Disentangling the nature of Italy’s capital flights

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna


Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks' accounting method continues to prove elusive. Even the same ECB is explicitly warning not to infer bold assumptions from analysis of these data since simplistic explanations could lead to wrong conclusions.

Some academic research on the importance of Target2 balances has progressed considerably from the seminal but disputed work of Sinn (2012). The Sinn research has the merit in attracting attention on the relationship between the current accounts and the Target2 balances of Eurozone countries. A surplus in the current account should lead to a positive Target2 net balance, and vice versa. In this perspective, the Sinn research considers the Target2 balances in terms of a “stealth bail-out” of peripheral countries by the creditor central banks. According to Sinn, in the case a “debtor” central bank would leave the Eurosystem, the Target2 net balance would become immediately payable. A subsequent default of the debtor central bank would turn into a net loss for the Eurosystem to be absorbed jointly by all the remaining members (risk mutualisation or risk-sharing). Whelan (2012 and 2014) contested this view in many papers, pointing out that any central bank can always operate with “negative equity” (in other terms it could offset losses "printing money", without fiscal transfers from the taxpayers).  Now it seems understood (Szécsényi, 2015) that Target2 assets and liabilities could eventually lead to losses in case of a Euro break-up, but these should be a lot less than the raw net imbalances suggest.

At the present, a large part of the financial community seems to acknowledge that diverging net balances in the last two years are driven by purely financial transactions.  The current accounts of Eurozone countries are mainly in surplus (see Figure 2) due to the depreciating Euro and the compression of the level of prices and wages in the periphery (i.e. a phenomenon also known as internal devaluation). Hence, it could be inferred that the intra-European trade between Germany and the periphery (the Sinn hypothesis) is not the leading factor in explaining Target2 net balances.

Figure 3.

Digging deeper, it’s interesting to highlight also the strong correlation between the size of the ECB balance sheet and NCBs Target2 numbers. When the ECB inflates its accounts via expansionary measures, newly created money flows towards Eurozone banks that use it to regulate different kinds of transactions. When they are settled and accounted, these operations produce variations in the Target2 net balances. Let’s investigate the Italy’s case. As Figure 4 clearly depicts, Italy’s Target2 net balance and central bank balance sheet show a 96% correlation between 2011 and 2016.

Figure 4.

In the pursuit to understand movements in Italy's Target2 net balance, a detailed decomposition has been calculated by exploiting financial account data from the balance of payments (see Figure 5). The reconstruction has a good degree of precision, with little unexplained residual flows (the orange bars).

Figure 5.

In 2011 and 2012, core Eurozone banks sold significant amounts of Italian government bonds on the secondary markets because of an augmented perception of Italy’s credit risk (the green bars grew quickly). Those bonds were then purchased by Italian banks, which increased their exposure to national public debt. At the same time, German banks were deleveraging from long-term commercial credit exposure to Southern Europe. Net borrowing by the Italian banks on the Euro area interbank market also decreased markedly, due to the substantial reduction of deposits abroad and the missed renewals of existing loans. These phenomena (together with a progressively higher cost of financing) were signaling stress on the Italian banking sector’s funding practices  (the yellow bars). Together, this led to large capital outflow from Italy to the Eurozone core (denoted with a positive sign in core Target2 accounts; vice versa for Italy). The ECB’s LTROs and other unconventional measures have supplied over € 1 trillion to the Eurozone banks (€ 270 billion to Italy alone) that have been employed to finance the capital flight and transfer risk from the German banking system to the ECB.

When LTROs repayments began in 2013, the ECB balance sheets gradually deflated along with the Target2 net balances. Foreign investment in the Italian public sector resumed, though it did not reach previous levels. The missing amounts were partially compensated by a positive influx of foreign money in the private sector (sky blue bars). The divergence returned in June 2014 when Mr. Draghi launched the new T-LTROs in an effort to revive the sluggish Eurozone credit growth. In March 2015, PSPP’s launch accelerated the growth of ECB assets and had widened the spread between Target2 net balances.

New money flows (TLTROs loans and revenues from the selling of government bonds) reached Eurozone banks but only partially were employed to increase the exposure on national government bonds. A new source of capital flows has emerged and become the primary driver of Italy Target2 negative net balance: a shift in Italy’s private non-banking sector from government and banking bonds to foreign shares and mutual funds.  Looking closer at Figure 6, one can infer that the Target2 net balance (blue line) was only affected by the sell-off and the subsequent repurchase of Italian government bonds (green line) until June 2014. Afterward, foreign investment by the non-banking sector (red line) played a larger role in dragging down the Target2 balance. Moreover, the last few months of decline could be attributed to a renewed – albeit moderate – flight from government bonds.

Figure 6.

