Contributed by George Dorgan, a macro-based fixed-income and currency overlay portfolio manager based in Switzerland, and the main editor of the blog SNB & CHF.
Silvio Berlusconi is finally back and candidate of his “Polo della libertà” (PDL) for the 2013 elections. Prime Minister Monti, who was not elected by the people but by the financial establishment, is supposed to govern only till Spring 2013 and might even step down earlier. In a June poll, the anti-euro movement “5 stelle” (5 star) would obtain 20.6% in elections, Berlusconi’s PDL 17.3%. The pro-Euro left-wing party Partito Democratic (PD) would get 25.7%. (Other voters undecided). This would result in an anti-euro majority, given that Berlusconi’s PDL is tempted by an Italian euro exit.
Italy is effectively the country which is most opposed to the euro (source).
More details in the guest post by Mike “Mish” Shedlock.
We wonder why as opposed to Greece or Spain, an anti-euro majority can occur in one of the peripheral states, when the risks of a euro exit seem to be overwhelming. This research resulted in a long list of reasons why an Italian euro exit might come in the next 2 or 3 years:
Political and economic situation in Italy
1. The rise of the Five Star Movement, that wants Italy to leave the Euro and possibly default on debt.
2. 44% of Italians view the euro negatively, only 30% favorably. That is the biggest negative spread in the eurozone. In Spain, more view the euro positively than negatively, albeit by a small 4 percentage point spread.
3. Only a mere 50% of Italian would vote to keep the euro if given a chance. That is the lowest percentage in the eurozone (see again Mish).
4. Many politicians think that Italy’s primary surplus, which is now and historically not that bad, should get even better with an Italian euro exit, making the country’s labour more competitive. After the euro introduction, Italy’s historical trade surplus with Germany has turned into a structural trade deficit. For example, German milk and milk products are exported to Italy via trucks through Switzerland and Austria whereas before, Italy had its own strong production. A perverse effect of the euro!
5. The economic situation in Italy is worsening, consumers stop spending. This situation has moved the primary surplus into a deficit in Q1/2012, but the hero of the english-speaking press Mario Monti is hoping on tax increases that will save his budget in Q2. We wonder what will happen to consumer spending then…
6. Thanks to reduced spending and the cheap euro, Italy’s trade balance deficit shrank considerably to -3.6 bln € between January and April 2012 from -15.9 bln € one year ago. An even cheaper New Lira might push the trade balance even in a surplus. Another advantage of an italian euro exit.
Lacking Competitiveness: European supply-side economists beat New/Post Keynesians
10. Supply-siders have also taken the lead in the European institutions. It can be seen in the latest Memorandum of Understanding to bail out the Spanish banks:
“A shift to durable current account surpluses will be required to reduce external debt to a sustainable level.” (Par. II, point 3)
“In particular, these recommendations invite Spain to:
1) introduce a taxation system consistent with the fiscal consolidation efforts and more supportive to growth,
2) ensure less tax-induced bias towards indebtedness and home-ownership,
3) implement the labour market reforms,
4) take additional measures to increase the effectiveness of active labour market policies,
5) take additional measures to open up professional services, reduce delays in obtaining business licences, and eliminate barriers to doing business,
6) complete the electricity and gas interconnections with neighbouring countries, and address the electricity tariff deficit in a comprehensive way.” (Par. VI, point 31)
11. Finally major newspapers and mainstream economists accept that Robert Mundell’s basic economic principle of the “optimum currency area“ will prevail and not the post Keynesian idea that printing money can heal economies even in the long-term, especially those with lacking competitiveness. For further basic economic principles which give a reason why the PIGS will not become competitive inside the eurozone see here.
12. If, on the contrary, the euro remains, then free-market forces will reduce the public-sector share and destroy the Southern European and the french welfare states as Robert Mundell said:
”It puts monetary policy out of the reach of politicians,” he said. ”[And] without fiscal policy, the only way nations can keep jobs is by the competitive reduction of rules on business.”
Economic principles might kill political dreams
13. The euro removes power from politicians to give election gifts to its people like recently the French president. Therefore further reforms to increase competitiveness are at risk. More countries will become more hostile against the euro. Finally the political dream of a common currency might destroy the European idea.
