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Wed Sep 28 10:31:43 PDT 2005

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Buttonwood

Credit where credit is due
Sep 28th 2005
>From The Economist Global Agenda

When markets don¹t price risk properly, weak governments‹and their
taxpayers‹are in even bigger trouble

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A FRIEND of Buttonwood¹s is cross these days. For some months he has had a
biggish bet that yields on Italian bonds would rise relative to German ones.
It was a no-brainer, one might think. Big-spending Italy has the world¹s
third-biggest stock of debt, equal to more than 109% of its GDP and heading
up, while Germany, though no fiscal angel these days, has a debt ratio of
under 68%.

He has yet to make money. The gap between Italian and German yields has
barely changed in recent months, and at close of trading on Tuesday
September 27th was a mere 20 basis points (hundredths of one percent).
Standard & Poor¹s (S&P) put Italy, rated AA-, on ³negative outlook² in
August. And Italy¹s finance minister resigned last week in despair over his
country¹s shambolic economic decision-making and his failure to dislodge the
compromised central-bank chief. Neither event affected yields for more than
a moment or two.

It was not always thus, as the chart below shows. Before monetary union in
Europe, the yield on the Italian government¹s ten-year bonds could be more
than 650 basis points higher than that on Germany¹s, over which the rigorous
Bundesbank kept watch. That gap narrowed sharply when currency risk
disappeared, a big new euromarket reduced trading costs, a single central
bank took charge of interest rates and monetary membership rules promoted
unwonted fiscal discipline.

Now the bonds of all the AAA-rated euro-area governments‹Germany, France,
Austria and so forth‹trade within a few basis points of each other. The
specifics of different bond issues (how big, how liquid, how useful for
repurchase agreements and so on) determine minor differences. Italy and
Greece move around a little on bad news, but not much. The credit-default
swaps market tells a slightly different story: the price of insuring against
an Italian default was around 14 basis points earlier this year and is about
21 points today. And bond buyers are not wholly blind to countries¹ ability
to repay. Economists at Goldman Sachs found, in a research note in late
July, that while they tend not to pay attention to issuers¹ current fiscal
deficits, they do ask a bit more of those with high stocks of outstanding
debt. But these are nuances. Broadly, bond yields are not reflecting risks.

Italy¹s economic problems are too well known to need long rehearsing here.
It produces too few of the high-tech goods in which trade has been expanding
and too many of the low-skilled goods where the threat from Asia and Eastern
Europe is greatest, points out Luigi Speranza of BNP Paribas. As a
consequence it has lost 30% of its export market share since 1995. Barely
out of recession, it is expected by the International Monetary Fund to show
zero growth this year.

Against this backdrop, its government began eurolife with an impressive show
of fiscal rectitude, but subsequently lost the plot. Like Germany, France
and others, Italy¹s budget deficit is over the limit set for monetary-union
members (3% of GDP), and it has been given two years to regain the right
path. One reason for the resignation of the finance minister, Domenico
Siniscalco, was deep opposition within the ruling coalition to his swingeing
draft budget. His successor now has less than a week, in law, to get a
budget through the government. Italy seems to be imploding before our eyes.

But perhaps the reason why the yield gap with Germany is shrinking is that
Germany is getting worse too. Bond-market benchmark or no, it is no role
model nowadays, with a fiscal deficit this year forecast at 3.9% of GDP. S&P
gave warning last week that Germany could lose its AAA status in a year or
more if it fails to get a grip.

Why, then, do investors still seem happy to snap up whatever European
government bonds come their way? There are several reasons. The first is the
tide of low-interest liquidity worldwide that is lifting all boats. The
yield on the ten-year German Bund touched 3% last week, an historic low and
more than a percentage point below America¹s comparable bond. When the
general level of yields is low, as it is in slow-growing Europe, there is
less room to differentiate. Finland, with a 2.1% fiscal surplus and tidy
debt, was yielding just five basis points less than Germany on Tuesday.

There are other reasons why Italian bonds in particular are popular. Banks
can present any government bonds to the European Central Bank as collateral
against borrowing. The ECB does not discriminate among member issuers, so
Italian bonds serve the purpose just as well as Finnish ones. Banks tend to
prefer presenting bonds of weaker quality, keeping the stronger ones on
their own books. The fast-growing market in ³covered² bonds‹securitised
notes backed by future cash flows from mortgage or public-sector loans‹is
also boosting demand. Many issuers like to hold Italian government bonds in
their cover pool, enjoying their slightly higher yield while paying out
lower ones to bondholders.

A third reason is that while no one expects a West European country to
default on its loans, the assumption is that if a Greece or an Italy got
into trouble, either its European Union (EU) colleagues or the ECB would
stand ready to pay off its obligations. But that is an assumption on which
it would be dangerous to rely: the ECB has neither the mandate nor, perhaps,
the resources to do so.

Is this all as loony as it looks? Maybe not. ³One of the points of monetary
union was to dampen volatility, encourage fiscal responsibility and reduce
borrowing costs, and in that it has succeeded,² observes Laurent Fransolet,
head of European fixed-income strategy at Barclays Capital. But there are
limits.

The problem now is that we seem to have the worst of both worlds. Bond
yields do not reflect real risks, so market discipline isn¹t doing its job.
Neither are the Eurocrats. The EU¹s fiscal requirements for euro members are
being flouted left, right and centre; Italy will be the first real test of
whether even the new, watered-down version of them will prevail. So making
tough decisions to reduce structural deficits and keep debt from taking off
falls squarely on the shoulders of national governments. And these are not
very robust.

The rewards for making difficult adjustments to get into monetary union were
obvious: lower borrowing costs, access to a bigger market. The rewards for
making them now appear to be recession and getting chucked out of office. A
leader with a strong mandate would find it hard. The broad coalitions that
dominate the landscape in both Italy and Germany will find it all but
impossible.

Buttonwood¹s friend has less than a year to realise his bet. It¹s not
looking good.

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