As of the beginning of 2016, over € 180 billion has shifted from Italy towards mutual funds located in Luxembourg, Netherlands and Germany. Only 20% of them can be traced back to Italian entities (i.e. round trip funds). The hunt for yield in a unprecedently low-interest-rate environment can only explain part of this sustained capital flight towards Northern Europe. Subtle but persistent redenomination risk (the risk that a euro asset will be redenominated into a devalued legacy currency after a partial or total Euro break-up) affecting Italian assets. Moreover, the fear of adverse effects of the bail-in regulation that came into effect in January 2016 may have had a meaningful role in explaining this massive portfolio readjustment by the private non-banking sector.
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References and Further Readings:

Publication of TARGET balances (2015) https://www.ecb.europa.eu/pub/pdf/other/eb201506_focus04.en.pdf.

Minenna et al. (2016 - forthcoming) “The Incomplete Currency: The Future of the Euro and Solutions for the Eurozone”, Wiley.

Sinn H.-W., Wollmershäuser T. (2012b), “Target balances and the German financial account in light of the European balance-of-Payments crisis”, CESifo Working Paper No. 4051, December.

Szécsényi P. (2015), “Nature of TARGET2 Imbalances”, https://www.asz.hu/storage/files/files/public-finance-quarterly-articles/2015/a_szecsenyip_2015_3.pdf

Whelan (2012) “TARGET2: Not why Germans should fear a euro breakup”, http://voxeu.org/article/target2-germany-has-bigger-things-worry-about

Whelan K. (2014), TARGET2 and central bank balance sheets, Economic Policy January 2014

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A stream of poor economic reports from the Eurozone may be more than just the "Putin factor"

A slew of negative economic surprises across the Eurozone is pointing to significant challenges the area faces on its road to recovery. Three of these surprises are listed below:

1. Italy's GDP unexpectedly contracted last quarter putting the nation into a third recession in since the financial crisis.

WSJ: - Italy has slipped into its third recession since 2008, data showed Wednesday, in an unexpected setback that threatens to restrain the broader euro zone's fitful recovery.

Italy's economy contracted at an annualized rate of 0.8% in the quarter ending June 30, according to a first estimate by national statistics institute Istat—the latest sign of how parts of Europe are still struggling to escape the legacy of the global financial crisis. It was the second successive quarter of falling Italian output, which meets the common international definition of a recession.

2. The area's retail sector took an unexpected turn for the worse last month.

Markit: - The eurozone retail sector started the second half of the year on a weaker footing. The fragility of consumer spending was exposed by the PMI, particularly in France and Italy where the data showed sharper downturns in sales. Even in Germany, the one area of relative strength, there was an appreciable slowdown from June’s recent peak. Retailers underperformed relative to their targets to the greatest extent since March 2013, leading to further accumulations of unsold stock and the prospect of greater discounting ahead.

3. German factory orders contracted at the fastest pace since 2011.

Deutsche Welle: - German industrial orders fell for the second consecutive month in June at a rate of 3.2 percent, following a similar 1.6 percent contraction in May, the economics ministry in Berlin said Wednesday. According to the data, orders contracted at their fastest pace since September 2011, disappointing analysts who had predicted gains of 0.9 percent in a consensus forecast.

While many are blaming these economic headwinds on the uncertainty related to Russia/Ukraine as well as the sanctions, some analysts are pointing to problems closer to home.

The Telegraph: - After what was dismissed as an irregular drop last month, Germany’s factory orders have seen another surprise fall in June. But the downturn has not been solely down to German exposure to ongoing tensions in Russia and Ukraine. Much of the poor performance is explained by crumbling demand from eurozone peers. Evelyn Herrmann, European economist at BNP Paribas, said that “the weakness was mainly driven by orders from within the eurozone” which fell by 10.4pc in June. Non-eurozone orders were stagnant in that month.

The collapse in German government bond yields accelerated in response, reaching another record low.

Moreover, the yield curve is beginning to show signs of inversion in the front end. This is not what the yield curve of a healthy economy is supposed to look like.

The so-called "Putin factor" has certainly shaken confidence of the area's consumers and added uncertainty to the corporate boardrooms (giving Putin additional leverage over western nations). But the Eurozone's challenges seem to go beyond that. As the ECB prepares for another meeting shortly, these issues are sure to be brought up. Draghi's last bullet - direct asset purchases by the ECB - may no longer be as easily dismissed by the Governing Council.


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From our sponsor:

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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From our sponsor:

With the ECB easing inevitable, periphery yields hit new lows

As France and Germany PMI measures converge on the rest of the Eurozone and with the area as a whole in a contraction mode, it is becoming increasingly clear that the ECB is likely to ease monetary policy further.

Composite Output PMI (reading below 50 indicates contraction; source: Markit)

Markit: - Activity fell sharply again in both manufacturing and services. While the former saw the steepest rate of decline for four months, the latter saw the downturn ease slightly compared with March.

New business fell for the twenty-first successive month, with the rate of deterioration accelerating for the third month in a row to signal the steepest decline since December. Marked falls were seen in both manufacturing and services.