Italy’s costs in the euro zone are too high
17. Italy is too big to bail, due to the limited size of the ESM.
18. Interest rates have reached a point where Italy will struggle to roll over its debt. An April estimate of italian government sources saw Italian debt servicing costs to rise to 5.4% next year and to 5.6% of GDP in 2014.
Germany and other Northern states will not pay for cheaper PIIGS funding
21. The leader of the government party FDP Roesler that a year ago advocated a Marshall Plan for Greece, wants Greece to “accept wisdom of exit if aid terms fail”. He has finally understood that the risks Germany takes with the ESM are far higher than the 5% of GDP that the United States had to pay for the Marshall Plan. Or like in a recent discussion of German intelligentsia the former president Herzog said: “Germans like the French, but the French do not like us, they just want our money”. Together with a potential German downgrade and higher borrowing cost, it makes clear that the German opinion has changed since 2011, the previously open German wallet is closing more and more.
22. This intelligentsia discussion also confirms that the Germany’s policy, but also the one of Finland, Austria and the Netherlands is the one of small steps. Bold steps are taken only when the global economy is in danger (like in autumn 2011) and when these countries are able to afford it.
23. As opposed to Germany, who still feels responsible due to its history, Finland is especially resistant and wants collateral for further bailouts.
24. The Northern states prevent any further funding like ECB monetizing. Therefore it can be expected that ECB purchases of government bonds will be limited this summer despite market turbulences.
25. To our minds, there are people in Merkel’s party who wants to accomplish Italy out of the euro in order to limit German risks in the ESM. Certainly they do not want a “5 star movement”-like Italian default, but a controlled exit from the euro zone. These politicians would like to keep Germany still inside the Euro to take further advantage of cheap German exports and the advantages of the common market and currency. The loss of Italy as consumer for German products is less important.
France or Italy will not accept a German fiscal big brother
26. A German politician of Merkel’s party recently compared a future European fiscal union with the one with the former RDA. The former RDA had to accept a full dominance of Western Germany in fiscal questions without even a seat in the Bundesbank.
27. France and Italy oppose a fiscal union, which would be under German or Brussels/German control. Spain and Portugal are rather marionettes of the German, Finnish and ECB fiscal discipline in form of the fiscal compact or even more in the memorandum of understanding:
According to the revised EDP recommendation, Spain is committed to correct the present excessive deficit situation by 2014. In particular, Spain should ensure the attainment of intermediate headline deficit targets of 6.3% of GDP for 2012, 4.5% of GDP for 2013 and 2.8% of GDP for 2014. Spanish authorities should present by end-July 2012 a multi-annual budgetary plan for 2013-14, which fully specifies the structural measures that are necessary to achieve the correction of the excessive deficit. Provisions of the Budgetary Stability Law regarding transparency and control of budget execution should be fully implemented. Spain is also requested to establish an independent fiscal institution to provide analysis, advice and monitor fiscal policy.
(Memorandum of Understanding, part VI, point 30)
As opposed to Italy, Spain and Portugal have no other chance because their risks are a lot bigger (see below).
Greece, however, is resistant to the German fiscal policy similar as France or Italy, but the country incurs huge risks. Markets, however, will be booming, when Greece has finally left the euro and this will pave an easy way for the next one: the Italian Euro Exit.
The risks of an Italian Euro exit are limited
- Italy’s central bank has enough gold reserves that it could avoid hyperinflation if it left the euro.
- As opposed to Spain, Italy’s international investment position is only slightly negative, whereas Spain’s one is negative by 92% of GDP.
- Combined public and private debt is 260% of GDP, similar to Germany and much lower than France, Spain, or the UK (UK total debt). With private wealth of €8.6 trillion, Italians are richer per capita than Germans.(source).
- ”Italy’s very high savings rate and private wealth mean that any interest rate shock would mostly be rotated back into the economy in higher payments to Italian bondholders. The macro-effects would even out.” (Telegraph). They are particularly high in real terms, with a return to the Lira, at least in real terms, they should go down.
- Italy is first on the IMF’s long-term debt sustainability indicator at 4.1, ahead of Germany 4.6, France 7.9, the UK 13.3, Japan 14.3, and the US 17. An alternative approach for long-term debt including implicit debt (via pension promises, etc.) shows an even better Italian result.
- A strong nominal interest rise after the Italian euro exit would harm Italy’s mortgage borrower a lot less than Spain’s ones, because the level of private indebtedness in Spain higher than in Italy.
