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November 14, 2011

All Eyes on Italy

While the markets seemed to calm down over Greece (although nothing there is concrete yet), the red light has begun to flash in Italy. While to many, Italy may not seem to be much different of a problem than Greece, the debt numbers are far more disturbing. Italy holds a little more than EIGHT times the debt of Greece. At approximately $2.6 trillion, its default would be larger than if AIG had gone bankrupt.

This past week, interest on Italian debt rose above 7%. This is an important benchmark considering Ireland, Greece, and Portugal all had to seek help from the European Union and the European Central Bank when their interest rates hit 7%. Unfortunately, Italy is not only too big to fail, but it is too big to save as well.

This benchmark rate also represents a near inability to borrow new funds for the government. If Italy is not currently operating on a balanced budget, cash reserves will begin to drain, and once they run out, a default will occur. Besides the interest rate, clearing houses which sell sovereign debt have raised their collateral requirements for entities interested in buying Italian debt. This is because they don't want to be caught holding the losses of the debt if both Italy defaults and their counter-parties holding the debt fail.

While many think the resignation of the Prime Minister will alleviate many of the short term ills, I believe a more radical approach is required. In order for Italy to calm the markets, it needs to project its interest expenses based on an 11% or 12% interest rate. Then, it needs to immediately balance its budget with those projections. This will communicate to the markets that Italy can handle the higher interest rates and the bond markets will calm.

Then, assuming rates end up 5% lower than forecasted, the Italian government will run a surplus. That surplus can then be used to pay down the debt. At a 5% spread, we would be talking about $130 billion. The only thing stopping this from happening is the political environment in that country. The people and politicians must decide to bite the bullet on austerity, or something far worse.

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