Some have been hoping that the ECB will follow the Fed, the BOJ, and the BOE into the brave new world of QE on an unprecedented scale. The probability of such action is quite low however because the ECB does not have the dual mandate of the Fed and (for now) is only focused on price stability. The ECB also may hold back on buying periphery debt until/unless the nations request "assistance".

Even if the central bank commences some bond buying, it is unlikely to be large and would probably end up being sterilized. Nevertheless in preparation for this easing action by the ECB, yield hungry investors bought sovereign bonds across the board. Italian and Spanish yields dropped to the lowest level since 2010.

In an economy that may be close to becoming deflationary, the drive for yield seems to override sovereign risks. This move in yields is especially remarkable given that less than a year ago the Spanish banking system was teetering on collapse (see post).

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From our sponsor:

Trends behind declining LTRO balances; Italy overtakes Spain as the largest LTRO borrower

As European banks find some private sources of capital to fund themselves, they continue to repay their ECB loans - particularly in the 3y LTRO program.

FoxBusiness: - Next week, nine banks will repay just over 4 billion euros ... in loans during the first round of three-year financing in late 2011, ECB data showed Friday. Eleven banks will repay just under EUR4 billion of the second borrowing spree in early 2012. Total repayment is just over EUR 1 billion more than was repaid this week.

LTRO balances in the Eurosystem (unit = €1mil; source: ECB)

Part of this repayment trend however is coming from over-borrowing in early 2012. As banks, particularly in Spain saw their deposits dwindle, they went into a panic mode, borrowing all they possibly could - particularly with Spain's government "encouraging" them to buy government paper. But as portions of the deposits came back (see post) and banks being able to sell some government paper (thanks to the ECB's commitment to buy it), they are repaying some central bank borrowings.

One of the issues Eurozone banks are facing is that they simply can't grow their assets - in fact balance sheets are shrinking. Due to tougher regulatory capital environment as well as general fear of extending credit, lending has been grinding to a halt. Loans to corporations have been declining steadily for some time.

Change in loan balances to companies year-over-year (source: ECB)

And loans to households are basically not growing.

Change in loan balances to households year-over-year (source: ECB)

With banks not willing to extend credit nor sit on cash, the only viable option is to repay some of the liabilities - hence the decline in LTRO balances.

Of course the repayment of LTRO has been uneven across the Eurozone.

Source: Credit Suisse

Spain, having been the largest borrower, also had the largest (in absolute terms) reduction. Clearly most German banks don't need this funding, given the growth in the nation's deposit base. Italy on the other hand remains a problem. In fact Italy is now the largest borrower from the Eurosystem, as Spain dropped to second place. Given the devastating recession and the political uncertainty Italy is facing, LTRO balances of Italian banks will be critical to watch going forward.

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From our sponsor:

Europe back in focus as Italy braces for a deadlocked parliament

All of a sudden Europe matters. As discussed last week (see post), Italy's election was creating risks of a "weak and fragmented coalition" that could slow down or even reverse the pace of much needed reforms. And now we are indeed looking at a deadlocked parliament, with little ability to form a coalition in the upper house.

Reuters: - A huge protest vote by Italians enraged by economic hardship and political corruption pushed the country towards deadlock after an election on Monday, with voting projections showing no coalition strong enough to form a government.

With more than two thirds of the vote counted, the projections suggested the center left could have a slim lead in the race for the lower house of parliament.

But no party or likely coalition appeared likely to be able to form a majority in the upper house or Senate, creating a deadlocked parliament - the opposite of the stable result that Italy desperately needs to tackle a deep recession, rising unemployment and a massive public debt.

Such an outcome has the potential to revive fears over the euro zone debt crisis, with prospects of a long period of uncertainty in the zone's third largest economy.

Of course people were quite surprised about the comeback of Berlusconi (discussed here back in December). It takes a crook to promise to pay the electorate for voting him in, but that's exactly what Berlusconi did. He tapped into the "electoral rebellion", and although he did not win, he certainly injected himself into whatever coalition that may end up being formed.

WSJ: - Surprising, too, was the comeback of Mr. Berlusconi, whose party was in the doldrums as late as November of last year. The 76-year-old billionaire politician's late surge is attributed largely to the media blitz in recent weeks.

"Whoever thought Berlusconi was finished will have to think again," said Angelino Alfano, head of the conservative People of Freedom party.
...
"The cost of austerity led to an electoral rebellion," said Enrico Letta, deputy head of the Democratic Party. "This is a complex situation to live and manage."

Italian government bond spreads widened in response and the euro sold off.

The market reaction was particularly strong in equities where Italian stocks took a real beating. The chart below shows market action over the past five days for EWI (USD-based Italian market ETF - blue) vs. SPY (S&P500 ETF - red).

Click to enlarge

Given that much of today's selloff took place after the European close, the markets' open in Europe tomorrow morning is expected to be ugly.

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From our sponsor:

Italy's recession and upcoming elections threaten reforms

The Guardian had a good summary yesterday on the situation in Italy, where the recession is showing no signs of abating. The winner of the upcoming elections will face some severe challenges.