- The peripheral states with their 100 million people with a lower per capita GDP are not relevant enough to trigger a collapse of the Northern European economies with their 200 million and the higher per capita GDP, major developing countries like China or India with 2 billion people or the one of the United States with its 300 million inhabitants. Even the Asia Crisis and the Russian default in 1998 that affected about 2 billion people could not bring the US economy into a recession, on the contrary, cheap oil prices fueled US consumer confidence. Four years after the financial crisis, US consumers are strong enough to absorb a crisis in the European periphery, especially when oil prices remain relatively cheap. Certainly, this does not mean strong growth, the US has still some years to go in de-leveraging, but some more years of balance sheet recession.
- The main risk is a shortfall in capital for peripheral banks, following the points made in risk 4, the risk will be limited, at least in Italy. The ESM will need to get a new temporary role in short-time financing some Italian banks, in return Italy will promise not to default on its debt. Debt under italian law should be transferred into New Lira at the 1999 Euro exchange rate, resulting in an implicit hair cut for foreign borrowers. The ESM finally will do something more useful than the long-term financing of peripheral economies by the German tax payer.
Wolfgang Münchau of the pro Eurobond establishment (FT and Euro Intelligence) was quick to respond to a potential Italian Euro exit in the German edition of Der Spiegel. His first argument is that German taxpayers must recapitalize the German banks.
The German bank exposure to Italy was even in 2010 only 36 bln. €, a small figure compared to the risks Germany takes with the ESM. Since then Deutsche Bank hedged its exposure by 88% , many more foreign banks dumped italian bonds . As we all know, German banks managed to offload their PIIGS risks on the Target2 balance, on the Bundesbank, i.e. the German tax payer. Therefore the risk of a recapitalization of German bank is now negligible from the German taxpayers’ view. Most Italian government bonds are held now by Italian banks or Italian individuals.
- If, according to Münchau, Italy went bankrupt, then Germany would need to accept billions of losses from the Target2 system. The Target2, which was previously just a technical settlement mechanism (source Whelan BoE) among euro member states. Thanks to the discussion, that Hans Werner Sinn started, Münchau and the common economic opinion have accepted, that when a country leaves the euro, the Target 2 liabilities of the leaving member come due. In order to scare the German readers, Münchau points on the worst case, namely that Italy will not pay back its Target2 liabilities at all.We think that Italy wants to remain a member of the international community, even in the case of an italian euro exit. Therefore a more realistic approach would be to assume that Italy pays back at least the euro liabilities valued in the new Italian Lira. Based on Nomura’s Jens Nordvig‘s full euro break-up scenario loss of 27% for the New Lira, we estimate an 15-20% loss of the New Lira against the euro in the case of Italian euro exit. As of July 2012 Italy has a 274 bln. € Target2 liability. If this is revalued in New Lira it would imply a loss of 40-50 bln. €, a mere 2% of German GDP.
Now it is still early enough to break the euro ties with Italy, but how will the Target2 balance look like in a couple of years ? How much money Italy will have obtained via the (for Italy enhanced) ESM in a couple of years ?
- Then Münchau states that except some old economy professors like the former ECB chief economist Othmar Issing nobody in Germany would be in favor of an Italian Euro exit. The response to Münchau’s post can be seen in 75 pages of German readers’ comment, who are by 80-90% against his view.
We think that Italy, as opposed to Argentina in 2001 and Spain today, would survive a euro exit without big problems. Given the current public and political opinion in both Italy and Germany this scenario has a high probability to happen in the next 2-3 years. A new task of the ESM will be to support possible temporary fallouts on peripheral banks. After initial problems the euro will appreciate because two of the weakest members, namely Greece and Italy, will exit the common currency, the italian and the european economies will recover quite quickly.
If Italy, however, does not leave the euro zone, both Italy and Germany run the risk of long-lasting balance sheet recession, in which both consumers and firms try to reduce debt and consume less, Germans in the fear of future German liabilities via the ESM, Italians in response to more and more austerity measures. Hence an italian Euro exit would really help the euro zone.
The main author of this blog speaks Italian and lived in Italy a long time. Italians are since the beginning not happy with the euro, many think that prices strongly increased due to the euro, but salaries remained the same. In Germany this attitude was initially the same, but vanished with the time when prices became relatively cheaper. In Italy this internal opposition against the euro did never go away, consumer prices are now as high as in Germany, but salaries are half or even less.