Financial Storm Clouds Gather Over Italy

Wishful thinking may not be enough.

The financial markets have been exceedingly calm in Italy of late. At the end of October the government was able to sell €2.5 billion of 10-year debt at auction at a yield of 1.86%, the lowest since last December — an incredible feat for a country that four months ago witnessed a major bank bailout and two bank resolutions, and that has so much public debt that it spends €70 billion a year to service it, the world's third-highest.

And there's the ECB's recent decision to slash its bond buying from roughly €60 billion a month to €30 billion as of Jan 1, 2018. Then there's the over €432 billion of Target 2 debt the government owes the ECB, the growing likelihood of political instability as elections approach in 2018, the recent referendums for greater fiscal and political autonomy in Lombardy and Veneto and serious unresolved issues in the banking sector.

Monte dei Paschi di Siena may still be alive as a bank, but it's not out of the woods. Last week its stock resumed trading after ten months of being suspended from Italy's benchmark index, the FTSE MBE. Shares opened on Wednesday at €4.10, then rose 28% to €5.26. But it didn't stick. On Friday, shares closed at €4.58.

It's a far cry from the €6.49 a share the Italian government paid in August when it injected €3.85 billion into the bank to keep it alive. It spent another €1.5 billion shielding some of the bank's junior bondholders, whose debt was converted into equity. As part of the rescue, the Tuscan bank was forced to present a plan to cut 5,500 jobs and close 600 branches until 2021, in addition to transferring 28,600 million euros in unproductive loans and divesting non-strategic assets. Investors clearly have their doubts.

In Veneto the situation is, if anything, even bleaker as over 40,000 businesses have been left starved of credit following the impromptu resolution of the region's two biggest banks, Popolare di Vicenza and Veneto Banca.Bloomberg:

While Intesa Sanpaolo SpA, Italy's second-largest bank, paid a symbolic sum to acquire the healthiest parts of the two Veneto lenders, the state entity that's absorbing the 18 billion euros ($21.3 billion) of troubled debt the banks amassed, called SGA, isn't fully operational yet. That has left small and midsized companies in the lurch—in many cases unable to do business.

"Many of these borrowers are profitable companies, but they're stuck in limbo," said Mauro Rocchesso, head of Fidi Impresa e Turismo Veneto, a financial firm that provides collateral to companies seeking lines of credit. "They don't have a counterparty anymore and can't find fresh capital from a new lender because of their exposure to the two Veneto banks."

It's not just businesses and investors that are losing faith in Italy's financial sector; so too is the public. Just 16% of Italians still have confidence in the country's lenders, according to a poll by the SWG research group of Trieste on Friday.

Trust in the Bank of Italy is also in decline, having plunged from 36% in June to 24% in October. Such widespread public mistrust didn't stop the national central bank from awarding the bank's governor, Ignazio Visco, another six-year term after presiding over the worst banking crisis of a generation.

The Bank of Italy's reputation was further dented this month after documents presented in a Milan court case revealed that Italy's central bank knew that MPS' management had papered over a loss of almost $500 million in 2010 and failed to report it. At the time the governor of the Bank of Italy was Mario Draghi.

Now, as chairman of the ECB, Draghi is in charge of withdrawing the QE monetary punch bowl upon which many peripheral EU economies have grown dependent to keep servicing their debts.

Saddled with one of the biggest public debt mountains on the planet, Italy is particularly vulnerable to this change in policy. Even after three years of QE, Italy's economy is growing at a rate of 1.5% a year — good for Italy, but still the worst in Europe. Once the the ECB stops snapping up Italian debt over the coming years, the southern European nation will almost certainly struggle to find buyers for its government bonds.

The ECB has purchased €300 billion ($353 billion) of Italian bonds under its QE program, which is more than three times the net bond issuance for the country during that period, according to Christian Schulz, European economist at Citigroup. That means the ECB has not only bought pretty much all new bonds issued in Italy since 2015, but also existing bonds from other investors.

As the ECB cuts its purchases by roughly half in two months' time, those investors, including foreigners, Italian households and Italian retail investors, will have to come back into the market in a big way; otherwise the yields on Italian bonds will begin soaring, driving up the costs of funding for the government.

Once the ECB stops buying Italian bonds altogether, the only way for the game to continue is — according to research by Alleston Capital — if over the following six years non-banks increase their purchase activity up to seven times that of the past nine years. But these are the very investors who, via QE, were eager to offload the risks of Italian liabilities onto the Bank of Italy, and then onto the Eurosystem.

It's a long shot, to put it mildly.

But Luca Cazzulani, deputy head of fixed-income strategy at UniCredit in Milan, doesn't seem unduly fazed. "Because there has been a net transfer of bonds from private investors to the ECB, it must mean that the private investors now own less compared to before the QE program started," he said. "There should be room for these other types of investors to step back to sort of restore what they originally had." Now that is what you call wishful thinking.