The Guardian: - A stagnating economy, corruption, organised crime, political apathy, misogyny, youth unemployment ... The person elected to run Italy next weekend will have a formidable to-do list.

The country is now in its longest recession in 20 years, the economy having contracted for the last six consecutive quarters and languished in more than a decade of almost non-existent growth. Unemployment is at more than 11%; for under-25s, it is more than 36%. Italy has the second highest ratio of sovereign debt to GDP in the EU.

It could have been worse. In autumn 2011, when Mario Monti took over after years of successive governments largely ignoring the problem, there were fears that the EU's fourth largest economy might fall into the abyss and drag the rest of the eurozone with it. The technocrat government avoided that disaster scenario and has done much to restore the markets' faith in Italy. Late last year, before the spectre of a Silvio Berlusconi comeback unsettled matters, 10-year bond yields were at a two-year low. It has implemented reforms – including of the pension system and labour market – that are viewed as a crucial part of long-term recovery and could, according to the IMF, lead to a 6% increase in GDP if properly implemented.

But economists say much more needs to be done to effect the kind of deep and lasting change needed to get Italy growing again. They focus on Italy's lack of competitiveness; its untapped labour market resources – women and young people; a thorough reform of product markets and of crucial institutions such as the justice and education systems. Only once these have been properly tackled, they say, will Italy be in a position to capitalise on its strengths, which include a strong manufacturing base, successful exporters, relatively low budget deficit and relatively high domestic savings. The big fear, however, is that the election will not usher in a strong, responsible government, but yet more political instability, which Italy can ill afford.

It is particularly troubling to see the industrial sector of the economy still contracting, even as Germany's industries stabilize.

Source: Deutsche Bank

As discussed earlier (see post), Berlusconi is now using the nation's economic mess to his advantage, increasing the risk to recent reforms implemented by Monti.

Reuters: - Confidence in Italy has been shaken in the run-up to the voting, after a strong campaign by former prime minister Silvio Berlusconi that has opened up the three-way race with outgoing premier Mario Monti and centre-left leader Pier Luigi Bersani.

"Investors are becoming more and more cautious ahead of the weekend ... and altogether people decided here to pull the trigger and go risk-off," said Christian Lenk, a fixed income strategist at DZ Bank.

According to S&P, Italy could repeat its history of forming "weak and fragmented coalition governments", dampening or even reversing the much needed reforms.

S&P: - We believe that a risk exists that after the Feb 24-25 elections there may be a loss of momentum on important reforms to improve Italian growth prospects ...

The implementation of measures to boost Italy's medium-term growth prospects depends, in our view, on the strength of the next government's mandate in both houses of parliament.

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From our sponsor:

Monti to face two key challenges in his bid for re-election

Mario Monti's decision to run in the next Italian election is a positive development for the future of Italy and the stability of the Eurozone. At this stage the last thing the global economy needs is the return to fears of the euro area breakup, particularly if it's driven by Italy. Those who profess that Italy should consider exiting the union simply don't comprehend the impact such an event would have on the global financial system. And Monti has been instrumental in bringing credibility to Italy's commitment to stay in the union.

Bloomberg: - Italian Prime Minister Mario Monti said he will lead a coalition of centrist political parties that support his agenda of fiscal rigor and pro-European policies in February elections, marking a de-facto bid for a second term.

Monti’s announcement, made at an impromptu press conference in Rome yesterday, takes his political role in the upcoming vote a step further after the former European commissioner said Dec. 23 that he would consider leading a group of parties supporting his agenda.

“A new political movement is being formed,” Monti told reporters in Rome. The 69-year-old economist is heading a coalition that includes small parties led by Catholic politician Pier Ferdinando Casini and Luca Cordero di Montezemolo, the Ferrari SpA chairman, who formed a new movement in an attempt to lure Monti into the race.

However Mario Monti will face two key challenges in his attempt to remain Italy's prime minister.

1. Italy's consumer recession is worse than it was in 2008. There is no question that a portion of the voters will blame it on Monti's policies, which were inevitable in order for the Italian government to remain solvent. Italy in effect has undergone its version of the "fiscal cliff".

Source: Markit

2. Berlusconi will continue to undermine Monti's efforts. He will level accusations and spread rumors in order to vilify the current prime minister. His recent approach is to label Monti as a "leftist" (even though Italy's business community generally supports Monti).

Reuters: - Silvio Berlusconi said on Saturday that outgoing Prime Minister Mario Monti was plotting with the left in his centrist alliance's bid to win Italy's national election in February, but centrist leaders denied any secret accord.
...
Speaking to reporters at Milan Central railway station, Berlusconi said Monti wanted to help the left secure power after the February 24-25 election so he could continue his austerity agenda of tax hikes and spending cuts.

"This grouping has been formed to favor the left - also the harmony with the left's programme they have celebrated heads in this direction," he said, after earlier describing Monti as "the spare wheel" of the PD in an interview with Vista TV.

