Problems in Italian Bailout

Italy may a face a bailout sooner than later. Like the Italian sovereign, also Italian banks are somewhat hiding behind Spanish banks. The situation there isn’t much better; however, Italy’s main problem is financing itself (the sovereign) in the markets.

There is a good chance that Italy will receive some kind of help to lower its yields during the month of July. This might be a limited bond-buying program to lower the yields. The EU Summit decided on no seniority for the ESM bailout mechanism over private bondholders. But that’s the end of the good news. Here are the problems:

1. No seniority also in Italian case?: The biggest achievement of the EU Summit (which is full of holes) is that the bailout funds will have no seniority over private bondholders, thus not scaring them off. There is doubt that this will apply to Italy in addition to Spain. In addition, the ESM hasn’t been ratified by all the euro-zone countries.
2. Sufficient size: It is highly doubted that the current bailout mechanisms are sufficient to safeguard Italy, due the size of the economy and the debt. Placing Italy in a bailout scheme casts an even bigger shadow over the euro-zone.
3. ESM Not Ratified: The “permanent” bailout mechanism, ESM, hasn’t been ratified by all EU countries. This includes a heated debate in Germany, the paymaster, which faces challenges in the court. The changes in the rules of the ESM also require approval.
4. Withdraw of Italy from funding: As the euro-zone’s third largest economy, Italy has a significant part in funding bailed out countries. If it requires a bailout, the stack of cards may tumble down. Other countries will have a higher burden and Italy’s bailout may be too high.

As we’ve seen too often, action from the EU is usually greeted by the markets, and results in a rise of risk currencies such as the euro, pound, Aussie, kiwi and loonie against the dollar and the yen.

However, when the markets understand that these moves are half baked, require approval and are subject to conditions, the trend quickly reverses.

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