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Roubini Global Economics - Italy Should Restructure Its Public Debt Now ABOUT US Logged in as [email protected] VIEW CENTER ECONOMIC RESEARCH MARKET STRATEGY CRITICAL ISSUES REGION CONTACT US ECONOMONITOR Search TOPIC MY ACCOUNT RESEARCH AND STRATEGY FIXTURES Italy Should Restructure Its Public Debt Now By Nouriel Roubini Nov 28, 2011 10:00:00 AM | Last Updated RGE Share Italy’s public debt is rapidly becoming unsustainable as the country has a large and rising primary gap. Now is the time to restructure its debt in an orderly manner, rather than delay and make a futile bid to escape the inevitable default. The latter would only lead to the restructuring being disorderly. The new technocratic government, led by the capable Mario Monti, unfortunately faces the same constraints and problems as its discredited predecessor: Spreads are rising and policies imposed by the markets, EU and ECB—fiscal austerity and structural reforms—are doomed to further weaken growth in the short run and make the debt even more unsustainable. Rather than wasting precious official resources (which currently aren’t even sufficient to backstop Italy for the next three years) to prevent the unavoidable, such resources should be used to make the debt restructuring orderly via a coercive but market-oriented exchange offer that provides both a par and a discount bond with no collateral guarantees. Even an orderly debt restructuring—that deals with Italy’s stock problems—would not resolve its flow problems (i.e. the lack of growth/outright recession, the lack of competitiveness and the large current account deficit). To resolve the latter needs a real depreciation that may require the eventual exit of Italy and other member states from the eurozone (EZ). It is increasingly clear that Italy’s public debt is becoming unsustainable and should be restructured TOP 10 MOST READ immediately. Making the same mistake that was made in the case of Greece and wasting another year to try to prevent the inevitable default and restructuring will mean the latter will be disorderly rather than ECONOMIC RESEARCH 1. Italy Should Restructure Its Public Debt Now orderly. The EZ’s apparent desire to eliminate private sector involvement (PSI) from the design of the new ECONOMIC RESEARCH European Stability Mechanism (ESM) on the basis that restructuring will never occur again is pig-headed: 2. Conference Call: A Preview of the U.S. Outlook for 2012 The markets now realize that it isn’t only Greece’s debt dynamics that are unsustainable. With public debt CRITICAL ISSUE at 120%, real interest rates close to 5% and growth at 0%, Italy would need a primary surplus of 5% of 3. Italian Borrowing Costs Soar GDP rather than the current 0.5% expected for 2011 to stabilize its debt at this high level; i.e. the primary MARKET STRATEGY gap is currently about 4.% of GDP. Moreover, soon, real rates may be higher (if market and economic 4. Global Equity Quarterly: Risk Sets Up Camp— Strategies for Uncertainty conditions worsen) and growth negative, making the primary gap larger and debt dynamics even more unsustainable. Moving to a 5% primary surplus—the bitter medicine that the ECB and Germany are now imposing on ECONOMIC RESEARCH 5. Sharp Slowdown in the Offing For India As Deficit Concerns Loom ECONOMIC RESEARCH Italy and the other PIIGS—will make the Italian recession (like that in Greece) a depression, as raising 6. Conference Call Highlights: Can the EZ Be Brought Back From the Brink? taxes and cutting spending and transfer payments reduces aggregate demand and disposable income. ECONOMIC RESEARCH Even the much-vaunted structural reforms will make the recession worse for a while: You need to loosen labor market laws to allow the firing of hundreds of thousands of public and private employees; you need 7. Running Out of Time: Likely Path Ahead for the EZ GLOBAL ECONOMIC OUTLOOK 8. Outlook Center to shut down thousands of loss-making firms; and you need to move labor and capital from declining ECONOMIC RESEARCH sectors to new emerging sectors in which you have a new comparative advantage. Furthermore, what are 9. A Cheat Sheet for the Eurozone Crisis these phantom emerging sectors, given that Italy can’t have a nominal and real depreciation to restore its CENTRAL BANK WATCH 10. Global Policy Loosening Begins competitiveness and create new comparative advantages? Thus, while the new technocratic government headed by the well-respected Mario Monti is much more FEATURED ECONOMIC RESEARCH AND MARKET STRATEGY credible than the discredited Berlusconi regime, the basic macro and financial constraints have not changed: Italy’s debt is becoming unsustainable and policies to reduce it will worsen the recession and make the debt even more unsustainable. That is why markets have essentially ignored the good news of Monti’s arrival and pushed Italian spreads to even higher and more unsustainable levels. Against this background, Berlusconi is still scheming and is ready to pull the rug from under Monti as soon as it is http://www.roubini.com/....php?utm_source=contactology&utm_medium=email&utm_campaign=From Nouriel's BlackBerry®: Italy Should Restructure Its Public Debt Now[11/30/2011 4:26:01 PM] Roubini Global Economics - Italy Should Restructure Its Public Debt Now politically, judicially and electorally convenient for him to do so. The new government, assembled in a fit of undemocratic desperation without the effective support of the two major center-left and center-right