THE UGLY MATH BEHIND ITALY’S SOVEREIGN DEBT CRISIS….
Peter Boockvar posted some ugly figures at Barry’s site yesterday. He notes the depressing math behind the Italian sovereign debt situation:
“REVISED: Here’s a back of the envelope calculation on Italy, highlighting the impact that a rise in financing costs coupled with a lack of growth can have on their finances. Italy needs to refinance about 310b euros of debt in 2012. I estimate the average interest rate they are paying on this maturing debt is 2.7% (short term rates collapsed in ’09-’10). With an average debt maturity of 7 years, Italy may be paying 6%+ on the refinancing. Assuming a 350 bps additional cost times the 310b euros of maturing debt, this adds 10.9b euros of interest expense to the 54b euros of interest payments scheduled to be made in 2012. At the same time, Italy’s 2T economy is expected to grow REAL GDP.1% in 2012 and nominal around 3%. Thus, nominally 60b euros will be added to their economy with all of the incremental gain thus going to service interest expense. This also doesn’t take into account any new debt Italy has to take on over and above what is maturing. Over time, just to tread water, any country needs to generate nominal GDP growth equal to its financing costs. In the 10 years prior to the sharp ’08-’09 economic contraction, Italy saw nominal GDP growth of 3.7% (REAL averaged 1.3%), near its financing costs over that time period. A continuation of nominal GDP growth of 3.5-4% (now mostly consisting of inflation) will no longer cut it for Italy with funding costs at current levels.”
As we know with Greece, growth is the key. If these nations cannot grow their way out of this crisis then they are doomed to deteriorating budgets. The worst part about the situation in Italy is that the growth outlook is the absolute worst of the major EMU nations and has been for a very long time. In a recent note, Albert Edwards of SocGen noted this depressing fact:
“I had a very long chat with our Italian economist, Vladimir Pillonca. He says one single variable encapsulates the depth of Italys economic problems: GDP per capita is lower today than it was a decade ago – one of the worst performances among advanced economies” in the IMF’s words.
The real issue is Italys incredibly low productivity growth (see top right-hand chart above). Hence, having been in excess of 2% yoy in the late 1990s, Italys trend GDP growth rate is now barely positive on Vladimirs estimates.”
The math just doesn’t add up here. Even if the country can right its bloated debt issue, they are unlikely to grow their way out of this debt crisis any time soon. In fact, given the austerity measures the odds of them achieving their growth targets are remote. I continue to think that Europe underestimates the gravity of the situation here. They have to be realistic with themselves. In order to resolve this crisis you must eliminate the solvency issue at the sovereign level. The only way to achieve this is via a fiscal union or the re-implementation of the old single currencies. The latter would likely involve the partial or complete destruction of the Euro and would, in my opinion, be a disastrous situation for Europe and the global economy. The former, unfortunately, involves choosing Euro national pride over individual country pride. Easier said than done….
Unfortunately, the Germans are in the driver’s seat hoping the situation will fix itself so they can go along their merry way with record low unemployment and decent relative growth. What they don’t seem to understand is that the wheels are coming off of the car they’re driving and if they don’t act soon the car is certain to crash. Mario Draghi, an Italian, is taking over the ECB. Of all the people in charge, we should hope that he would be able to convince the Germans that the ECB bazooka must be picked up and fired straight into the heart of this crisis….
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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39 Comments
Italian bond yields hitting 6.2% overnight. They didn’t fix jack sh$t with last week’s deal.
Mr. Boockvar, did you take into account that Italy has 1,9 trillion public debt and 9 trillion of private sector wealth?
Would you consider a possibile solution of a debt cut one off via an extraordinary wealth taxation?
Isn’t a haircut also some kind of wealth tax?
What’s up with the RSS feed? When did you change it? Now I only get summaries (which is fair, there is some ad revenue to be made), no author names and it seems like the dates are also wrong.
Cullen,
The real economy in Italy, Greece and many other countries is underground where there is growth without taxes. Anybody visiting Europe finds people have money and they seem to live a pretty happy life.
EU is not viable because decision process is so convoluted that even Devil wouuld throw up.
I have your calculation right here. 2+2 = 4 is a constant, and just because TPTB say it’s 10 doesn’t make it so, as we are finding out this morning. It’s not any harder to figure out than you cannot cure a debt problem with more debt. Has history taught us nothing? Governments and empires have been debasing their respective currencies for as long as recorded histroy. Do we really think we are more special?
DanH, they lost the 6,7 and 8 handle while you slept.
Where are you seeing that? 3 months down the line, maybe, but not on today’s print.
It is interesting to watch as reality sweeps away the illusion that debt without productive investment can be serviced from the sweat of citizens and these citizens are expctef to watch passively as different classes of wealth are treated unequally. It is the seeding of revolution.
Just goes to show how quickly all this could unravel. Austerity and unrealistic revenue models are hair triggered… Still, Gov’t puts save the day then when markets recover some see breathing room to get obstinate. Then repeat? That chain has to break down sooner or later. That said, US equities are holding up pretty well considering the news. Bad news is being shrugged off well so far in US equity markets- what would news like this have done in September? Maybe the market is a little slow, the VIX took off. Once again S&P 1220 is looking to be some kind of launchpad one way or the other. I can’t count out the upside. Of course this is just my opinion (my trades last two days are -.25%) TLT woulda shoulda coulda. Thoughts?
