Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:

Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.

There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research

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The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB, Investing.com

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics

Source: Investing.com

Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.

RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.

Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.

Source: Investing.com

But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.

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Improvements in the euro area credit conditions should not be ignored

While there is almost no coverage of this topic in the financial media and the blogosphere, credit conditions in the Eurozone are showing marked improvements. This is an unpopular view these days, but ignoring the trend results in an incomplete view of the area's economy and markets. Here are the key indicators:

1. Credit supply/demand fundamentals are trending in the positive direction. Loan demand has improved dramatically and credit standards are looser than at any time since the Great Recession.

This shows indicators for corporate loans and residential mortgages (source: ECB)

2. Since the conclusion of ECB's stress tests in early 2014 (which had been a major source of uncertainty for banks in 2013), loan balances in the Eurozone are beginning to stabilize. Corporate loans are still declining (as maturing loans are not being fully replaced by new loans) but at a much slower rate. These improvements are of course dwarfed by credit expansion in the US where loan balances are growing at over 8% per year (see chart). Nevertheless, the painful deleveraging process in the euro area's banking system is coming to an end.

Source: ECB (adjusted for sales and securitization)

3. Lending rates in the Eurozone periphery are declining sharply. The so-called "monetary transmission" of zero ECB policy rate into rates paid by borrowers is still not great, but the process is starting to work.

Source: @sobata416 

4. Corporate capital markets flows in the EU have jumped recently and a number of Eurozone-based companies will benefit from this trend. Cash-rich euro area investors are shopping for yield and now there is some demand from the corporate sector.

Source:  @lcdnews 

5. Perhaps the best indicator of credit expansion and diminishing effects of bank deleveraging is the growth in the Eurozone's broad money supply. The improvements which followed the ECB's stress tests have been impressive.

Source: Investing.com

Why then do we need such an aggressive monetary response from the ECB? The answer has to do with rising deflationary risks in the euro area. While some have associated falling inflation with sharp declines in energy prices, the issue in the Eurozone is broader than energy (see "core" CPI). And deflation could easily extinguish this nascent improvement in credit.

Clearly the area faces significant headwinds such as the mess related to Greece. Rising probability of "Grexit" for example could dampen lending in other nations. The improvements to date however have been impressive and should not be ignored.

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The ECB focusing on downside risks

The ECB struck a dovish tone this morning, with Draghi hinting that the Governing Council is prepared to take action.

BBC: - He said that the 24-member ECB council was "dissatisfied about the projected path of inflation" and is "not resigned to have too low inflation for too long a time".

... he added that the ECB was "comfortable with acting next time", raising expectations that the bank could alter policy in June.

Eurozone bonds rallied in response, with periphery yields hitting new lows.

10y Spanish government bond yield (source: Investing.com)

The ECB is becoming inpatient with the so-called "creditless" recovery (see post), as pressure mounts on the central bank to take action. This is exacerbated by external factors such as China's slowdown and the situation in Ukraine.

Draghi: - ... although labor markets have stabilized and shown the first signs of improvement, unemployment remains high in the euro area and, overall, unutilized capacity continues to be sizable. Moreover, the annual rate of change of MFI loans to the private sector remained negative in March and the necessary balance sheet adjustments in the public and private sectors continue to weigh on the pace of the economic recovery.

The risks surrounding the economic outlook for the euro area continue to be on the downside. Geopolitical risks, as well as developments in global financial markets and emerging market economies, may have the potential to affect economic conditions negatively. Other downside risks include weaker than expected domestic demand and insufficient implementation of structural reforms in euro area countries, as well as weaker export growth.

However it remains unclear what options the ECB really has. A traditional bond buying program could be difficult, given the unease in the Eurozone core with the central bank taking on more periphery credit risk. And a program focused on ABS and other consumer and corporate credit products will be limited in scope (see post).

GS: - ... in line with Mr. Draghi’s recent signals to German parliamentarians, a large-scale asset purchase programme Fed-style remains unlikely in our view (around 15% probability for such measures through year-end). However, the likelihood of some targeted asset purchases in specific financial market segments is higher (we attach a 25% probability).