coalitions (as it comprises only technocrats and doesn’t have any senior ministers representing the major parties), has unfortunately been born wounded and weakened. RELATED ARTICLES Going back to fundamentals, even if austerity and reforms were to eventually restore Italy’s debt sustainability, the loss of market credibility and the time that it will take to restore it require a lender of last Italy: Fiscal Position Italian Borrowing Costs Soar resort (LOLR) to provide support and prevent sovereign spreads from exploding. Italy’s financing needs for the next 12 months alone are not just the €400 billion of maturing debt and the expected flow deficits; The ECB and the Eurosystem ECB as Lender of Last Resort? at this point, most investors long in Italian securities would dump their entire holdings of Italian debt to the sucker—ECB or European Financial Stability Facility (EFSF) or IMF or whoever else—that would be willing to buy that debt at current yields as such yields (and capital losses) could become much higher if that official support eventually dribbles down. So now, the entire stock of €1.9 trillion of Italian debt will Italy: Economic Profile Italy: Services PMI at Lowest Level Since June 2009 IMF's Role in Central and Eastern Europe Romania: IMF-Required Reforms on Track soon be offered by the investors holding it if an LOLR is on the other side of this game. The IMF loans (purportedly €600 billion) now circulating in news reports will also repeat the mistake of the Greek program: By subordinating the existing debt to official lenders, the likelihood of PSI is increased and recovery value is decreased, elevating yields and precipitating a flight to the exit. So, using precious official resources to prevent the unavoidable is a huge mistake that will finance the exit of those lucky enough to have claims maturing now and/or lucky enough to dump their claims on the official sector. And since the official sector is effectively senior as provider of debtor-in-possession (DIP) financing, the spreads on the remaining private claims will become—as in Greece—higher as such claims become more junior in the presence of official financing. FEATURED ANALYSIS BRICs in Africa: After More Than Just Resources Maya Senussi and Rachel Ziemba Nov 22, 2011 “Driven by China and India, Asia has displaced Europe as Africa’s largest trading partner, a trend that European recession and balance sheet repair will exacerbate.” And not enough official money exists to backstop Italy (and soon Spain and possibly Belgium) for the next three years: You would need €2 billion-3 trillion of real hard money, not the fake money of the two unableto-fly turkeys, the levered EFSF and EFSF SPIV. Even the current attempt to ramp up such resources with IMF, BRICs, sovereign wealth funds and other international resources is bound to fail if the EZ core is FEATURED @ RGE unwilling to ramp up its own contributions—a much larger EFSF or ESM closer to €1 trillion—and if the ECB is unwilling to play the role of an unlimited and unsterilized LOLR. Thus, recent press reports that ROUBINI FEEDBACK FORUM the IMF is readying a €400 billion-600 billion program to backstop Italy for the next 12-18 months are, so What Do You Think? Weigh in on Roubini.com's new look or report any problems you encounter. far, hot air as the EZ (meaning Germany, the rest of the core and the ECB) is unwilling to provide additional financial resources. And if Italy remains stuck in an uncompetitive recession and is unable to regain market access in the next 12 months (a highly likely scenario), even if such large official resources Website Feedback Content Feedback were to be mobilized, they would be wasted by financing the exit of investors and thus postponing an inevitable debt restructuring that would then be more likely to be disorderly. Italy’s public debt thus must be reduced now—on a net present value (NPV) basis—to at least 90% from the current 120%, or roughly a 25% haircut. Avoiding a formal default, this can be done with an exchange offer with two options: A par bond (lengthening maturing bonds by 20-30 years) with a low enough coupon, whose NPV debt reduction is equal to 25%; or a discount bond that has a face-value reduction of 25%. Both options should be made available—without the burdensome Brady-style collateral guarantees SUBMIT that landed Greece with even more debt: The par bond option may be more attractive for banks or insurance companies that hold to maturity and don’t mark-to-market. Holdout problems can be fully dealt with through a credible commitment not to pay such holdouts if they do hold out; and if that triggers the CDS, so be it: Those who bought such protection/hedging should not be shafted—as they have been in Greece—under the excuse of a technically “voluntary” debt exchange that is actually very coercive. The par bond option—with appropriate regulatory forbearance—would allow banks to pretend for a while that no losses have occurred and thus give them more time to recapitalize. This is not because they deserve such subsidies, but because a credit crunch, already underway, would be worsened by the sudden need to deleverage further and faster. Some losses would imply that many Italian banks would need to be recapitalized by the government as they don’t have access to equity financing; but such recapitalization is already in the cards; only its size would have to be larger. And to reduce fiscal costs, the senior secured and unsecured debt of such banks—as well as the junior