Tuesday, July 12, 2011

Why Italy Is “Attacked”

Nothing changed much in the state of the Italian economy and debt during the last few days, compared to let’s say one or two months ago. But suddenly “the markets” (as the press puts it) “attacked” Italy under the form of a fall in value of Italian bonds, and as a consequence of Italian banks and insurance companies that hold these bonds. Is it a sort of duel between these shadowy characters  - speculators -and the Italian government (or the whole list of Euro zone governments)? Not at all.

There is, in fact, no “attack” against Italy, specifically. What happens is that the absence of any intergovernmental solution to the Greek problem (i.e. a massive bailout by northern taxpayers, followed by permanent transfers to the indebted country for the indefinite future, and possibly accompanied by a major partial default on the country’s debts) has progressively led, from one failed “plan” to another, investors worldwide to anticipate a Greek exit from the euro. This could in turn prefigure the most likely scenario for other over indebted members of the zone, penalized by the overvalued euro and unsustainable indebtness: exit now or accept the punishment of an unending recession.

For international investors the meaning of these developments is clear: the risk of the euro debts is rising (see Moody’s recent downgrades). Accordingly the required interest rate on euro instruments is also rising (augmented by a potential devaluation premium) and as a consequence the value of the euro debts is falling at the same time, as is the value of the euro in the currencies market. The more indebted the country, the higher is the required premium, Italy now catching up on Spain.

The inevitable exit of Greece from the euro zone will only confirm the soundness of this anticipation and will precipitate the fall of the euro, which already slipped from nearly 1.44 dollars last Friday to less than 1.39 today. This means, in other terms, that the markets incorporate in their valuations a partial default of debtors in euros.

A much larger depreciation is warranted if Greece exits the euro zone, but this will be good news indeed for indebted countries since it will amount to a corresponding reduction of the burden of their debts and a move towards the restoration of their international competitiveness.  

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