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This article was published 11/11/2011 (1636 days ago), so information in it may no longer be current.
The worst-kept secret in the world of finance was revealed this week when Italy's bond market went into seizure and took the global capital markets down with it. It was as if investors had been so preoccupied with Greece they forgot about Italy. Well, get used to this kind of volatility, if you aren't already. But don't panic, either. The world is not coming to an end.
Italy, to be sure, is in a spot of trouble. Its economy isn't as weak as Greece's, but its debt is still huge at 1.9 trillion euros (that's about $2.6 trillion). Worse, Italy has a lot of bonds maturing in short order -- about 300 billion euros worth. Given the way investors have fled from Italian bonds, driving their prices down and their yields up, the country will have a hard time replacing that maturing debt with new bonds. Investors will have a hard time buying bonds from a troubled European country, given that Greece's lenders will lose a big chunk of the capital they advanced to that country.
The situation is grave, but not as bad as it might seem by the headlines. First, although Italy's debt is enormous, its deficit is actually quite small at about four per cent of gross domestic product. Italy actually produces what they call a primary surplus. That is, the government takes in more money than it spends if you don't count interest. That's small comfort, but it does speak to some government discipline, and at the end of the day, markets are all about confidence.
Another problem this week was that investment dealers increased the amount of margin -- think of it as a kind of down payment -- investors have to post to own bonds. Higher margin requirements, wherever they're imposed, be it in the stock, bond or commodity markets, usually lead to sell-offs as investors liquidate other assets to get the cash to post the higher collateral.
That's not to say this fully explains the swoon in Italian bond and, indeed, global-asset prices. Investors are spooked, and for good reason. Italian bond yields, the effective interest rate on the money the government borrows, are over seven per cent. Ireland, Portugal and Greece all needed bailouts when their borrowing costs went north of that number. It might not sound like a lot, but on 1.9 trillion euros, two percentage points means Rome needs an extra 38 billion euros every year to finance its overall budget. You can't do that when you're running an austerity program that's already crunching your economic output.
So it looks bleak, but there's hope. First, there's the European stabilization fund, a 400-billion euro lifeline the continent wants to expand to one trillion. It's having trouble doing that right now, but I think emerging economies such as China, as ironic as this sounds, will ultimately contribute to the fund. It's in their interest.
The other stopgap is the European central bank. No one would accuse it of always doing the smart thing. It actually raised interest rates earlier this year, which one prominent economist called the stupidest thing it could have done. But it has bought the bonds of troubled European countries, including Italy, to keep yields down (buying bonds increases demand, which raises the price of the bond, which lowers the interest rate) and can do more. Ultimately, the European central bank can print money if necessary. I suspect it will have to do that eventually, especially given that once Italy is out of the headlines, France is probably next -- and France is the second most powerful economy in Europe.
It's easy to get scared by the headlines, which are terribly bleak and foreboding these days. But remember that the business media have an interest in sensation, and so do politicians: They know very well that scaring an electorate is usually the fastest way to get them to take their medicine.
Fabrice Taylor is an award-winning financial journalist and analyst and author of the President's Club Investment Letter. Email him at email@example.com