Bond sale puts Italy to the test

Italy faces a crucial test later today as the technocrat government of Mario Monti launches its first big auction of long-term bonds since a disastrous upset a month ago.

Sydney Morning Herald,

29 December, 2011

The outcome will set the tone for a string of debt sales through early 2012 that risk stretching the eurozone bond markets to breaking point.

The EU authorities are hoping commercial lenders will use last week’s flood of cheap liquidity from the European Central Bank to soak up southern European debt and bring yields back under control, starting with Italy’s 8.5 billion euro sale of 10-year bonds today.

The country must raise 440 billion euros in debt in 2012, beyond the current fire-fighting power of Europe’s bail-out machinery.

Rome managed to sell euros 9 billion of six-month bills at 3.25 per cent yesterday - half the rate paid in near-panic conditions last month - but there was no follow-through to longer-term maturities and the rally in Europe’s equity and credit markets quickly spluttered out.

‘‘Even bankrupt states like Greece can sell bills: what matters is the long end of the credit curve, and this hasn’t moved much,’’ said Jacques Cailloux, Europe economist at RBS.

The S&P/ASX200 was down 0.7 per cent in afternoon trade, in line with other regional sharemarkets, as investors remained nervous ahead of the auction. Both US and European markets posted losses overnight. The German DAX index and Spain’s IBEX each fell 2 per cent, and the Dow Jones closed 1 per cent lower in New York.

The euro fell sharply to almost 1.29 euros against the US dollar, the lowest since January, as markets digested news that euro-zone banks had parked a record 452 billion euros in overnight deposits at the ECB for safe-keeping on Tuesday.

The flight to safety exceeds the most extreme moments of the Lehman crisis in 2008. Although the picture may have been distorted by the Christmas holiday, it is clear large parts of Europe’s financial system remain under acute stress.

‘‘The interbank lending market is broken. The ECB is having to step in as intermediary to do the lending that banks won’t do for each other,’’ said Mr Cailloux.

The ECB lent banks 489 billion euros last week at 1 per cent for three years in an unprecedented long-term repo operation (LTRO) to head off a credit crunch, but the level of fear remains so high that the banks have in effect lent the money back to the ECB at just 0.25 per cent (annualised) for a small loss.

Europe’s politicians had hoped that lenders would use a chunk of the ECB funds to carry out a back-door rescue of euro-zone governments in trouble without breaching the ECB’s legal mandate. Italian, Spanish, and French banks have all been under political pressure to buy their own government debt, and take advantage of the fat yield spread on offer known as the ‘‘carry trade’’.

Bundesbank chief Jens Weidmann described the ECB operation as ‘‘bridging help’’ for banks to keep them going until the sovereign debt crisis abates.

‘‘We think household income will rise 3 per cent next year, so it is not as if the world is collapsing,’’ he said.

In Italy, Mr Monti won Senate backing for 30 billion euros in austerity measures last week but it is far from clear if investors believe this can alone lift Italy out of its debt trap - or even if it is the right policy at all.

Italian bank Intesa SanPaulo said fiscal tightening will equal 3.6 per cent of GDP in 2012, pushing the economy deeper into recession. The business lobby Confindustria said the economy will contract by 1.6 per cent next year, and concerns are mounting that the shock therapy will cause tax revenues to plunge and prove largely self-defeating.

The latest package includes a petrol tax, duties on luxuries, a financial stamp tax and a property levy of 0.4 per cent on first homes, but so far lacks the structural reforms and labour shake-up needed to help Italy cope with the rigours of euro membership.

In Spain, home loans plunged by 44 per cent from a year earlier, the sharpest fall since modern data began. It is a reminder of how hard it will be to clear almost a million unsold properties. Luis de Guindos, a former Lehman banker now serving as economy minister, warned that Spain is on the cusp of a double-dip recession.

‘‘Make no mistake, the next two quarters are not going to be easy,’’ he said.