Searching for politically acceptable policies is fine if the set considered intersects with market-acceptable solutions. Can the Italian bond market be stabilised without mobilising the ECB balance sheet?
The alternative instruments available are essentially a combination of support from reluctant secondary market interventions by the ECB and potentially the EFSF (including its new SPIV) and a credible Italian commitment to cutting the (small) budget deficit. The trouble is that the ECB will not commit to open-ended secondary market support, and is in any event intervening at interest rates which are too high. The EFSF is severely constrained in the short-run and the new arrangements to extend its balance sheet are stuck on the runway. Italy appears to have rejected an IMF standby (or not), and it could hardly have been big enough to matter anyway.
Early fundraising for the EFSF went reasonably well but Monday’s issue was a disaster. The spread over bunds is now outside France, Belgium next stop, has risen over 100 bps since the market debut and lenders have been unnerved by the continuing re-definitions of the status and mission of this supranational borrower. Klaus Regling’s pilgrimage to Beijing the previous week failed to secure any commitment to the new borrowing vehicle and the old one could be on negative watch before France. In any event a balance-sheet-constrained vehicle will always be tested. A bail-out fund paying large spreads with continuing uncertainty about its structure and mission, and which competes with sovereigns in the market, is in danger of itself contributing to instability.
The €350 billion required by Italy over the next year to fund roll-overs and the prospective deficit may not be forthcoming even with a credible new fiscal adjustment programme. Worthy long-term measures to raise the potential growth rate in Italy will not inspire bids at bond auctions. There may be no equilibrium rate above 6% or so.
European policy could be characterised as seeking sequentially the set of previously unthinkable measures needed to stop the rot and continually falling short. Working backwards, the bond and interbank markets could be stabilised by the following shock-and-awe package, with lots of moral hazard:
– Hard default for Greece and for any other countries (not including Italy or Spain) which need them, calculated to make them unambiguously solvent on exit from their programmes.
– Compulsory re-capitalisation for the banks
– An ECB reverse tap in the Italian bond market
If this set of actions is politically infeasible, and if no lesser package will work at this stage, the inference is inescapable and will be drawn soon.