But it doesn't take much to see what Monti has been able to accomplish during his short tenure. The yields on Italian government paper are now the lowest in over 2 years. Clearly at least some of that should be credited to the ECB, but this would have been an impossible task if Berlusconi was still in power. Italian voters, who (for now) don't have to worry about their deposits and pensions being converted to lira, understand this and are likely to support Monti's bid for re-election.

Italy 10y gov. bond yield (source: Bloomberg)

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From our sponsor:

Get ready for Eurozone-induced volatility as Italy trumps Greece

Guest post by Marc Chandler (www.marctomarket.com)
(This is a follow-up to an earlier post on Berlusconi undermining Monti's government.)

News that the Greek bond buy scheme did not get sufficient takers to reach the 30 bln euro target, set the commentariat ablaze.  This may prove to be a minor technicality, as Greek banks initially offered 75% of the Greek bonds, but were prepared to pitch them all if necessary to ensure EU aid is forthcoming, which is the source of their recapitalization funds.

The bigger story is the fall of the Monti technocrat government in Italy.  Berlusconi's PDL party pulled support by abstaining from economic reform votes at the end of last week.   After a series of consultations with the Italian president, it appears that parliament will not be dissolved until two important pieces of legislation are approved, the 2013 budget and financial stability measures.  The former is needed for obvious domestic reasons.  The latter is needed to maintain credibility in  EMU; assuring its partners.

Italy's deep consumer recession allows Berlusconi to undermine Monti's government

Italy continues to be mired in a prolonged recession (see discussion from May). In particular, consumer recession is most severe - as can be seen in the following three indicators:

1. Unemployment rate is grinding higher.

Source: Tradingeconomics.com

2. Consumer confidence is at new lows.

Source: Tradingeconomics.com

3. Retail Sales PMI shows sharp ongoing contraction.

Source: Markit

This situation creates a perfect environment for opportunistic politicians. And one of the most crooked politicians in the developed world, Silvio Berlusconi is making his move (see discussion). With the election coming up next year, Berlusconi wants to blame Mario Monti for the current recession.

Bloomberg: - “We can’t go on like this,” Berlusconi said in a statement announcing that he was considering running again in the election. “I can’t allow my country to precipitate in a recessionary spiral without end.”

For the first time recent history, Monti put Italy on the right fiscal trajectory, finally gaining respect for the nation's government across the EU as well as globally. However, after experiencing the equivalent of a "fiscal cliff", Italy went into a recession. Given the severe but much needed fiscal measures, it was inevitable.

Now Berlusconi is beginning to undermine Monti in order to improve his chances to win next year's elections. Italy had one thing going for them recently: government borrowing costs have been declining. But the prospect of Berlusconi in power is making Italian bond markets uneasy again.

Bloomberg: - Former Prime Minister Silvio Berlusconi threatened to withdraw his party’s support from his successor, Mario Monti, leaving the government teetering and sending Italian bonds tumbling.

Monti today postponed a cabinet meeting at his office in central Rome and rushed to the nearby Senate to attend a confidence vote after Berlusconi allies announced a mass abstention. While the economic stimulus bill survived, Monti faces another confidence vote in the lower house today and the remaining months of his tenure were placed in doubt.

Of course what else should one expect from a crook who has been convicted no less than five times for perjury, corruption, false accounting, and tax evasion (and has been embroiled in a case involving his relationship with underage girl.) Berlusconi's victory could be a major setback for Italy, reversing recent progress on fiscal sustainability, creating a rift with Germany, and destabilizing the Eurozone periphery bond markets.

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From our sponsor:

Is Berlusconi - in spite of his shady reputation - contemplating a move back into politics?

Silvio Berlusconi has been a supporter of Monti's government until recently. But there is a possibility the former Prime Minister may decide to re-enter politics once again. This is particularly troubling, not only due to the risk of Berlusconi rolling back Monti's austerity measures but also because the man is a crook - there simply isn't another way to put it. On Friday he was convicted of tax fraud by a court in Milan. OK, that happens to a politician or two. But this is not the first time for Mr. Berlusconi.

WSJ: - This is Mr. Berlusconi's fifth conviction since 1990, though so far he's managed to avoid his sentences for alleged perjury, corruption and false accounting, thanks to amnesty laws, successful appeals and expired statutes of limitations. Friday's sentence has already been reduced to one year, and despite the verdict, he won't set a foot in jail until his lawyers exhaust Italy's appeal process, which could take years. Even if the expected appeal fails, the proceedings may well let Mr. Berlusconi run out the statute of limitations on tax fraud.

He has also been pulled into another trial that involves his relationship with an underage woman - which of course he denies. What's amazing however is that in spite of all this, Mr. Berlusconi could in fact garner enough political support to run in the next election. And he can do it by tapping into the public's disillusion with current conditions in Italy. The prolonged recession (see discussion), austerity measures, higher taxes (and more enforcement of tax evasion laws), high fuel prices, nearly 11% unemployment rate, etc. makes for some unhappy voters. This unease among the Italian population is evidenced by the latest consumer data. Consumer confidence has declined sharply since last year.