MS, what? Shrugged it off if you don’t include the last 2 weeks worth of gains blown away in two days. The market usually eats like a bird and craps like an elephant! Welcome to the elephant area of the zoo, and what is that smell?
Yeah, I thought that would draw a comment. I’m just surprised we’ve only seen -2.5% today on the S&P. If this latest blowout doesn’t kill this rally dead then all this selling is just a big shakeout imo. Sometimes market s**t smells just like roses. Birds & elephants LOL. So true.
Oh, and the 3 month T-Bill has had a negative yield for the last two days. Houston we have a problem!
Big problems! Will the bulls run up the blind alley? Stay tuned.
PI,
Goodbye 9 Handle: BTP Collapses To 89.5, Down 4.3% On The Day; Next: Bidless?
http://www.zerohedge.com/news/goodbye-9-handle-btp-collapses-895-down-43-day-next-bidless
MS, LOL! Ya the bird/elephant analogy makes me laugh as well, but it is a truism. I have been short this market through the charade formally known as the EU Crisis, and I have had to grit my teeth everyday while the markets melted up, but I follow long term/duration charting which takes out the daily noise that just confuses the underlying truth of the situation. I’m only using a small percentage of my book for speculating while the majority sits in MM accounts because it’s all about return of my principal and not the return on my principal. Now if the MM market doesn’t freeze up, as it did in 2008, I should be good to go. IF…if…if…ain’t that always the case.
The money market is the fly in the ointment. It used to be that if things got out of hand you just went to MM. I’m close to 100% MM at the end of most days but in the event of a really big disaster (grece & rest of the piigs) where do you put money at the close? It’s getting chippy out there.
MS, it sounds like we are on the same page regarding the market and all the various scenarios. I will never forget looking at my MM accounts in 2008 with a big fat red/loss on something that should always be money good, but then again, ARS were supposed to be money good as well, and we know how that worked out. Some may still be in litigation. The 3 month sitting at -.02% doesn’t exactly bring much comfort either.
Spider etf BIL 1-3 month T-bill is one option but it means trading in and out so more comissions and like you point out negative returns. But if that freezes guns and ammo will be the new currency. No point in planning for that I guess.
Either way the EURO is going down. If the new ECB president can save the EU, the EURO will go down. And if he doesn’t, the EURO will go down. This is getting to be like the Yen trade.
They keep finding ways to make an expensive problem more expensive
the math will convince the germans to print the euro if they want to buy some time to hope for a solution that will not come.
it is the least-worst of the available possible alternatives(going fiscal not being one of them–lots of people with memories have to ‘pass away’ before that)
the ‘bad memory’ that inevitably gets them to go ‘fiscal’ will be the memory of the coming worldwide depression they will trigger(not cause–every developed and developing economy has a debt bubble including china) thru the southern periphery’s decades long unsustainable entitlement state coming to the forefront FIRST.
in the ‘now’ and ‘for nothing’ centered cultures of the developed world, all one has to do to get elected is promise and deliver ‘now’ and ‘for nothing’….thru debt that is becoming overwelming.
so, the world goes thru a great econ reset, with much pain for many….what will they learn?…..not much, i bet.
Mario Draghi was one of the guys who has said that the italian govt should fire 30, 40 or 50% of its workers and then the rest can be more productive and can be paid e.g. 20 or 30% more. In other words increase productivity.
What scares the heck out of me is history. First you have currency wars, then trade wars and finally the real war so that everything is reset to whatever currency regime the winning side picks, but always know the pigmen will be right there to give a helping hand at first use of whatever regime is picked. How sad is that for the little guy who gets used as fodder? VERY!
And a lot of countries (including the US) assume there will be growth in the first place.
Re: Mario Draghi, an Italian, is taking over the ECB. Of all the people in charge, we should hope that he would be able to convince the Germans that the ECB bazooka must be picked up and fired straight into the heart of this crisis….
Only if you think a Goldman Sachs man represents a solution.
Bazooka and Germany should not be used in the same sentence. Too many bad memories for the rest of Europe when it comes to weapons and the Germans use of them to bring Europe to it’s knees twice in a century. Screw the Germans and their banks which knew exactly what they were doing to the rest of Europe in the same way our US banks hosed anyone who could fog a mirror.
This was a helpful and provocative piece but I think the assumption that Italy borrow at 6% for a number of years can be challenged. The eurozone belief is that Italy is as much a victim as they are the culprit. Italy can easily withstand the 6% funding costs for a couple of near-term debt maturity rolls, but I think the monetary leaders in the Eurozone anticipate that the spreads to German bonds will normalize. Somewhat to Cullen Roche’s point- they have to! I reviewed Mario Draghi’s speeches and writing recently in order to think this through. For what it’s worth I couldn’t come to any sort of a definitive answer based on Draghi’s background. I have link ins to his most relevant speeches. Will Draghi, in due course get the ECB to subsidize Italy’s funding costs. In my view – it is highly likely that Draghi will have to.
http://crackerjackfinance.com/2011/11/welcome-to-the-ecb-mario-draghi/
An omen since we just had Halloween:
The magic number for the S&P 500 is -2%
November 1, 2011, 10:57 AM
.
