September 21st, 2011
12:05 PM GMT
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Editor's note:  Elisabeth Afseth has worked in bond markets for 17 years, starting out at Williams de Broe. She currently works as a fixed income analyst for Evolution Securities. She has an economics degree from the London School of Economics and a masters in economics from Oxford University.   

London (CNN) – Just when everyone was waiting for ratings agency Moody’s Investors Service to downgrade Italy, Standard & Poor’s gets in first with what is a much more damaging downgrade. S&P’s rating of Italy was already lowest of the three major agencies, and its downgrade from A+ to A, with a negative outlook, puts it three notches below Moody’s Aa2 rating (on watch for downgrade) and two notches below Fitch Ratings' AA-.

The financial markets largely shrugged off the downgrade. While bond yields on Italian sovereign debt - an indicator of risk - rose slightly, European equity markets were positive through the day.

Some have argued a downgrade was expected so therefore priced in. But it wasn’t this downgrade that was expected or priced in. It came from the agency with the lowest rating, which did not even have the sovereign on credit watch, but merely a negative outlook. Negative outlook generally means there is a one in three chance that the issuer may be downgraded within two years - it is much less of a warning of an imminent downgrade than a watch for downgrade.

To illustrate the point, S&P's has the U.S. rating on negative outlook after its controversial downgrade in August; I think it would be fair to say most market participant would be very surprised if the ratings agency downgraded the U.S. in a couple of months.

So how much does the downgrade matter?

It doesn’t alter the eligibility of Italian bonds as collateral for the European Central Bank, which banks need to borrow funds. It doesn’t cross any key ratings thresholds, therefore is unlikely to trigger automatic selling.

What we need to watch is investors’ confidence in Italy, and if those investors continue to buy the country’s sovereign debt.

Italy needs to raise about €380 billion of funds by the end of 2012. After the recently added austerity measures, Italy is expected to run a deficit of 1.2% of gross domestic product next year (though the ratings agency in yesterday’s report questioned the government’s budget savings projections). This is not a large deficit by global comparison.

Also in Italy’s favour is its debt maturity profile - the average life of government debt is just over seven years, which is longer than most, though there are quite hefty redemptions over the coming five years.

Italy’s main problems are lack of economic growth and a very high debt burden, at 120% of gross domestic product, which almost inevitably means large rollover of debt every year and therefore sensitivity to interest rate levels. The first problem needs to be addressed by politicians implementing structural reforms; the second requires investors' confidence so that they keep buying the bonds. These issues are interlinked, as that confidence will be very difficult to maintain if the resolve for reforms is seen to be falling short.

The €380 billion Italy needs over the next 15 months would pretty much wipe out the current European bail-out fund, or European Financial Stability Facility - even if the modifications to the facility are approved to allow it to increase its lending capacity to €440 billion. Italy is the third largest euro area country, generating about 17% of total eurozone growth (compared to Greece, Ireland and Portugal which combined account for about 6%).

Any contagion effect would be extremely serious. If markets decide not to fund Italy it is very likely that the fourth largest country, Spain, will also need support. Spain needs about €200 billion to cover redemptions and deficit funding requirements between now and the end of 2012.

The Italian and Spanish have benefitted from central bank support in the bond markets over the last six weeks. The ECB has bought up about €80 billion of the debt - which keeps the country’s funding price down - since it started intervening in the market.

We know that there is opposition to the program which enables this intervention, both within the ECB and amongst European politicians, but for the time being it looks the closest we are to a solution to the European debt crisis.

The ECB keeps repeating it cannot solve the euro area’s problems - that is the job of politicians, and will require financial and economic changes. But the ECB and expanded bailout funds can buy the high deficit/debt countries much needed time.

We can than just hope that this time is then used more efficiently than S&P’s revised outlook suggest.



soundoff (8 Responses)
  1. Sal

    The Italian Govt. has all the Public assets it needs to get a better debt ratio. And such assets are ready for privatization. It looks to me that too many people in London are getting excited about a possible Euro collapse. So at the end somebody can say: " I told you that it was not a good idea to join the Euro currency group !".

    September 21, 2011 at 8:17 pm |
  2. CraigNL

    No the ECB should NOT be buying anymore debt. It does not have the money to do so. And if this organisation thinks it can keep stealing Northern European money from hard working taxpayers they should think again. Out with the PIIGS, New Europe rising.

    September 21, 2011 at 9:10 pm |
  3. yl

    bo, you stuck, the whole is going to sink, it's too late to pull out, you all die togather

    September 21, 2011 at 10:06 pm |
  4. lala

    why cant europe just build something like borrow a little more and build a theme park or create parades or fashionn street markets to boost their tourism sector and hence jobs, then maybe it might help a little?u.s is in just a huge debt situation as well but they can handle it!

    September 22, 2011 at 1:07 am |
  5. Clive

    She says that the Italian deficit is 1.2% which is low by international standards – and so it is. The problem is that the underlying 120% debt has to be paid off. It cannot be inflated away because the ECB's remit is to keep inflation low and the Italians can do little about that.

    That means that Italy actually has to run a surplus, not a deficit – and for many years – to pay off the debt.

    The difference with, say, the US debt is that US debt CAN be inflated away as can the debt of all nations with fiat currencies.

    Oh and Sal, it is blindingly obvious that the euro was a political leap in the dark. Do you think they expected any of this to happen ? In that sense, its founders have already been completely wrong.

    September 22, 2011 at 8:01 am |
  6. Steve Thompson

    Italy's most recent downgrade is deserved. As the holder of the world's third largest debt in nominal terms, Italy has the world's eleventh highest debt-to-GDP ratio and is unlikely to reduce its debt-to-GDP ratio to less than 115 percent even with massive cuts to its annual deficits as shown here:

    http://viableopposition.blogspot.com/2011/07/italy-and-their-debt-bronze-medal.html

    Should the Eurozone economy contract as it appears to be doing, Italy will most likely be forced to default, an action that would very heavily impact the world's sovereign debt market in comparison to the threat of a default by Greece.

    September 22, 2011 at 12:32 pm |
  7. CraigNL

    @ yl, It may be to late to get out. But there is still time enough to KIK other OUT. You see, when we stop paying for PIIGS, they have no choice but to leave. And we have seen worse in our history! We will rebuild. Only this time without Southern and Eastern nobodies.

    September 22, 2011 at 4:59 pm |
  8. Gerard

    To get to a federal states of Europe a few omelets have to be cooked...and how that is done in the kitchen will be messy and for the client who has ordered it...it is just as well he does not see how his eggs are prepared...it can be messy...the hope being that the omelet remains intact and is edible.

    September 22, 2011 at 9:40 pm |

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