The ECB is hoping that this dovish language by itself will ease monetary conditions. It has worked so far by lowering bond yields and capping euro's appreciation. But with the Eurosystem's balance sheet continuing to decline (draining liquidity), will talk be enough?

Eurosystem consolidated balance sheet (source: ECB)

See the full video of Draghi's speech below:

The unprecedented chase for yield

The major market surprise of 2014 so far has been the extent of investors' appetite for yield in the developed fixed income markets. It has been quite spectacular. The Eurozone in particular has been a key beneficiary of this trend. We've seen German government bond yields hit a low not seen in almost a year (see Twitter post), but the real action has taken place in the periphery bonds. We are seeing multi-year and even all-time lows in government bond yields.

Source: Investing.com

And this trend is not limited to sovereign paper. European corporate high yield bonds are now yielding  just over 3.6% on average - a record low. Let's just put this in perspective - this is sub-investment-grade paper trading at these levels.

While European fixed income markets clearly feel frothy, it is not clear if there is a near-term catalyst to bring about a correction. With the Eurozone inflation still MIA, capital seems to be chasing anything with a reasonable yield. The shift in attitudes from just two years ago is unprecedented.

Bloomberg: - “We’re still in a world where investors are starved of return,” said John Wraith, a fixed-income strategist at Bank of America Corp. in London. “People are still happy to diversify their holdings and buy bonds that not so long ago they would have shied away from. The slightly better data helps reassure people that finally some of these weaker countries are turning a corner.”

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Why is the ECB hesitating on monetary easing?

The Eurozone's unemployment rate is at 12% and holding while the area's youth unemployment is at staggering 24%. Private lending is still contracting (see post) and disinflationary pressures persist even within the "core" states (see chart). The price stability situation in the "periphery" is starting to look outright deflationary - see chart.  The euro is still at mulit-year highs, putting pressure on the area's export businesses. At the same time monetary conditions continue to tighten as the area's central banking system balance sheet approaches pre-LTRO levels.

unit = mm € (source: ECB)

Given the situation, most central bankers would take action. A simple policy change for example could be to suspend the sterilization of securities already held by Eurosystem - see post. But the ECB is hesitating. Why? Here are some reasons:

1. This may upset some folks but the reality is that the ECB is notoriously indecisive as it is pulled into various directions by the member states. Many forget that the institution is relatively new (just over 15 years in existence) and the shock of the recent crisis had left the organization a bit paralyzed. It rarely takes a decisive action unless it's forced by the markets to do so. The decision to "save the euro" only arose as Spain approached the point of "no return".

2. The ECB is also somewhat distracted as it prepares to take on the massive task of regulating the area's banking system - a responsibility that was not initially part of the central bank's charter.

3. The ECB does not have the dual mandate of the Fed and is only focused on price stability. The central bank views the area's horrible unemployment problem as being outside of its "jurisdiction". While technically correct, many central bankers would regard this narrow interpretation of the rules as shortsighted.

4. The hawks at the ECB continue to view the disinflationary pressures in the euro area as transient.

Reuters: - The ECB is running official interest rates at a record low but unlike other major central banks has resisted calls to follow that move with outright "quantitative easing" to pump more money into the economy.

[Bundesbank President Jens] Weidmann said that about two thirds of the falloff in euro zone inflation to 0.7 percent, the lowest since the economy was deep in recession in 2009, could be attributed to falls in energy and food prices.

"Monetary policy should respond to such factors only in the event of second round effects," he told a conference in Berlin, saying he would not talk about current monetary policy ahead of the ECB's monthly policy meeting next Thursday.

"With regard to the rate of inflation at the moment, the euro area is not in a self-enforcing downward spiral of price decreases, which is nominally the definition of deflation," he said.

5. The ECB has been heavily focused on the recent improvements in corporate growth, particularly the PMI indicators. Markit indices for example show a steady recovery from the 2012 lows.

Mario Draghi has been speaking about these improvements lately but he continues to ignore some warning signs hidden in these numbers.

