We have long suspected that Italy would enter recession either during the 4th quarter of this year or the 1st quarter of 2012. However, it is now likely that the Italian economy entered a new recession during the 3rd quarter of this year as GDP contracted 20bps during the quarter and expanded a mere 20bps over the trailing 12 months. If indeed a new recession has begun, it would be the fifth one in Italy since 2001.
The fact that the Italian economy contracted in the 3rd quarter presents a significant challenge to the nation’s attempts to address its debt crisis. Italian debt is approximately 120% of GDP. The nation’s parliament passed some rather modest austerity measures in the summer and is currently considering more significant austerity proposals from the new Monti government as this is being written. None of these measures, which will initially negatively impact GDP, were in force during the 3rd quarter. With a contraction already underway, the implementation of austerity programs will most likely plunge the Italian economy deeply into recession. A deep recession is likely to significantly reduce government revenues while increasing its expenditures on social safety net programs. This will significantly offset, if not completely overwhelm, government savings from austerity programs, making it difficult for Italy to reduce its debt-to-GDP ratio. In fact, according to PIMCO’s Andrew Bosomworth, at its current cost of financing, Italy would need to achieve a permanent primary budget surplus (i.e. prior to factoring in interest on the nation’s debt) of 4.5% just to stabilize its debt-to-GDP ratio. The chance of that happening is negligible to say the least.
ECB Offers Massive Liquidity
At the ECB’s meeting two weeks ago it reduced its benchmark lending rate 25bps to 1%. It also extended the term over which it would lend banks unlimited sums of money from one to three years while easing the collateral requirements on such loans. On Wednesday, the central bank lent Eurozone banks 489 billion Euros in three-year loans, 67% more than the 293 billion Euros estimated in Bloomberg’s survey of economists. It also lent banks 25 billion Euros in 14-day loans, up from about 3.86 billion Euros last week.
This is an enormous injection of liquidity into the European banking system. The ECB’s goal is to ensure continued flow of credit to individuals, businesses, and indeed, sovereigns. Yet the extent that this liquidity will be injected into the economy by the banks remains to be seen. Indeed, the major failing of quantitative easing in the US has been the fact that banks have simply increased their deposits at the central bank rather than significantly increasing lending. Given our expectation for a recession in the Eurozone in 2012, it seems likely that banks will maintain large cash reserves and that relatively little of this money will find its way into the general economy. Some will likely find its way into sovereign bond markets, but aside from very short maturities, little is likely to find its way into troubled sovereign markets. Banks have been shedding assets, particularly long-term debt of troubled sovereigns, over the last six months.
The ECB’s loans significantly ease liquidity pressures on Eurozone banks. The banks have about 230 billion Euros of debt to roll over during the first quarter of 2012 alone according to ECB President Mario Draghi and about 600 billion Euros maturing over the course of the year according to a study by the Bank of England. Yet these loans do not address the solvency issues, which given the leverage ratios of some very large European banks, is likely to be a problem. Dexia, the troubled French-Belgian bank, is unlikely to be the last banking failure experienced during the Eurozone crisis. The question is likely to be when, rather than if, another large European bank (or banks) fails.
Additional ECB Note
We have noted in the past that the ECB is legally constrained by its mandate and EU Treaties that prevent it from acting as a lender of last resort to Eurozone sovereigns. We have also noted that the bank is relatively lightly capitalized. However, Roubini Global Economics recently issued a report discussing the relative importance, or lack thereof, of capital in the functioning of central banks. They note that the ECB has only purchased about 207 billion Euros in assets, roughly equivalent to 2% of Eurozone GDP. This leaves significant scope to increase purchases when one considers that the Fed and Bank of England asset purchase programs represent 17% and 19% of GDP, respectively. Roubini notes, as we have above, that central bank asset buying programs have not stoked inflation as it has been met by a corresponding rise in bank reserves. As such, this would give the ECB scope to act without putting significant upward pressure on inflation in the short-to-intermediate term.
Roubini goes on to note that central banks typically only become insolvent due to unsustainably large exposure to foreign currency denominated liabilities, which comprise a mere 50bps of the ECB’s liabilities. Otherwise, the ability to issue money enables them to remain both liquid and solvent even if they temporarily have negative equity. They note that paid in capital for the ECB, Fed, Bank of Japan, Bank of England, and the Swiss National Bank are no more than 20bps of respective GDP levels. In short, it seems that central banks generally operate with modest levels of capital and the ECB is no exception.
Roubini’s research suggests that the ECB’s modest capital levels may be less of a hindrance to its acting as a lender of last resort to sovereigns than we had thought. It strongly suggests that despite the bank’s modest capital base, the ECB has significant room to maneuver from a financial standpoint. However, from a legal standpoint, it simply does not have the right to do so. From a political standpoint, Germany stands staunchly in the way of granting it such authority. In short, both law and politics prevents the ECB from stepping more forcefully into the breach than it has thus far. As such, the constraints preventing the ECB from acting more aggressively to stem the crisis are largely political, rather than financial, in nature. The end result, however, is that the crisis continues to fester, placing greater economic distress on the entire Eurozone.