond spreads for Greek, Irish and Spanish government paper as compared with the benchmark German Bund.


The yield on Spain’s 10-year bond averaged 8.5 percent in the six years before it joined the euro and the gap with the equivalent German bond was 246 basis points. In the next eight years, the average yield fell to 4.5 percent and the spread to 13 basis points. That convergence is now being thrown into reverse. In the past week, Standard & Poor’s has downgraded Greece’s credit rating, and those of Portugal and Spain are also under threat. The difference between the Spanish and German 10-year bonds rose to 115 basis points today, the highest since 1997. The spread on Italy’s bond at 144 basis points was the most in 12 years and the Greek spread was the most since 1999.

Different economists take differing views on the implications of this development. The LSE's Willem Buiter argues that the widening of the spreads is a good sign, as it shows that market mechanisms are finally working. In the past the problem had been the way that markets assumed for too long that governments would be bailed out if they defaulted. But RGE Monitor's Nouriel Roubini makes the very valid point that if financial markets get concerned about the risks of exits, a vicious circle of rising rates and poor debt dynamics may force exit regardless of the will to stay in. The effects can be very similar to a currency crisis or a self-fulfilling run on the government debt or the banking system. Basically, countries like Italy and Portugal have quite low trend growth rates as it is, if fiscal support is withdrawn and bond spreads rise this can easily produce a lose-lose dynamic which virtually forces default.

And this is without any reference to the negative feedback effects that can be produced by the health and pension spending required to meet the needs of a rising elderly support ratio, and a lower productivity from a working population with a higher median age. All in all, a very difficult can of worms for everyone to get to work on.

Unicredit Shares Fall Again, Merrill Lynch Downgrades

At the present time the Achilles heel of the Italian economy has a name, and it is called Unicredit. In a number of posts on this blog (here, here, here, here) I have tried to draw attention to the potential problem the deteriorating balance sheet of what is now Italy's second bank by market capitalisation (after Intesa Sanpaolo) it used to be the first before the shares fell) and first bank by assets, and how this issue is exaccerbated by the fiscal embarassment of the Italian state.





The spread between Italian and German 10-year bonds hovered around 1.36 percentage points on Monday, more than four times its average over the euro's first eight years. Continuing social unrest in Greece has also pushed the gap between the yield on that country's 10-year bond and that of its German counterpart to a fresh high of more than two percentage points (see much more on Greece here).

At the same time, the cost of buying insurance on Spanish, Italian and Greek debt has more than tripled over the past six months, according to credit information firm Markit Group. Even as the market turmoil has eased in recent weeks, the price of such insurance on Southern European debt has continued to increase, touching highs earlier this month. The widening spreads and increasing insurance costs show opinions among investors about the short term outloook now vary considerably between one eurozone country and another.

Such widening spreads mean more expensive bond auctions for the Italian government in the future, and this is just where the trouble comes, since Italy has a very hefty accumulated debt to continually refinance (around 105% of GDP), and it is partly because investors don't see clearly how a government with a damaged banking system and an economy which looks set to shrink for at least two years can continue shoulder the weight of this debt let alone increase it, especially given the evident difficulty faced by the Italian government in enforcing measures to reduce it, that the widening is occuring.

And this is what makes Unicredit such a major headache for the Italian government, since any substantial increase in government borrowing needs could become completely counter productive if it precipitated an increase in the spread and thus an increase in the costs of borrowing over all those parts of the debt which fall due for refinancing.


Unicredit 2008 Earnings Won't Meet Target


Unicredit shares fell in Milan trading this morning after the bank admitted 2008 earnings won’t meet their target. Unicredit shares were down as much as 4.7 percent - to 1.52 euros at one point - their lowest price since 5 December, and were trading at 1.55 euros (down 2.6 percent) in Milan, giving it a market value of 20.7 billion euros. UniCredit said in a statement late yesterday that it expects net income of 4 billion euros in 2008, excluding a property sale that will be smaller than planned. The company in October forecast net income of 5.2 billion euros.

UniCredit recently reached an agreement with unions to offer early retirement to 3,700 workers in an attempt to cut costs amid the global financial crisis, and last week they bank pulled out of an option they had to buy the Polish government's remaining 3.95 percent stake in Bank Pekao in order to not put more strain on the bank's solvency ratios.


Merrill Lynch Downgrade

Unicredit was downgraded to "neutral" from "buy" by analysts at Merrill Lynch this morning. The bank cited “the fast deteriorating macro picture in Italy and Central Eastern Europe”

“The high exposure to Central Eastern Europe and to the corporate business result in UniCredit above average sensitivity to the poor macro environment and to asset quality deterioration,” London-based analysts Antonio Guglielmi and Andrea Filtri wrote in a note to investors today.

Ukraine Clients May Default On 60% Of Loans

A 44 percent slide so far this year in the Ukraine currency, the hryvnia, is threatening the repayment of loans and mortgages denominated in foreign currencies. Roman Zhukovskyi, head of the social and economic department in President Viktor Yushchenko’s office, estimated in a televised press conference in Kiev on Wednesday that if the hryvnia traded near 9 per dollar, some 60 percent of loans may not be repaid.

“A substantially weaker hryvnia is going to seriously hurt corporations since Ukrainian companies have massive external liabilities,” said Ozgur Yasar Guyuldar, a senior emerging markets strategist in Vienna at Raiffeisen Centrobank AG, who forecast the decline to below 9 per dollar in November. “It is inevitable to see dozens of corporate bankruptcies.”

In an attempt to soften the devaluation blow and bolster the currency Ukraine’s central bank raised its refinancing rates for the second time in two days today to 22% after the hryvnia fell as much as 16 percent in the past two days. But this is likely to be of little avail given that the economy is already headed for an estimated 5% GDP contraction in 2009, and these kind of interest rates make any softening of the economic slump impossible.

Of course the meltdown which is taking place in the East at the moment does have its own special surreal dimension, since while Merrill Lynch analysts in Italy are busy pushing down Unicredit's share price, Unicredit analysts in Moscow are busy biting the hand (in Italy) that feeds them by downgrading the Russian property market, and with it the Russian property developers, whose defaults will, in their turn, drive Unicredit's share price in Italy down even further.

Russian property stocks slid in Moscow trading after UniCredit SpA said real-estate prices are so inflated they may need to be halved to lure buyers back to the housing market. OAO Sistema Hals, the developer controlled by Russian billionaire Vladimir Yevtushenkov, slid as much as 11 percent to 319 rubles, as UniCredit called Moscow’s property market “overheated.”

Ukraine is just one - at this point extreme - example of the kind of level of default we can see among holders of forex loans across Central and Eastern Europe in 2009, and Unicredit is in the forfront of the exposure to these defaults, which means, effectively, that the medium term future of the Italian economy at this point in the hands of the CEE countries. Which is why Italy's biggest economic headache has a name, and that name if Unicredit.