Markit: - Policymakers will be encouraged by the survey in terms of the signs of sustained recovery. However, concerns will persist regarding the deflationary forces, especially in the periphery. With prices charged by manufacturers and service providers both falling again in March, there remains an argument for further stimulus, especially if the rate of growth of activity cools again in April.

6. The central bank is also hanging its hat on improving sentiment surveys in the euro area - see Twitter post. The thought is that if consumers and businesses are happy, credit growth will somehow stabilize. Perhaps. But the mood of these crisis-weary survey participants can easily turn if the area's labor markets do not heal soon.

7. The policymakers are also betting on the fact that the rapidly falling long-term rates in the Eurozone periphery will provide some "natural" stimulus to the area's economy. Indeed, as the markets perceive lower risks of default, the yield declines on longer-dated periphery sovereign paper have been quite spectacular. The OMT backstop provided by the ECB has certainly helped.

Source: Investing.com

The reason behind these recent sharp declines in yield however has to do with bets on disinflationary pressures and a subsequent easing action by the ECB.

Reuters: - Spanish, Italian and Portuguese bond yields hit multi-year lows on Thursday, with speculation about further European Central Bank monetary policy easing prompting investors to seek the bigger returns offered by lower-rated assets.

Should the ECB fail to act, these yields will inevitably rise. It is also important to note that low government borrowing costs are no guarantee of stimulus to the private sector. The private sector can not or is unwilling to borrow, reducing the impact of lower benchmark rates.

Ultimately the ECB could be right and some day, as the banking system is "restructured", the Eurozone's economy will heal itself. But that was also the attitude in Japan years ago when the nation undertook its banking reform. Yet deflation in Japan persisted for years since then, becoming heavily entrenched in the economy. Is the ECB now willing to take that chance?

Update: More CPI results from the Eurozone are out this morning.

a. Here is the latest aggregate euro area CPI result.
b. Below is the CPI measure for Italy:

Source: Investing.com

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Moody's upgrades Greek government debt

Yesterday the Eurozone received some positive (though largely symbolic) news. Moody's decided to upgrade the rating on Greek government debt from C to Caa3. It's an important psychological step for the area because Greece was the flashpoint for the Eurozone crisis. Here is the rationale for Moody's action:

Moodys: - 

(1) The significant fiscal consolidation that has taken place under Greece's structural adjustment program despite low growth and political uncertainty. As a result, Moody's expects that the government will achieve (and possibly outperform) its target of a primary balance in 2013, and record a surplus in 2014 in accordance with the adjustment program.

(2) The improvement in Greece's medium-term economic outlook supported by a cyclical recovery in the economy and also the progress made in implementing structural reforms and rebalancing the economy.

(3) The significant reduction of the government's interest burden following previous restructurings and official sector repayment assistance.

To be sure, most economic data out of Greece continues to resemble a full-scale depression. The unemployment rate is at 27% and youth unemployment is at 57%. Credit to the private sector has fallen 56% from the peak and continues to decline. Manufacturing, new orders, industrial production, retail sales, etc. are all contracting (though the rate of contraction has slowed). Moody's nevertheless is betting on the following:

1. The country's debt to GDP ratio, while still horrible, seems to be moving in the right direction.

2. With the domestic demand in shambles, the nation's current account is in the black. To the extent some of the planned reforms are implemented, the economy could benefit from this trend. Also as discussed last summer (see post), Greek businesses have been showing surprising optimism. Moody's is hoping that all this will eventually translate into a "cyclical recovery in the economy".

3. As discussed last year (see post), the restructured Greek government debt (including the EU/EFSF loans) carries extraordinarily low interest burden and extended maturities, giving the Greek government a great deal of flexibility. This is Moody's third reason for the rating upgrade.

The bond markets have been reflecting these improvements for some time and the upgrade should have relatively little impact on yields.

