{"id":30346,"date":"2012-06-19T17:13:50","date_gmt":"2012-06-19T21:13:50","guid":{"rendered":"http:\/\/countingpips.com\/forex-news\/2012\/06\/spain-and-italy-different-problems-same-crisis\/"},"modified":"2012-06-19T17:13:50","modified_gmt":"2012-06-19T21:13:50","slug":"spain-and-italy-different-problems-same-crisis","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex-news\/2012\/06\/19\/spain-and-italy-different-problems-same-crisis\/","title":{"rendered":"Spain and Italy: Different Problems, Same Crisis"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

The Greek election came and went without much in the way of market reaction.\u00a0 It would appear that \u201cMr. Market\u201d is tired of hearing about Greece and has now moved across the Mediterranean to Spain.<\/p>\n

But for all the wailing and gnashing of teeth over the country\u2019s finances, even Spain is a relatively minor problem if tackled correctly.\u00a0 At 69%, Spain\u2019s current debt load as a percentage of GDP is actually lower<\/em> than that of Germany, France or the United Kingdom.\u00a0 And even if the planned bank bailout from earlier this month adds another $100 billion, total indebtedness will be roughly in line with these Western European peers.\u00a0\u00a0<\/p>\n

Should Spain need a full sovereign bailout due to its short-term funding needs\u2014and it is looking increasingly likely that it will\u2014a Spanish bailout would be affordable under the existing bailout mechanisms in place.\u00a0 Unless Europe\u2019s leaders are even more inept than the most cynical of us could imagine, it won\u2019t be Spain that derails the European project.\u00a0<\/p>\n

No, the real crisis that will eventually determine the fate of the European Union is not Spain and it\u2019s certainly not Greece.\u00a0 It\u2019s Italy.<\/strong><\/p>\n

With a GDP of $2.2 trillion, Italy is the 8th<\/sup> largest economy in the world, slightly smaller than Brazil but larger than Russia, Canada or India.\u00a0 But the Italian government bond market is the 3rd<\/sup> largest <\/em>in the world, after only the United States and Japan.\u00a0<\/p>\n

Italy\u2019s outstanding government debt amounts to 120% of GDP, making Italy the most indebted of all industrialized countries save Japan or Greece.\u00a0 When it comes to spending money they don\u2019t have, it would seem that Italy\u2019s politicians can compete with the best in the world.\u00a0 And given Italy\u2019s lackluster growth rates of the past two decades, the country\u2019s ability to pay those debts should be called into question.<\/p>\n

Spain and Italy are on odd sort of mirror image.\u00a0 Before the crisis, Spain\u2019s government was considered to be a model of responsibility, and its government debt load was among the lowest in Western Europe.\u00a0 Spain\u2019s current predicament was not brought on by government spending run amok but by a real estate bubble and bust that wrecked the country\u2019s large banking sector.\u00a0 In Italy\u2019s case, the private sector is fine.\u00a0 The country\u2019s banks are, for the most part, in decent health and conservatively financed.\u00a0 It is wanton government spending that called Italy\u2019s credibility into question.<\/p>\n

The issue of timing is also very different.\u00a0 Spain\u2019s short-term outlook is desperate; the country is struggling to close a yawning budget deficit without killing an economy that is already on life support, but its longer-term outlook is not particularly bad.\u00a0 In Italy\u2019s case, it is the short-term picture that isn\u2019t particularly bad.\u00a0 Excluding debt service, the country\u2019s current budget is close to being balanced, and its immediate borrowing needs are modest.\u00a0 But without growth, Italy\u2019s debts become harder and harder to pay.\u00a0<\/p>\n

But while we have two very different countries with two very different sets of problem, we have one crisis\u2014a crisis of confidence.<\/p>\n

The bond market is indicating a pronounced lack of confidence in Spain and Italy and in the European Union itself, as we can vividly see by the rising bond yields on Spanish and Italian debt.\u00a0 A couple points should be made about this, however.\u00a0<\/p>\n

Contrary to popular notion, the \u201cbond market\u201d is not<\/em> an all-knowing, all-powerful collective intelligence that sifts through the economic data and prices the respective bonds accordingly.\u00a0<\/strong> It is a collection of emotional buyers and sellers who react to each other far more than to fundamental data.\u00a0<\/p>\n

Financial theory would tell you that bond prices change to reflect changes in the underlying fundamentals.\u00a0 But as any good trader knows, that relationship also goes the other way.\u00a0 Price movements take on a life of their own and change the fundamentals.\u00a0 A country that could easily finance its expenses at 4% interest may find it difficult to do so at 6%.\u00a0 The country thus becomes \u201criskier\u201d and now requires an even higher interest rate to compensate investors for the risk\u2026which in turn makes the country riskier still.\u00a0 The predictive power of the market is often no more than self-fulfilling prophecy.<\/em><\/strong><\/p>\n

Let\u2019s return to Italy.\u00a0 Italy was able to amass its gargantuan debts precisely because<\/em> the bond market priced yields so attractively.\u00a0 \u00a0\u00a0But what the bond market giveth, the bond market taketh away, and now Italian 10-year yields have crept up to crisis levels close to 6%.\u00a0 In Spain, the yield has crept above 7%.<\/p>\n

So, how is this vicious cycle broken?<\/p>\n

Frankly, it\u2019s not easy.\u00a0 You need a \u201cbig bazooka\u201d blast to shock the bond market into reverse.\u00a0 In the case of Europe, you would need either a public commitment from the European Central Bank or one of the bailout facilities to buy as many bonds on the open market as it took to lower yields to a sustainable level.\u00a0<\/p>\n

Germany has resisted this approach, rightly pointing out that doing so takes away the incentive to cut government spending.\u00a0 Angela Merkel seems to believe that the only way to convince the problem states of Europe to get their houses in order is to threaten them with bond market oblivion.\u00a0<\/p>\n

Unfortunately, there are limits to how far this exercise can go, and we are quickly reaching those limits.\u00a0 Germany needs to commit itself to stabilizing the Eurozone, and it needs to do so quickly.<\/p>\n

As bearish as this article might seem, I am actually quite bullish on select European stocks.\u00a0 The crisis has created some fantastic opportunities to buy Europe\u2019s best multinational blue chips and prices we may never see again.\u00a0<\/p>\n

I trust that as dense as Europe\u2019s leaders may seem to be at times, they do know better than to cut off their noses to spite their faces.\u00a0 When faced with the destruction of the Eurozone,\u00a0 they will do what needs to be done.\u00a0 Today, this means aggressive bond buying by the ECB and some sort of EU oversight over the national budgets of its member states.\u00a0<\/p>\n

It will happen\u2026eventually.\u00a0 In the meantime, we watch and wait.<\/p>\n

Related posts:<\/p>\n