Bespoke Investment Group has helpfully run down the data for the the worst starts to November.
The early 2.7% slide in the S&P 500 would qualify for the third worst after Nov. 4, 1929, and Nov. 1, 1932.
The S&P 500 has fallen more than 2% on the first trading day of November four times.
On each of those occasions it’s gone on to fall for the rest of the month.
However in Novembers when the first-day slide has been less than 2% but greater than 1%, the index has gone on to end the month higher.
-Tom Bemis
CJ, 6% would be lovely, but market events have totally destroyed that thesis.
The ECB should monetize Italian bonds and implement a tax on foreigners holding German debt. The only other way out (other than break up and fiscal union) is to dare the world to prop up the Euro by buying lower quality debt. I’ve always been very critical that the US would allow China to control the exchange rate via buying only the best US asset … if you want to peg, you should have to hold Qwest junk bonds, Rockefeller Plaza, etc. along with those USTs (it worked for the US with Japan! Look what we did to them!).
1% (GDP growth) unsustainable situation
Debt = 120% of GDP -> unsustainable can’t last for long
Alternate universe:
better understanding of monetary system -> fix flawed currency -> ECB-backed interest rates would be less than 2% -> Italy would have a sustainable situation to buy time until the global economy improves
All that needs to be said.
1%(GDP growth) < 6%(interest rate) is an unsustainable situation (sorry, the first line was chopped somehow)
“Assuming a 350 bps additional cost times the 310b euros of maturing debt, this adds 10.9b euros of interest expense to the 54b euros of interest payments scheduled to be made in 2012. At the same time, Italy’s 2T economy is expected to grow REAL GDP.1% in 2012 and nominal around 3%. Thus, nominally 60b euros will be added to their economy with all of the incremental gain thus going to service interest expense.”
The conclusion is incorrect. You’re increasing the interest expense by 10.9B, and growing the economy by 60B, so you still have 50B left of growth. All of the incremental gain does NOT go to servicing the interest expense. Of course new debt will eat into the growth, but Italy would have to take out a lot of debt to eat that 50b. Obviously if they grow the economy by less, or go into recession, the numbers change.
Hi Mr. Cullen Roche,
I,ve just read your article on:
http://www.businessinsider.com/the-ugly-math-behind-italys-sovereign-debt-crisis-2011-11
and I don’t agree at all with your analysis because if you call your website “Pragmatic Capitalism”, you should also explain that there are far better alternatives to calculate the national debt of a country!!
I’ll explain my reasoning straightaway!!
The worst thing of this matter called “Sovereign Debt Crisis” is that the traditional ratio,
“Central government debt, total (% of GDP)”
is calculated in a wrong way because GDP is an annual flow instead Central government debt is a stock rather than a flow!!
http://data.worldbank.org/indicator/GC.DOD.TOTL.GD.ZS
What’s more, if average debt maturity ( in the case of Italy is seven years ) was considered to calculate the ratio in the right way ( in other words , the ratio with a right comparison among two annual flows), the rank would change significantly!!
Apart from that, another fair measure of the national debts could be:
http://www.gfmag.com/tools/global-database/economic-data/10403-total-debt-to-gdp.html#axzz1cWfNgxS6
Even in this case, all the matter would be very different!!
In conclusion, they ( international public authorithies ) have chosen the worst way to calculate a very important ratio so that the banks can play dirty games whenever, whatever, wherever they want!!
Shame on them!!!
All the best!
Fab, greetings from Italy.
True, Boockvar’s calculation isn’t perfect, but the stock to flow comparison still gives us a fairly reasonable metric from which to gauge the affordability of the debt. Thanks for pointing it out.
Hi Mr Roche,
thank you for your response, that’s very kind of you!
Anyway, another time I don’t agree with you at all because starting different assumptions cause final different results!!
In Spanish language: “Todo Depende”!!
I’ll write a post later about this issue.
Best regards.
Fab
The figures aren’t changing enough to make a really meaningful impact on the final result. I think you’re making a bit of a semantic point though you are certainly correct. Debt as a % of GDP does provide us with a useful though imperfect metric. Either way, the math for Italy is the same. Given their low growth estimates, their debt levels appear incredibly difficult to overcome and reduce.
Hi Mr. Roche,
I take it for granted that if the starting assumptions are quite different, the whole western financial system would behave in a totally different way because the actions and reactions would be very different!!
Here is an interesting article about this kind of issue:
http://www.centroeinaudi.it/qlettera-economicaq/ricerche-economiacentroeinaudiit-99/1200-non-esistono-fatti-ma-solo-interpretazioni.html
To translate it into English for free:
http://translate.google.com/
In conclusion, there is an old Latin saying which goes: “In medium est virtus”
The English translation: “Virtue is in the middlle”.
Best regards.
Fab