Greek 10y government bond yield (source: Tradingeconomics.com)

While the upgrade comes as welcomed news, major risks to Greek economic recovery and fiscal stabilization remain. Apart from some nasty political risks (see story) as well as pressure from the Eurozone leadership and the IMF, Greece is facing two key concerns that are tied into the rest of the Eurozone periphery:

1. The banking system remains all but frozen, with nonperforming loans, undercapitalization, and poor deposit base hampering credit creation. Achieving a sustainable economic recovery will be extraordinarily difficult unless this issue is addressed.



2. Persistent strength in the euro (in spite of tepid economic data) is believed to be detracting from the overall economic growth across the Eurozone. Strong currency is particularly painful for the more vulnerable nations that depend on exports. Further increases in the value of the euro could make the situation worse.

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ECB contemplating new LTRO - with a twist

As discussed back in September (see post), the ECB may be forced to take further action in an attempt to reignite the area's recovery. The central bank's consolidated balance sheet is continuing to decline and many are blaming this reduced liquidity for the area's weak credit growth as well as tepid and uneven economic expansion.

It was therefore not too surprising to hear that the ECB is in fact discussing taking further non-conventional policy measures.

Reuters: - The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources.

ECB President Mario Draghi and other Governing Council members have repeatedly mentioned the option of conducting more liquidity operations, or LTROs, to help the fragile euro zone economy and ensure the flow of credit to the private sector.

A few months ago some economists were hoping that the relentless decline in credit growth in the Eurozone may have bottomed. The year-over-year changes in the area's loan balances have turned in the right direction. Unfortunately the latest data show that not to be the case - both in corporate and consumer lending.

Source: ECB

This lack of credit expansion is a dangerous trend that could result in years of Japan-style stagnation. In order to address it, one approach the ECB is contemplating is forcing the banking system to use the new LTRO proceeds to provide capital into the consumer or corporate sector.

Reuters: - The ECB extended more than one trillion euros ($1.36 trillion) of cheap three-year loans to banks through two long-term refinancing operations in late 2011 and early 2012.

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The new LTRO could also run for only nine or 12 months, the paper said.

The news came after ECB policymakers said last week they were open to taking fresh measures to support the euro zone economy, where inflation is running well below target [see discussion].

It's difficult to know if this program will work. Banks are under pressure to shrink risk weighted assets to comply with the new Basel accord. And retail and corporate (particularly unrated smaller firms) loans tend to attract significant amounts of regulatory capital (risk weight) charges. It's much easier for a Eurozone periphery bank to buy its government's bonds - with almost no regulatory capital impact - than to lend to small firms and households. Therefore many banks may forgo the new LTRO that has such strings attached. Nevertheless it seems that the ECB may be willing to try.

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From our sponsor:

Eurozone's falling excess reserves - is another round of LTRO required?

The euro area banking system excess reserves are continuing to decline - touching the lowest level since 2011.

Just to put this in perspective, the chart below shows excess reserves in the US. With the Fed continuing to pump liquidity into the system, these swelled above $2.3 trillion last week - a new record.

The reason the Eurozone reserves are declining has to do with the area's banks gradually repaying what they have borrowed from the Eurosystem via MRO and LTRO loans.

Source: ECB

Some economists view this decline in excess reserves as an indication of tighter monetary conditions in the Eurozone. They point to weak consumer credit growth and a severe contraction in corporate lending.

YoY change in loans to euro area households (source: ECB)

YoY change in loans to euro area companies (source: ECB)

A few economists have called for Mario Draghi to offer up another round of LTRO lending or lower the rates on MRO (short-term) loans in order to boost excess reserves. The thought is for the ECB to follow the Fed's and the BOJ's lead at the October meeting and expand its balance sheet.

Such action however is unlikely at the next meeting. Certainly if these declining excess reserves push up rates, the ECB will have to act. But the central bank does not have the Fed's dual mandate and is not as focused on the Eurozone's dangerously high unemployment levels. Instead Draghi will concentrate on forward guidance of maintaining low overnight rates for the foreseeable future. The ECB will want to keep the LTRO tool in its back-pocket in case the crisis flares up again. After all, there is a nonzero risk of the German Constitutional Court ruling against the OMT program (ECB's commitment to directly purchase government bonds of periphery nations). Other issues, such as political uncertainty in Italy (see post), could potentially reignite the crisis as well.