debt—would have to be treated; thus, the mistakes made in Ireland should not be repeated. To make the restructuring even more http://www.roubini.com/....php?utm_source=contactology&utm_medium=email&utm_campaign=From Nouriel's BlackBerry®: Italy Should Restructure Its Public Debt Now[11/30/2011 4:26:01 PM] Roubini Global Economics - Italy Should Restructure Its Public Debt Now orderly, official resources—that are coming anyhow—should be made available to recapitalize the financial system. And since about 40% of the Italian public debt is held by non-residents, a debt restructuring would imply some burden-sharing with Italy’s foreign creditors. Some influential figures in Italy have suggested that the same reduction in the public debt could be achieved with a capital levy—a wealth tax—as opposed to a debt restructuring. But debt restructuring is superior to a wealth tax. To lower the debt ratio by 25% (to 90% of GDP from 120%) with such a tax, you would need a capital levy of €450 billion (30% of GDP). Even if the payment of such a levy were to be spread over 10 years, that would imply an increase in taxes equivalent to 3% of GDP for 10 years running; the subsequent fall in disposable income would make the Italian recession a depression as consumption would collapse. While private wealth in Italy is reportedly about €9 trillion[1] and the capital levy is only 5% of wealth, the consumption effects would be massive as the capital levy is 30% of GDP/income. To reduce such negative effects, one would have to tax disproportionately (or only) the wealthy—the 10% of households that hold 50% of such wealth. But such a tax would need to be 10% rather than 5% of the wealth of those taxed. Leaving aside the political economy of such a huge capital levy and the associated risk of massive capital flight, a debt restructuring implies greater risk-sharing as some of the burden is shared by foreign investors, who hold 40% of Italian debt. So the negative consumption and growth effects are smaller in the debt restructuring option. And since Italy is running a small primary surplus, a debt restructuring would be feasible even without significant official external financing for Italy. A debt restructuring is thus a better option than trying a Plan A that will fail and then cause a disorderly restructuring or a default of larger magnitude down the line; although even a debt restructuring—dealing with Italy’s stock problems—would not resolve its flow problems (i.e. the lack of growth/outright recession, the lack of competitiveness and the large current account deficit). To resolve the latter needs a real depreciation that—most likely—would require the eventual exit of Italy and other member states from the EZ. Exit can be postponed for a while. Restructuring, instead, should be considered and implemented now. The alternative is much worse. [1] The €9 trillion figure may be overstated, complicating the prospects for redressing excessive public debt with high private wealth. Italian household wealth has increased significantly in the past 10 years, even though the economy has grown little or not at all. The main cause, given a high degree of home bias in household asset allocation and a 65% concentration in real estate, most of it domestic as well, has been the EZ integration-induced collapse in real interest rates, which is now reversing itself. The fall in real rates boosted the value of the cash flows and assets in the Italian economy without a commensurate increase in the (real) size of those cash flows or real returns on those assets (which would have shown up in a rise in real potential and trend growth). The trajectory of real and nominal rates has now gone into reverse; the rise in rates will reduce the value of those assets/cash flows; and indeed the Italian stock market has sharply fallen in the past few years as real rates and sovereign spreads have risen. Furthermore, most of the remaining 35% or €3 trillion of financial assets is invested in government bonds directly, indirectly through bank deposits, or through funds and securities. Levying an asset tax will raise the cost of capital for Italy; so either the cash-flow variant of the asset tax, 30% of GDP over 10 years, hits household income and thereby consumption, hitting growth/activity here and now; or it hits investment, reducing the long-run growth potential of the economy, which was already stagnant at a time when the world was growing rapidly and even the EZ was growing reasonably well. All this suggests that, eventually, both the debt and the real exchange rate will have to give, even though Italy seems to start from a better flow position (fiscal and external) than Greece, and a comparable stock position (after a restructuring of Greek public debt). The following content is offered for the exclusive use of RGE's clients. No forwarding, reprinting, republication or any other redistribution of this content is permissible without expressed consent of Roubini Global Economics, LLC. All rights reserved. If you have received access to this content in error, RGE reserves the right to enforce its copyright and pursue other redress. RGE is not a certified investment advisory service and aims to create an intellectual framework for informed financial decisions by its clients. This content is for informational purposes only and does not constitute, and may not be relied on as, investment advice or a recommendation of any investment or trading strategy. 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