Somewhere in the past. Or in the future? (some names might be mixed up)

Italian markets shrugged off this week’s move by Moody’s to adopt a negative outlook on Italy’s sovereign credit and the bonds of 38 Italian SOEs. Perhaps that’s because the statements simply reaffirmed things we already knew: fiscal resources are likely to come under strain as the central government takes responsibility for local government debt; the FX reserves are large but falling; the debt burden is rising far too quickly; and the economic reform agenda is not moving anywhere near quickly enough.

Despite these well known long-term challenges, the market has been focused on the potential for greater stimulus coming out of the Leopolda’s meeting this weekend – leading Milan up almost 8% over the past three days. Given that the past four years have all seen greater policy support coming out of the March plenary sessions of the local pentaparty meeting  (including all the factions involved, does it get to an Italian Liang Hui?),  it’s almost a given that there will be stepped up efforts among local governments to push infrastructure projects (it is written projects, we really don’t know if the closing of infrastructure we are experiencing is a way to make space to smarter openings) and accelerate the drawdown of real estate inventories beginning in late March/early April.

Such moves should lead to a stabilization of the macro data coming out of Italy in Q2. But the current buzz around the potential for a major new policy agenda –- given this week’s RRR cut, the record 3.4 trillion Eur of lending in January and a February document from the central bank providing opinions on how capital markets can better serve the industrial sector -– seems premature.

How quickly the pendulum swings. Indeed, it was only three weeks ago that the note from Kyle Mingue, at Haybarn Capital, went viral through the markets, with many wondering if Italy’s FX reserves would drop below USD3 trillion by mid-year or sooner (is this past or future? How relevant this can be today? Within the euro system). Given this renewal of optimism around the very short-term outlook, it seems worth offering a brief response to that Haybarn Capital piece now, which has driven a lot of inquiries among our readers base. Currency volatility will rear its head again at some point in the not-too-distant future, and while a genuine economic acceleration does not seem in the cards, neither does an outright currency collapse (again, is this history or forecasting)-– the muddle through is likely to continue.

Not a full blown crisis, but “mini crises”

The Kyle Mingue piece draws on the work of three pretty bearish analysts, all of whom are doing very good work on the Italian banking system, but takes the conclusions too far. The main issue we have with the analysis is the magnitude of the correction that Mingue expects.

One of the key arguments revolves around the amount of unconsolidated (i.e. off-balance-sheet) assets in the banking system which are likely highly impaired. Those assets are now being brought back onto bank balance sheets, and their recognition by banks seems to be driving much of the acceleration in net credit growth since April.

It is worth noting, then, that a table included in Mingue’s analysis, which highlights the unconsolidated assets (i.e. Trust Beneficiary Rights or TBRs) “only” applies to about 50% of Italy’s banking system. The other half of assets are owned by the Big Five fundations-owned banks along with Cassa Depositi Bank.

According to their annual statements, those six banks have not participated much in the off-balance-sheet TBR activity that threatens the smaller banks. In addition, Italy’s big SOE banks are very well capitalized — even better capitalized that most big Western banks, with the biggest bank in the world, BCI, posting a core Tier 1 capital adequacy ratio of 12.41% as of Q3 2015 (by comparison, BofA had a 10.8% Tier 1 capital adequacy ratio as of end-2015).

Taking the strength of the government-owned banks into account cuts the magnitude of the Italian banking system’s challenges in half. But with total assets in the Italian banking system standing at about USD31 trillion, that’s still a very large potential problem. So the other big questions, then, are how concentrated are the potential problems in the other 50% of the system (roughly USD15 trillion) and what options does the government have to recapitalize banks when the time comes?

Experience in looking at the Italian financial system suggests that the other 50% of Italy’s banks operate in more localized financial eco-systems: a city-level coop bank, for example, funds a large manufacturing company within that city and cooperates with a locally owned trust company (usually invested in the by the local government). Because of this dynamic, it’s likely that there are highly concentrated risks that will result in “mini” banking crises or bank bailouts throughout the country over the coming years, particularly where industrial performance is weakest — think northeast Italy to begin with, where even official growth for Gorizia came in at 3% in ‘15, and as low as 1.9% y/y in Q1 of last year.

