Spain and Italy: Different Problems, Same Crisis

The Greek election came and went without much in the way of market reaction.  It would appear that “Mr. Market” is tired of hearing about Greece and has now moved across the Mediterranean to Spain.

But for all the wailing and gnashing of teeth over the country’s finances, even Spain is a relatively minor problem if tackled correctly.  At 69%, Spain’s current debt load as a percentage of GDP is actually lower than that of Germany, France or the United Kingdom.  And even if the planned bank bailout from earlier this month adds another $100 billion, total indebtedness will be roughly in line with these Western European peers.  

Should Spain need a full sovereign bailout due to its short-term funding needs—and it is looking increasingly likely that it will—a Spanish bailout would be affordable under the existing bailout mechanisms in place.  Unless Europe’s leaders are even more inept than the most cynical of us could imagine, it won’t be Spain that derails the European project. 

No, the real crisis that will eventually determine the fate of the European Union is not Spain and it’s certainly not Greece.  It’s Italy.

With a GDP of $2.2 trillion, Italy is the 8^th largest economy in the world, slightly smaller than Brazil but larger than Russia, Canada or India.  But the Italian government bond market is the 3^rd largest in the world, after only the United States and Japan. 

Italy’s outstanding government debt amounts to 120% of GDP, making Italy the most indebted of all industrialized countries save Japan or Greece.  When it comes to spending money they don’t have, it would seem that Italy’s politicians can compete with the best in the world.  And given Italy’s lackluster growth rates of the past two decades, the country’s ability to pay those debts should be called into question.

Spain and Italy are on odd sort of mirror image.  Before the crisis, Spain’s government was considered to be a model of responsibility, and its government debt load was among the lowest in Western Europe.  Spain’s current predicament was not brought on by government spending run amok but by a real estate bubble and bust that wrecked the country’s large banking sector.  In Italy’s case, the private sector is fine.  The country’s banks are, for the most part, in decent health and conservatively financed.  It is wanton government spending that called Italy’s credibility into question.

The issue of timing is also very different.  Spain’s short-term outlook is desperate; the country is struggling to close a yawning budget deficit without killing an economy that is already on life support, but its longer-term outlook is not particularly bad.  In Italy’s case, it is the short-term picture that isn’t particularly bad.  Excluding debt service, the country’s current budget is close to being balanced, and its immediate borrowing needs are modest.  But without growth, Italy’s debts become harder and harder to pay. 

But while we have two very different countries with two very different sets of problem, we have one crisis—a crisis of confidence.

The bond market is indicating a pronounced lack of confidence in Spain and Italy and in the European Union itself, as we can vividly see by the rising bond yields on Spanish and Italian debt.  A couple points should be made about this, however. 

Contrary to popular notion, the “bond market” is not an all-knowing, all-powerful collective intelligence that sifts through the economic data and prices the respective bonds accordingly.  It is a collection of emotional buyers and sellers who react to each other far more than to fundamental data. 

Financial theory would tell you that bond prices change to reflect changes in the underlying fundamentals.  But as any good trader knows, that relationship also goes the other way.  Price movements take on a life of their own and change the fundamentals.  A country that could easily finance its expenses at 4% interest may find it difficult to do so at 6%.  The country thus becomes “riskier” and now requires an even higher interest rate to compensate investors for the risk…which in turn makes the country riskier still.  The predictive power of the market is often no more than self-fulfilling prophecy.

Let’s return to Italy.  Italy was able to amass its gargantuan debts precisely because the bond market priced yields so attractively.    But what the bond market giveth, the bond market taketh away, and now Italian 10-year yields have crept up to crisis levels close to 6%.  In Spain, the yield has crept above 7%.

So, how is this vicious cycle broken?

Frankly, it’s not easy.  You need a “big bazooka” blast to shock the bond market into reverse.  In the case of Europe, you would need either a public commitment from the European Central Bank or one of the bailout facilities to buy as many bonds on the open market as it took to lower yields to a sustainable level. 

Germany has resisted this approach, rightly pointing out that doing so takes away the incentive to cut government spending.  Angela Merkel seems to believe that the only way to convince the problem states of Europe to get their houses in order is to threaten them with bond market oblivion. 

Unfortunately, there are limits to how far this exercise can go, and we are quickly reaching those limits.  Germany needs to commit itself to stabilizing the Eurozone, and it needs to do so quickly.

As bearish as this article might seem, I am actually quite bullish on select European stocks.  The crisis has created some fantastic opportunities to buy Europe’s best multinational blue chips and prices we may never see again. 

I trust that as dense as Europe’s leaders may seem to be at times, they do know better than to cut off their noses to spite their faces.  When faced with the destruction of the Eurozone,  they will do what needs to be done.  Today, this means aggressive bond buying by the ECB and some sort of EU oversight over the national budgets of its member states. 

It will happen…eventually.  In the meantime, we watch and wait.