'Quitaly' risk premium lingers even as Italy's new
government commits to euro
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[June 19, 2018]
By Dhara Ranasinghe, Sujata Rao and Ritvik Carvalho
LONDON (Reuters) - Italian financial assets
still carry a risk premium regardless of the new government's commitment
to euro membership, with the coalition's promised spending plans still
expected to trigger a clash with European Union authorities later his
Since coming to power earlier this month the new government in Rome -
comprising the populist 5-Star Movement and far-right League - has been
at pains to reaffirm its support for the euro. That commitment has at
least partly reversed a late-May bond selloff, sparked by fears of snap
elections that might become a de facto referendum on the single
But uncertainty over Italy's future within the euro lingers.
"'Quitaly' or 'Italexit', or whatever you wish to call the possibility
of Italy leaving the euro area, is not on the political horizon. But
once the seed of risk is planted, financial markets tend to
extrapolate," said Shweta Singh, senior economist at TS Lombard.
Another crunch could come in October when the government's 2019 budget
is released. Its proposed spending plans are at odds with EU fiscal
rules and, if carried out in full, could worsen what is already the euro
zone's second-highest public debt ratio.
There are also concerns the new administration has not entirely shelved
prior plans to issue short-dated securities to pay state arrears - a
move some fear effectively creates a parallel payments system and proxy
So how significant are these risks in the eyes of investors and what
gauges do financial markets use to measure the outside chance of "Quitaly"?
Here are some that are monitored closely and will be watched over the
1. Getting real
Italy's yield spreads over Germany widened at the end of May to over 300
basis points, a five-year high. That is effectively the premium
investors demand to hold Italian debt because of its default risk. But
to gauge risk of re-denomination rather than just default, nominal yield
spreads may be inadequate.
A better gauge, according to Marcello Minenna, contract professor of
financial mathematics at Milan's Bocconi University, is the spread
between German and Italian "real" bond yields, i.e. the gap after
accounting for inflation differentials.
That spread currently stands around 3.5 percent, having risen above 4
percent during the Italy selloff peak on May 29 -- the highest since
mid-2013. Nominal yield spreads meanwhile are lower than that, around
2.2 percentage points. https://tmsnrt.rs/2JOI3Ez
Minenna explains that Italy's nominal yields do not properly reflect
inflation risks because its monetary policy is not set by its own
central bank which does not have the option, if needed, to buy
government bonds by printing money on a permanent basis.
So the BTP/Bund real spread is a better proxy of the default risk for
In a Quitaly scenario in which Rome reverts to the lira, a few things
would change: First Italy would set its own monetary policy, meaning its
securities would again reflect inflation risk. Second, default risk
would then include the inflation risk as all new debt would be in its
But because this currency would likely decline sharply in value against
the euro, Italian inflation would rise, causing investors to demand a
higher yield premium. Hence, "inflation risk would become again a first
component of the insolvency/default risk," Minenna said.
True, a sharp Italian inflation spike would also do this. But that's not
happening -- in fact, Italian annual inflation was at 1 percent in May,
half of German levels.
2. Welcome to New York
Italy, has two dollar-denominated bonds maturing in 2023 and 2033. Both
outperformed their Italian-issued, euro-denominated peers during May's
While yields on conventional long-dated Italian bond <IT10YT=RR> soared
more than 100 basis points in May, the yield on dollar-denominated
Italian government bond maturing in 2033 climbed about 80 bps
That's because dollar bonds governed by New York law would offer
stronger protection against debt restructuring, including a currency
redenomination, than the euro issues governed by Italian law.
[to top of second column]
Italian Minister of Labor and Industry Luigi Di Maio listens next to
Prime Minister Giuseppe Conte during his first session at the Lower
House of the Parliament in Rome, Italy, June 6, 2018. REUTERS/Tony
Michael Leister, head of rates strategy at Commerzbank, says that while
dollar-denominated bonds are less liquid and therefore harder to trade, their
recent outperformance suggests a rush to hedge the higher default risk in
3. From one CDS to another
Credit default swaps - derivatives used to insure exposure to a credit default -
surged during the recent mini-crisis, but CDS contracts based on guidelines
drawn up in 2014 rose more than those based on a 2003 definition.
That's because 2014-vintage CDS are considered more likely than their 2003
counterparts to pay out if a country like Italy exited the euro and
re-denominated debt back into the lira.
The 2003-dated CDS guidelines, created before Greece's euro exit scare in
2011-2012, provide for payouts for non-payment of debt but make it harder to
call a default in event of re-denomination. The spread between the two CDS sets
- commonly known as the ISDA-basis after the body regulating CDS - can be
considered a measure of redenomination risk.
On May 29, the Italy selloff peak, the ISDA basis widened to a record 120 basis
points, described by TS Lombard's Singh as the "rising cost of protection
4. Check your CACs
The ISDA-basis spread also relates to rules introduced in 2013, stipulating all
European government bond contracts contain collective action clauses (CACs).
These require a specified majority of creditors to agree a restructuring. All
sovereign euro zone debt issued after 2014 requires majority bondholder approval
if the issuer wants to change the currency of payments.
Around half of outstanding Italian debt was issued before 2013. During the rout,
yields on CAC bonds rose but less than on those without CACs.
5. Beyond Target(2)
Investors also look at Italy's balance within the European Central Bank's
Target2 payments system that connects euro area national central banks. The Bank
of Italy's liabilities toward other euro zone central banks hit a record high in
May at almost 465 billion euros ($548 billion).
While some of this could reflect domestic euro deposit flight to non-Italian
euro zone banks, the total is muddied by ECB purchases of Italian government
bonds via its quantitative easing scheme.
Overall, the concern is that if Italy were to leave the bloc these balances
would have to be settled, and complicated by redenomination or default.
During the 2012 debt crisis, capital outflows had driven the increase in Target2
imbalances and many reckon this could happen again should Quitaly fears
"We believe that a further increase of Italian Target2 (im)balances is likely to
reflect underlying concerns about the potential re-denomination or default of
Italian assets and may amplify prevailing tensions at the EU level," Goldman
Sachs told clients.
They added that should Italy's euro membership doubts rise further, "outflows
from Italy toward northern euro area countries could resume as Italian residents
seek a haven from re-denomination risk."
Italy's Target 2 balance hits record high in May https://reut.rs/2JOlzPX
Demand for Italy's dollar-denominated debt jumped during May crisis https://reut.rs/2JFkldR
Italy ISDA-basis flag redenomination fears https://tmsnrt.rs/2JM2kGp
Italian bonds with CACs fare better than non-CAC peers https://reut.rs/2JLmb8Y
Getting real https://tmsnrt.rs/2JOI4ID
Getting real (Interactive) https://tmsnrt.rs/2JOI3Ez
(Reporting by Dhara Ranasinghe and Sujata Rao; graphics by Ritvik Carvalho,
editing by Larry King)
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