Source: tradingeconomics.com

And with it went consumer spending and retail PMI (released today). Consumer expenditure has been worse than the lows of 2008-09.

Source: Markit

This increases the risk of potential troubles for Mario Monti's government and his supporters, particularly as Berlusconi - after his conviction last week - threatened to pull support for Monti's government. Berlusconi is in effect blaming Monti for somehow not allowing him to cheat on his taxes.

Chicago Tribune: - The election for a regional government in Sicily is a major test ahead of a national poll in April but the picture has been confused by Berlusconi's threat at the weekend to pull support from Prime Minister Mario Monti and bring down his government before an election expected in April.
...
Berlusconi's angry attack on Monti's technocrat government, which his center-right People of Freedom (PDL) group has supported in parliament for almost a year, underscored the political confusion ahead of next year's national vote.

The billionaire former prime minister, convicted of tax fraud last week, attacked Monti's austerity policies on Saturday, announcing that the PDL may withdraw its support and bring the government down.

Mr. Berlusconi has been also known to make jabs at Monti before this attack, insinuating that the Prime Minister is a puppet of Germany or is controlled by bankers. This rift has split the main center-right party People of Freedom (PDL) into Berlusconi's and Monti's supporters. With Monti not expected to run in the next election, Berlusconi could potentially make a move. Whatever the case, next year's elections in Italy will be critical, as Monti's efforts to put the government on a fiscally sustainable path (that finally gave Italy some credibility) could easily be reversed, threatening the recent signs of stability in the Eruzone.

SoberLook.com

What is Rajoy Waiting For ? Some Thoughts

Guest post by Marc Chandler (www.marctomarket.com)

Spanish Prime Minister Rajoy has continued to indicate that he will formally request more assistance when it is in the country's interest, which essentially means, when he is good and ready. And he is not now.

Following his meeting with Italy's Monti, Rajoy was quite candid. "The most important thing", Bloomberg quotes him saying, " is that the mechanism is there. He is acknowledging the actual value of the Outright Market Transactions (OMT) lies in its presence not operation.

Yet there is only so long that the market affections can be toyed with. The poor performance of Spanish bonds last week and the continued selling pressure today suggests investors patience is running thin. Draghi and the ECB had given Spain a reprieve in the form of the LTROs and the OMT.

Spanish bank deposits rose in September and anecdotal reports suggest a modest increase in foreign participation in the government auctions. Fitch's survey of the top ten US money market funds also found new exposure to European banks.

Rajoy is obviously and understandably reluctant to ask for broader assistance. And why should it? It still has access to the capital markets. That identifies the first condition that would likely force Rajoy's hand, namely, a dramatic rise in interest rates.

This is a distinct possibility, especially if one view the recent capital inflows as one-off adjustments, perhaps in part driven by benchmark/index considerations, as opposed to a reflection of new found confidence/optimism. The risk-reward has also shifted. Spain's 10-year generic bond yield has ranged between about 5.0% and 7.75%. The Draghi-induced rally saw the yield more than 200 bp to the lower end of the range (~5.25%). In addition, given the government's rosy forecast for only a 0.5% contraction next year, any signs of weaker growth trajectories could perversely weigh on bonds on account of the implication for the budget deficit. Typically, one expects weak or disappointing economic data to push yields lower, but in Spain, the dynamics may be overwhelmed by the fiscal impulses. Deeper economic contraction means large budget deficit and more debt.

The second condition that could force Rajoy's hand if he could not longer protect Spain's pensions. This is important in a country of 10 mln retired people in a country of 47 mln people.

It is the single biggest line item of the budget, accounting for 40% of spending and 9% of GDP (France 15% and Italy 13% for comparison). Given it size, it is clear that serious fiscal reform cannot take place without a discussion of pension. So far Rajoy has protected pensions in a way that Greece did not. In fact, the 2013 budget will fund a 1% increase in pensions by drawing down the fund's reserves.

Some reports suggest Spain's pensions also are part of the inter-generational transfer taking place. The government estimates that 1.7 mln of the 16 mln Spanish households have no salary income. Pensions in Spain appear to help support children and/or grandchildren.

Spain and Italy are on the same side of numerous debates in the euro area. They are both significant debtors and in the current environment this counts for a great deal. This is fine for the milquetoast joint press conferences, but below there surface there is a prisoners' dilemma game being played out and Monti is not cooperating.

It would be best for both if neither needed financial assistance.

Second best would be to ask jointly. Some Italian and French officials seem to think that if Spain were to formally request aid that it would help stabilize the financial markets. Monti may think Italy is being dragged down by Spain. However, the risk is that they are wrong: that if Spain gets assistance, the market, even if not immediately, will re-focus on Italy. What they do not seem to appreciate is the first mover advantage. A firewall is drawn and Spain in on one side and Italy on the other.

