Opinion: Italy is the next domino to fall in the Eurozone

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  • 30. July 2015

Jonathan RochfordJonathan Rochford
Portfolio Manager,
Narrow Road Capital

In the last six months the inevitability of a haircut on Greek government debt has become obvious with even the IMF putting forward that the current level of debt is unsustainable. Once markets have digested that, the logical question is who will be the next Eurozone nation to default?
Portugal, Ireland, Italy and Spain are the main contenders with each having their own issues that could bring them unstuck. Amongst this group, I’m singling out Italy as the weakest, even though the ten year government bond yields would indicate Italy is the second lowest risk amongst the four.

Firstly, Italy’s debt to GDP ratio is the third highest in the developed world coming in behind Japan and Greece. Not only is it higher than its peers at 135.1%, but it is growing at a rapid rate adding 3.0% in the last quarter. The growth in the debt to GDP ratio comes from both budget deficits and anaemic rates of GDP growth, neither of which is expected to improve anytime soon.

Secondly, Italy’s banks are amongst the worst performing in Europe with non-performing loans currently at 17% of gross loans and rising. There’s also a substantial pool of high risk loans on the edge of falling into default. The 2014 European Banking Authority stress test found that Italian banks were amongst the least prepared to deal with what was a fairly soft “stress test”. This all points to the possibility of future bank failures and deposit haircuts (think Cyprus) or the need for a government bailout. Either way, the debt/GDP ratio could rise quickly.

Thirdly, the Italian population is the fourth oldest in the world behind Monaco, Germany and Japan. When combined with a bloated welfare state Italy ranks highest in the OECD for pension payments as percentage of GDP at 14%. This is only set to get worse as the fertility rate of 1.4 children per woman is one of the lowest in Europe and migration rates remain low.

Fourthly, Italy remains a hopelessly inefficient and corrupt economy. The government bureaucracy is rated amongst the worst in Europe, the influence of the mafia cripples investment in the private sector and tax evasion is rampant. As Greece has shown, austerity measures alone are not the solution, economic reform is a necessary part of the process of change. Like Greece, there appears to be little appetite for long term reform measures in the short term political cycles.

Despite all of the above being public knowledge, markets aren’t yet pricing in much of a risk in Italian ten year bonds with the premium over German ten year bonds currently 1.15%. This looks like a good opportunity to go short with the aim of realising a substantial gain when markets either reprice Italy as an individual risk or when the spectre of European sovereign debt risk next resurfaces. As Italy’s sovereign debt is double the size of Spain and roughly ten times the size of Ireland and Portugal it is simply too big for Europe to bail out. Those looking to offset the cost of shorting can consider going long Australian AAA residential mortgage backed securities, which are currently paying around 1.10% above the Australian government bond yield.