By BLOOMBERG
As an Italian bond rally wraps up a sixth week, investors risk having their enthusiasm jolted by the country’s political gridlock.
Mario Monti
Italian bonds delivered returns of 3.4 percent since inconclusive elections on Feb 24-25 produced a hung parliament. Prime Minister Monti’s caretaker government has little scope to combat the longest recession in more than two decades and said this week its debt will reach 130.4 percent of gross domestic product this year, more than twice the euro-region limit.
The Bank of Japan’s unprecedented bond-buying stimulus coupled with the European Central Bank’s renewed pledge to defend the euro have underpinned the gains even as Italy’s political stalemate and recession deepen. Though the debt burden is headed to a postwar record this year, Italy did manage to keep its deficit within the European Union’s 3 percent of GDP limit, offering some comfort to investors.
The disconnect between yields and the country’s political and economic fundamentals “is certainly huge and very worrisome,” said Lex van Dam, who helps oversee $500 million at Hampstead Capital in London. “The amount of money that is in desperate search for yield simply ignores the political reality.”
Bond sales
Borrowing costs declined at auctions this week. The Treasury yesterday sold 4 billion euros of three-year bonds at 2.29 percent, down from the 2.48 percent on similar-maturity debt March 13. On April 10 it paid a record-low 0.24 percent to sell three-month bills.
Giorgio Napolitano
Under Monti, Italy’s 10-year bond yield has plunged from more than 7 percent to 4.33 percent. The yield difference with Germany has narrowed to about 300 basis points from a peak of 575 a week before his predecessor, Silvio Berlusconi, resigned in November 2011 and Monti was appointed by President Giorgio Napolitano to lead a government of non-politicians.
The government projected this week a primary surplus, or budget balance after interest payments, of 2.4 percent of GDP this year, a goal that is key to putting the debt on a declining path from 2014.
“In the realm of public finances credibility is something you work hard to gain and you acquire slowly, whereas you can lose it very quickly,” Monti told reporters in Rome on April 10 as he presented his government’s estimates. “Discipline in public finances needs to be maintained in the years to come.”
Borrowing costs
That surplus won’t prevent the jump in debt this year as the recession-hit economy borrows to contribute to euro-region bailouts and pays part of 40 billion euros (US$52 billion or RM157 billion) in arrears to government suppliers. The record debt level means the Treasury will spend about 5.3 percent of GDP, or approximately 83 billion euros, to finance its borrowing this year.
Resolving the current political impasse in Italy and producing a government stable enough to maintain fiscal discipline will be key to reducing the debt load.
“Italy’s risk is patently underestimated,” said Silvio Peruzzo, an economist at Nomura Holdings Inc. in London. “The markets have bet on the credibility of the ECB that is certainly very strong, although investors are not taking into account that there are differences between countries that cannot be erased by monetary policy.”
Pier Luigi Bersani
Gridlock
Italy’s Democratic Party leader Pier Luigi Bersani has so far been unable to form a government after winning a majority in the lower house of Parliament in the February vote, while falling short in the Senate.
Now lawmakers are focused on electing a new president to replace Giorgio Napolitano, 87, whose term expires in May. The president, largely a figurehead, does play a key role in resolving political crises, and sorting out Napolitano’s succession will lead to another attempt to form a government and avoid a second election. For now, Monti continues to serve in a caretaker role.
“Despite a muted market reaction thus far, a protracted political vacuum may bring Italy back into the spotlight,” Barclays economist Fabio Fois said in a client note. “It is imperative that Italy restarts the reform agenda launched by Monti’s government as soon as possible.”
Economic slump
Fois estimates that the political impasse will contribute to a 5.1 percent decline in investment spending this year, leading the economy to contract 1.5 percent, more than 1.3 percent forecast by the government.
While Italy’s credibility improved during Monti’s tenure, the former EU commissioner’s mix of spending cuts and tax increases pushed the nation deeper into its fourth recession since 2001.
The Italian economy contracted 2.4 percent in 2012 as unemployment remains close to a two-decade high amid falling household and business confidence and shrinking domestic demand.
“If the primary balance targets are not achieved, then the debt ratio remains vulnerable to adverse interest rate and growth developments,” the European Commission said April 10 in a report. “The public debt represents a major vulnerability for Italy, with potential spill over to the rest of the euro area.”
Mario Draghi
So far the Sept 6 pledge by the ECB and its Italian president Mario Draghi to purchase bonds of nations in distress has shielded Italy from the worst of the euro crisis. A new government may increase the chance that Draghi’s commitment gets tested, said Mediobanca analyst Antonio Guglielmi.
“One of the first tasks for the new government may be considering the opportunity of applying for” ECB bond buying, Guglielmi said in an e-mailed response to questions. “It would better to ask for it by themselves than being forced to by the market.”
-BLOOMBERG
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