However, if Italy and Spain sought a precautionary facility simultaneously, it would reduce the stigma and be a stronger firewall. In fact, there might be nothing like a simultaneous French request in sympathy to solidify the firewall. France would not have to drawn on the line, of course. Precautionary lines of credit for Spain and Italy and France would do for sovereigns what the largely unused bilateral currency swap lines do for financial markets--ensured their ongoing operations.

The third permutation that might move Rajoy off the stick and on the ball is his friends in Europe would seek precautionary facilities at the same time. No one is talking about a package for Italy, but at the press conference after meeting with Rajoy, Monti again made a point of essentially saying that Italy was not Spain. It did not need assistance.

Given that Monti heads up an un-elected technocrat government, it would not appear he has a mandate to enter into a multi-year commitment with the Troika. However, a move in conjunction with Spain (and France), could be presented by multilateral initiative. An agreement with the Troika could help increase the odds that the successor government (next spring) does not unwind Monti's reforms.

It would allow Hollande to head up a faction to do what France an no longer do on its own and that is serve as a counter-weight to Germany. It would bring into better balance the interests of the creditors and debtors and sustaining that tension, without an all out victory for either side, is what it is all about.

Nor will the countries really be giving up anything that won't be taken away shortly. Schaeuble's proposal, endorsed by Draghi, for stronger and more invasive EU (Monetary Affairs Commissioner) oversight of national budgets, would further weaken fiscal sovereignty.

It is not clear what European officials mean when they say they will do anything it takes to save the euro. Does it mean asking for a precautionary facility? It is precautionary rather than reactive. The current strategy remains reactive. The Rajoy and Monti meeting was an opportunity to break this dynamic. If Monti (and Hollande) want Rajoy to take a package, there may be no better way to persuade him than by taking a package themselves.

The alternative, is succumbing to increased pressure, either directly through the markets, where the country faces record debt refinancing next year, or indirectly through the deterioration of the social fabric.

It is because Europe moves by crisis that the euro is may have to work its way lower still. Key support has been established near $1.2800 and there has been talk of official interest below $1.2900. Many suspect that the euro is in a lose-lose situation. The economic and financial fall out from US not being able to avoid the full force of the fiscal cliff is thought to make investors more risk averse, which is thought to help the dollar. Alternatively, the fiscal cliff is avoided or mitigate and a US recession is avoided, and the superior returns and unresolved European debt crisis weighs on the euro.

SoberLook.com

Italy's prolonged recession could harm fiscal balances

Italy's deep recession is now a year old and the economy shows no signs of improvement. But it's important to point out that unlike Spain, Italy's main problem for now is growth (exacerbated by poor competitiveness), not fiscal balance.

Growth:

Relative GDP growth (source: DB)

Fiscal Balance (better than the Eurozone and the US):

Fiscal balances (source: DB)

Of course if the recession deepens even further and lasts considerably longer, the fiscal situation could worsen. There are signs this may already be taking place.

Reuters: - Finance Minister Vittorio Grilli said Italy's government would overshoot its 2012 deficit goal because of worse-than-expected growth but planned no extra budget cuts because Italy was on target to meet its EU obligations, a newspaper reported.

"We know there will be a worsening of the nominal deficit," Grilli told Rome's la Repubblica in an article published on Sunday. "Nonetheless, our compass remains the structural deficit, and on that we are and we will be perfectly in line."
... 

"When this recession is over, (the debt reduction plan) would permit a lowering in the debt-to-GDP ratio of 20 percentage points in five years," he said.

This is particularly dangerous because of the size of Italy's debt (some €2 trillion). If bond yields spike again, interest expenses alone could worsen the fiscal situation considerably. As discussed earlier, time is not on Monti's side  - as he desperately tries to cap Italy's cost of funds via the ESM/ECB.

SoberLook.com

From Euro Area Summit to the periphery "bridge loan" - a quick recap of major events in the Eurozone

The news from the Eurozone continues to dominate markets' direction. Yet the information from the area has been incredibly confusing, even for many who reside in the EU. The mass media has not made things easier by jumping from one event to another, often without connecting these events together. We've gotten numerous requests to try to clarify some of the key events that have taken place just in the last couple of months and what they mean for the euro area going forward.

Here is a highly simplified overview using basic diagrams. Solid lines indicate what actually transpired, while dashed lines show expectations at the time.

June 2012:

Between escalating risks of the Spanish banking system failure and Mario Monti's efforts to stabilize Italy's government funding costs, pressure was mounting on the Eurozone to take immediate action. Spain and Italy had somewhat diverging needs, but they came together to ask the Eurozone "core" to come to a decision.

