Market Directions: Italy and Greece, two very different confrontations

The European Commission rejected the Italian budget on Tuesday saying the government’s economic logic was "not convincing."  Having warned Rome earlier that the plan was unacceptable, the denial was inevitable. 

The Five Star/League coalition in Rome is not trying to convince the Commission or anyone in Brussels, Paris or Berlin. Its 2.4 percent deficit is designed to break the Italian economy from 15 years of stagnation. The audience is the Italian electorate. 

There has been little attempt by the Italians to negotiate a solution. For that the Commission can thank its own egregious example of the 2015 bailout of Greece and the populist government of Alex Tsipras. Elected by a large margin to wring better terms from the EU for the nation’s third bailout agreement, Mr. Tsipras thought he could negotiate with the EU from a position of political strength. In fact he was unable to obtain any substantive changes in the harsh rescue package. The EU refused to budge. The credit markets and specter of a collapsed banking system brought the Athens government swiftly to heel. 

An observer might have taken two possible conclusions from the Greek debacle. Do no cross the EU Commission and expect help on any terms but their own.  Or, if you choose to negotiate with the Commission be very certain of your position.

Greece’s only leverage in the 2015 crisis was its threat to leave the euro and reinstitute the drachma. For that to be a credible danger to the united currency and EU financial structures credit markets would have to believe that Greece was a forerunner of a much wider problem.

If in response to Greek threats credit markets forced sovereign rates in Portugal, Spain and Italy higher, that might have generated pressure on the EU to offer accommodation.  In the actual event Greek credit spreads ballooned and the rest of Europe barely stirred. However close to failure the Greek banking system was, and by some accounts it was mere days from collapse, its economy was too small, it’s banking system to peripheral and its debt load too marginal to continental credit markets to bring down the euro.

If Greece had withdrawn from the euro the only suffers would have been the Greeks themselves. The reality of the financial and social chaos that the drachma would have brought was too much for the Greeks to contemplate. They surrendered.

Will the tactics that succeeded three years ago in Greece work against Italy now?  Three questions.

Can the EU wait for the credit markets to do their work? 

The official timetable for the EU approval process stretches to the end of November. Italian rates have moved up. The yield on the Italian generic 10-year note closed at 3.60 percent on Wednesday. It is almost 60 points higher on the month and 150 points since May. Many analysts think that Italy cannot afford to pay more than 4 percent on 10-year notes given its debt to GDP ratio of about 130 percent. But Italy’s public financing problems are largely tied to the rollover of debt. The government has used the extremely low borrowing costs of recent years to extend the average remaining maturity of its debt to around seven years. Rising yields will take a considerable time to pressure the Italian public purse. In the meantime Italy will go about its national business, implementing its budget and gathering public support from doing so.

How vulnerable is the Italian banking system?

The telling weak point for Greece was the near illiquidity of its banking system. Without the loans the government was seeking to recapitalize its banks the Greek financial system would have shut down. A terrifying prospect in the modern world and not one a responsible government would choose to inflict on its citizens. While some of the Italian banks are weakly capitalized the system as a whole is nowhere near a crisis point and it cannot be used against the government in Rome to force capitulation.

Can extreme pressure be brought on Italian credit spreads without infecting the rest of Europe? 

The Italian economy is the third largest in the Eurozone and it is almost 10 times the size of Greece.  Its financial, commercial and manufacturing ties to the rest of Europe are myriad.  Though there has been little yield contagion yet, the confrontation is young.  And yields have moved. Spanish 10-year rates were at 1.63 percent on Wednesday, about 10 points higher on the month and 40 since April. Portuguese rates were 1.98 percent up about 10 points on the month and almost 30 since April. The spread of the Italian 10-year over its German equivalent was more than 300 basis points.

The crucial point in the EU–Italian dispute is that in order for the markets to bring enough pressure on Rome to make the coalition back down credit spreads must go and stay at levels where contagion becomes ever more likely.  Who would have greater patience, a popularly elected Italian government going about it mandate to improve the economy or Commission officials besieged with calls from member nations?

Passive tactics cannot prevail over Italy. The EU Commission will not be able to use the credit markets as its enforcer.

The only point of leverage over Italy, higher rates, would soon infect other countries. The Italian banking system does not require EU loans to prevent collapse so there is no threat of financial chaos and little public fear. The EU budget rules have no effective deadline. While the dispute lingers Rome will enact its budget strengthening the coalition’s domestic political position. There is no enforcement mechanism. Will the EU impose fines? Will Italy refuse to pay?

The longer the confrontation goes on the weaker the EU position becomes. The EU, despite its rules, regulations and bureaucracy, is essentially a voluntary organization.  Does the Commission want its powerlessness on display for the Union and the world to see?