For now Draghi will want to see if the Eurozone's credit markets can begin to "heal" themselves. The members of the Governing Council are following a number of business surveys which seem to point to stabilization in the area periphery nations.

Source: Econoday

If however lending volumes do not show a visible improvement in the next few months, another LTRO program could be in the works at a later date.

Bloomberg: - Frederik Ducrozet, an economist at Credit Agricole CIB in Paris says an LTRO is unlikely until December. The central bank could boost its forward guidance by putting a definite end date for loans at a particular cost, by issuing an LTRO with a fixed rate, he said. The previous loans were charged at the average of the ECB benchmark over the maturity.

‘‘A properly-designed LTRO would have the potential to kill several birds with one stone by enhancing forward guidance, keeping excess liquidity higher for longer, and further boosting the use of collateral from small businesses,’’ Ducrozet said.

ECB officials including Executive Board member Benoit Coeure have played down the short-term likelihood of a new round of long-term loans, saying that while it remained an option, it hasn’t been specifically discussed. The ECB’s Governing Council convenes in Paris on Oct. 2 for its monthly rate-setting meeting.

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Spain-Italy 10-year spread drops below zero

In the spring of 2012, Spain's 4th largest bank Bankia requested a bailout of €19 billion and it became clear that the whole of Spanish banking system will need government support. The world's markets had suddenly shifted their attention from Italy to Spain as the next hot spot in the Eurozone crisis. Spain-Italy 10yr government bond spread spiked, quickly turning positive.

In recent days however the spread became negative again. Italy is now viewed as being riskier than Spain.

This trend seems a bit surprising since the fiscal situation of Spain is thought to be worse than that of Italy. While Italy's current debt levels are higher in absolute terms as well as a percentage of the GDP, Spain's government deficit is far worse.

Source: Scotiabank

At this stage however Italy's poor economic recovery and political mess make Spain a better risk - on a relative basis of course. Both nations are struggling with an extraordinarily long economic contraction that started in 2011. But it recently became clear that Italy's recovery is materially slower of the two.

Source: Eurostat

And last week Italy surprised the markets with a sharp downturn in industrial production that contributed to the poor result for the euro area as a whole (see Twitter chart).

Source: Eurostat

But how does one reconcile all this with the fact that Spain runs just over 26% unemployment rate, while Italy's rate is around 12%? This takes us back to the question of how Spain got its ridiculously high unemployment to begin with. It has to do with the nation's high temporary workforce which provides corporations with better labor flexibility (see post). And this ability to lay off workers and lower prices during a slowdown and quickly rehire them when the situation improves makes Spanish firms more competitive on average.  This competitive advantage is in part why Spain's export growth has outpaced that of Italy.

Source: Scotiabank

It also doesn't help Italy's case when political uncertainty raises the risk of another debt crisis flaring up. And as always, Italy's most powerful crook, Berlusconi (see post), is at the center of it all.

Reuters: - European Union officials warned Italy on Sunday not to let politics ruin recovery prospects and upset debt markets in a week that could signal the end of Erico Letta's fragile five-month-old government.
... 

"I believe it is of paramount importance to keep political stability in the country to ensure a recovery, mainly because the latest data show the economy remains relativity weak, without clearly indicating a return to growth," Rehn, the EU's top economic official, told Italian business daily Il Sole 24 Ore.

Italian industrial output was much weaker than expected in July, falling 1.1 percent and undermining expectations that the country might emerge from its longest post-war recession in the third quarter.

Political instability has thwarted attempts to make the economy more competitive and whittle down Italy's government debt burden, one of the world's biggest.

Berlusconi's centre-right allies have threatened to sink the government if Wednesday's vote goes against him.

While both nations are far from economic stability, political uncertainty and weak recovery make Italy's situation look worse than Spain's. Sensing this dynamic, markets took the Spain-Italy spread into negative territory.

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