And with the brand new Socialist government in France lead by Hollande, Monti and Rajoy found a new ally. Hollande heralded a shift in the balance of power in the Eurozone (as predicted back in January). Together the three were able to pressure Germany into a new compromise. They reached a broad agreement to centralize bank regulation, provide bailout funds to Spain's banks, and most importantly give the European Stability Mechanism (ESM) the ability to buy periphery bonds in a "flexible manner" and allow the bailout vehicle to rescue banks directly. This was a broad agreement with no visible path to implementation. But as we know from 2011, the devil of the Eurozone multiple proposed solutions has always been in the detail, which was entirely missing by the conclusion of the Euro Area Summit.

July 2012 (first 3 weeks):

It didn't take long for the markets to become disillusioned in the agreement reached at the summit as the implementation got bogged down in the black hole of the EU bureaucracy. The existing Eurozone structures were never set up to decisively deal with rapidly changing market pressures. Spanish yields and spreads hit new records and it became obvious that Spain is now shut out of the capital markets. What's more, due to a change in collateral rules at the ECB, the Spanish banking system (which itself is in the process of receiving a bailout) would not be able to come to the government's rescue as it did in the past. And a Eurozone-wide rescue of Spain was out of the question as it would dwarf that of Ireland, Greece, and Portugal.

Last two weeks:

Once the leadership came to the conclusion that the markets won't wait for the new "empowered" ESM - which is not close to being set up, it was time to find some way to "bridge" to the ESM event. In leveraged finance, bankers use what's called "bridge loans" (short-term loans) to provide financing to a company until it is able to bring a bond deal (or even an IPO) into the market. The Eurozone needed one of those and the ECB became the only available option. At this stage, given how desperate the situation has become, the ECB was no longer acting as an "independent" central bank.  Instead it was drafted to help hold off the crisis until the euro are institutions put in place the ESM "solution". Using the ECB to only tackle the short end of the curve was a new compromise with Germany that would provide this "bridge loan" to the periphery without taking on long term risk.

Bloomberg: - Members of German Chancellor Angela Merkel’s coalition parties signaled they won’t stand in the way of European Central Bank chief Mario Draghi’s plan to buy government bonds.

The envisaged move to purchase troubled euro states’ [short term] government bonds is “a wise middle way” to solve the region’s debt crisis, Elmar Brok, a European Parliament lawmaker and executive-committee member of Merkel’s Christian Democratic Union party, told Deutschlandfunk radio today.

Germany knows that once the ESM is in place, they can control the bond-buying process (to avoid taking "excessive" risks) via their veto power. In the mean time Draghi was brought in to "save the day" (without the full knowledge of some other ECB central bankers) .

So what happens now? The ECB will try to quickly implement a backstop program to keep short term periphery rates low to allow Spain and Italy to roll short-term paper, creating a low cost "bridge loan". In the mean time the Eurozone bureaucratic machine will try to implement the ESM structure as envisaged at the Euro Area Summit. But as the area recession deepens, the implementation becomes a race against time and more market volatility is inevitable.

SoberLook.com

"Shorter part of the yield curve"?

It was all going well when Draghi started speaking. Yes the ECB is "working" on a bond buying program. Until this comment came out:

But we know the "shorter part of the curve" isn't the problem. Both Italy and Spain have the ability to roll short-term paper. The issue for these nations is being shut out of the long-term markets and having to constantly auction bills, risking market disruptions. We all know what happens when firms rely on short-term funding when markets lose confidence (Lehman).

Needless to say, markets reversed the initial euphoria, as Italian 10y bonds swung 3% and the euro went into the red on the day.

Italy 10y bond price intraday  (source: Bloomberg)

SoberLook.com

Monti's race against time

Italy’s Prime Minister Mario Monti is in a race against time. He needs to secure government funding via a pan-Eurozone bond buying program before Italy's economic conditions deteriorate further.

Bloomberg/BW: - Italy’s Prime Minister Mario Monti is pressing his European counterparts to sign on to collective action to fight the financial crisis, trying to bridge a north- south divide in the euro area for help to lower borrowing costs.

Monti, who is due in Helsinki today for talks with Finnish Prime Minister Jyrki Katainen, is seeking to capitalize on a pledge by European Central Bank chief Mario Draghi to do whatever it takes to defend the euro. Bundesbank President Jens Weidmann said the ECB shouldn’t exceed its inflation-fighting mandate, according to an article published on the German central bank’s website today.

He has a reason to move quickly. The onset of Italy's deep recession may damage the nation's fiscal conditions as tax revenues decline. Without a backstop from the Eurozone (ESM and ECB) it may become increasingly difficult to roll government debt. With over €100bn of bonds to roll this year alone, this backstop becomes critical. And the latest economic indicators from Italy are showing a further deterioration.

Manufacturing PMI (source: Markit)

Source: DB

Markit: - "July saw the recession in the Italian manufacturing sector extend to a year. Moreover, the downturn was shown to have deepened as the PMI sank to its lowest level in three months, primarily reflecting a sharper reduction in staffing levels. A solid and accelerated decrease in stocks of purchases also dragged the headline index lower, and suggested that firms had grown more concerned about cash flow and were not anticipating a rise in production requirements in the near term."

SoberLook.com