Italy is becoming too similar to Greece: unsustainable debt, a technocrat government run by an ex-banker and slow moves on reforms. Yet contrary to Greece, Italy is too big to bail. And contrary to Greece, Italy’s problem is mostly a liquidity problem rather than a solvency problem. Italy can certainly avoid PSI, IMF intervention and default. This analysis originally appeared in the Forex Outlook for Q1 2012. You can download the full report for free by joining the mailing list in the form below. Liquidity to Solvency The key lies in bond yields. Italy’s big redemptions in 2012 mean that every new bond auction enlarges the debt pile of Italy, which stands on around 120% of GDP. The prescription by the European Union is austerity, and Mario Monti, an ex Goldman-Sachs banker, is up for the task. More austerity means smaller GDP, in a country with a stalling population and low growth. Italy cannot grow its way out of spiraling debt through austerity. What can be done is more active action by the ECB to lower yields. It doesn’t need to intervene directly in the primary markets, but move in the secondary markets and send a clear message. ECB The Italian head of the European Central Bank, Mario Draghi, another ex-banker, is reluctant to act, and is under pressure from the dominant German central bank (Bundesbank). The ECB buys Italian bonds only to keep yields from jumping to extremely high levels. This is enough to keep Italy dragging its feet and to put pressure on the government to act. The ECB already introduced a bigger step: LTRO which is an indirect way of QE, as it encourages banks to buy low grade sovereign debt and pledge it as collateral for the money it gets from the ECB. This nice arbitrage had a small effect. Here are three scenarios for this quarter: Another LTRO: The ECB has another operation planned on February 29th. This might give the necessary boost for banks to buy sovereign debt, including Italian and lower the yields but isn’t likely to push them to low levels. The impact on the euro depends on the success of this operation. Given the almost inexistent impact of the first operation, the euro will probably drop. Chances are high. More leg dragging: Also here the chances are high, as this behavior is classic. With Italy paying 7% on long term debt, the burden will rise, and so will the chances of a default. An Italian default in Q1 2012 seems very remote, yet more expensive auctions will lay the foundations for this later in the year. The euro will drop on more bad auctions. Bond Buying En Masse: With rising chances of Italian debt getting out of control, the European banks are at great risk. Will this convince Germany to give a green light to act aggressively in the secondary market and lower the yields? The chances are low. In this scenario, the euro will likely rise on serious action, even if this means performing American style QE – something that weakened the US dollar. Yohay Elam Yohay Elam Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts. Yohay's Google Profile View All Post By Yohay Elam Opinions share Read Next The unbearable lightness of being FxPro - Forex Broker 11 years Italy is becoming too similar to Greece: unsustainable debt, a technocrat government run by an ex-banker and slow moves on reforms. Yet contrary to Greece, Italy is too big to bail. And contrary to Greece, Italy's problem is mostly a liquidity problem rather than a solvency problem. Italy can certainly avoid PSI, IMF intervention and default. This analysis originally appeared in the Forex Outlook for Q1 2012. You can download the full report for free by joining the mailing list in the form below. Liquidity to Solvency The key lies in bond yields. 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