Singapore - Italy brings world closer to another Lehman moment

As I learnt in my primary school, as you no doubt learnt in yours, it is futile to lock the barn door after the horse has bolted. But to find the barn door wide open, with the beast still inside, and then walking away without doing anything - well, that is European policymaking.

By the time European politicians had woken up to the debt overhang in Greece, that country was already insolvent; the beast had scampered off. But Italy was - and is - different.

Europe's third-largest economy was perfectly solvent, even with a debt-to-gross domestic product (GDP) ratio of 119 per cent, when the yield on Italian bonds started rising a year ago, showing investors were turning jittery and something needed to be done to restore confidence.

Nothing was done.

Italy was solvent even when the yields on 10-year Italian debt briefly topped 6 per cent in August.

When that happened, bondholders were, in effect, saying: "Look, we think there's a 50 per cent chance that our money won't return to us in full if we keep it with Mr Silvio Berlusconi's government for the next 10 years. Please prove to us that our fears are irrational."

Once again, no one listened to what the market was saying.

Now, yields have tested 7 per cent. If Italy is forced to keep borrowing from the market at such an expensive rate, it will eventually go bankrupt. To prevent this outcome, it is essential for the bond market to be convinced that its fears are unfounded, and Italy is still solvent.

But who will bell the cat?

No one will listen to the hopefully outgoing Italian Prime Minister Berlusconi. He is part of the problem, and as far as the markets are concerned, has overstayed his welcome.

French President Nicolas Sarkozy is sympathetic to Italy's woes. He has to be.

Once Italy loses access to private credit markets and has to be bailed out with European taxpayers' funds - a harrowing outcome that looks increasingly likely - bond investors will target France. If nothing else, his country's pristine AAA bond rating could wilt under that attack, pushing up French borrowing costs.

But Mr Sarkozy has only a cameo role in this theatre of the absurd. The central characters are German Chancellor Angela Merkel and European Central Bank president Mario Draghi.

Chancellor Merkel is so fearful of making any open-ended commitment to standing behind Italy, a promise that will never be ratified by German lawmakers or voters, that all she can do - and is doing - is to mouth homilies.

The euro, she is fond of saying, will be protected at all cost. That it may well be. But the question is, whose euro? A euro that is shared by 17 nations, or one that is eventually the single currency of only Germany, France and perhaps Belgium?

Speculation that the euro will not survive the current conflagration in its present form is adding to the raging crisis of confidence in the European financial system. A slowing European and world economy is aggravating the debt burden.

By far the most important actor in this drama is the European Central Bank (ECB). It can do what no one else in Europe can: print money.

But the ECB only reluctantly buys Italian bonds from the secondary market, in quantities that hardly make a difference. Had it committed itself to using newly minted money to buy Italian bonds by the truckload, and if it had vowed to keep doing it until Italian borrowing costs fell closer to German levels, the crisis might long have been over.

Why doesn't the ECB try this approach? The answer, in one word, is pigheadedness. The ECB says its only mandate is to keep euro zone inflation below 2 per cent. And if it were to print a lot of money, it might fail to keep that promise. The German people, who carry memories of severe hyperinflation from the 1920s, do not want ECB to take too many risks.

We in Asia, meanwhile, can only bang our collective heads against the wall in frustration. The MSCI Asia-Pacific equity index has declined 11 per cent since end-June. The big worry is a 2008-type shutdown in credit markets that will impair trade and investment flows.

For this Armageddon scenario to unfold, one or two major financial institution will need to crash - and no, piddly brokerages like MF Global going belly up won't do.

A banking crisis could indeed occur.

In borrowing and lending euro funds for just three months, banks are displaying a greater fear of one another's solvency than they did just before the collapse of Lehman Brothers in September 2008.

French banks, in particular, are sitting on piles of debt issued by peripheral European nations. The value of this debt is falling. The banks may not have enough equity to absorb the losses, and the European Financial Stability Facility, Europe's bailout fund, is still waiting to get bulked up.

That is just one more hole in what increasingly looks like a tattered barn door. Probably it no longer matters if European policymakers just leave it ajar.

Andy Mukherjee

The Straits Times

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