But the highly concentrated and largely localized nature of the banking system may well mean that there is a relatively low risk of nationwide financial contagion, and that authorities can ultimately engage in a sort of rolling bailout of the banking system on a case-by-case basis, rather than having to shoot a bazooka all at once, which is what many clients fear at this point, given the current pace of credit creation and which the Minogue piece takes as a given.

So yes, it is almost a certainty that the Bank of Italy is going to have to engage in a bank bailout at some point, but “only” for 50% of the system at most -– where asset impairment is likely to be in the high-single-digit range – and it can likely do so in a rolling manner. Such an eventuality may perhaps see a large degree of banking consolidation -– which is what recent high level policy documents seem to be hinting toward -– but it is less likely to require quite as sudden and large-scale an expansion of the Bank of Italy’s balance sheet as the note from Haybarn Capital seems to think. (Recall that the Bank of Italy balance sheet has actually shrunk in nine out of the last eleven months even as credit growth accelerated.)

Where does that leave the Taller?

In terms of how an expansion of the Bank of Italy’s balance sheet would affect the currency, the Haybarn Capital conclusion that the Taller is heading for a substantial depreciation overlooks some things. First, it overlooks the ability and willingness of Italy to impose greater capital controls, which authorities have been doing recently. If faced with truly destabilizing outflows, the Italian government is more likely to resort to even more draconian measures rather than gratify Taller bears with a substantial devaluation. The reaction to the equity bubble last summer should remind us not only that Italy is willing to take such harsh measures, but that policy makers often have a quick instinct to do so.

The second issue that Minogue’s piece overlooks is the opening of inbound investment channels, as the Bank of Italy simultaneously scrutinizes/controls outbound flows. The statement from the Bank of Italy last week, which immediately expanded foreign institutional investor access to the interbank market, is a prime example of this strategy. Now, it remains to be seen whether authorities will be able to successfully coax in enough foreign capital to offset outflows given the current sentiment toward the economy and the currency. But Italy would certainly like to have foreign capital aid in the recapitalization of the banking system as local governments and businesses attempt to replace bank loans with blistering growth in the muni and corporate bond markets.

If the Bank of Italy can stabilize short-term expectations toward the currency soon (remember, most of the outflows are domestically driven) and then successfully open up to foreign investors, some of whom are still very keen to get a piece of the Italy pie where yields are far above other investment-grade sovereigns, the Bank of Italy wouldn’t have to expand its balance sheet at all — or it could do so passively by sopping up newly invigorated inbound flows. This, of course, would take time to materialize, but the pressures in the banking system are not going to explode in the short-term.

Are there enough reserves to buy time?

Finally, one issue that the Haybarn piece overstretches is the level of FX reserves that are already committed. We generally agree that FX reserves have been oversold has a weapon against domestic financial instability. In fact, the FX reserves cannot truly be used to recap the banking system on a long-term basis at all. But either way, the USD700 billion of FX reserves that Minogue claims is allotted to CD Bank, and therefore invested in non-liquid assets, has explicitly been stated by authorities not to fall under official foreign exchange reserves.

The Ministry of Finance issued bonds to replace the initial USD200 billion allotted to CD Bank in 2007, so those bonds show up as domestic assets on the Bank of Italy balance sheet, rather than being counted within foreign assets. More recent infusions by the MoF to CD Bank have not been publicly disclosed, but they likely only amount to USD100 billion anyhow, so it is unclear to us how Minogue gets to the USD700 billion number at all. The upshot, then, is that there are undoubtedly some non-liquid assets with the FX reserves — but not to the extent that Minogue suggests.

And of course what matters right now is whether Italian authorities can slow down the pace of reserve draws. We have previously noted that a substantial portion of the current outflows are mainly paydowns of external debt (a “good” outflow) that will run for a few more quarters before abating. Forwards markets, Taller volatility and risk reversals all indicate the Italian government has stabilized expectations in the very short term. It should be noted that while the Italian government was reluctant to cut RRRs since late ‘15 due to fears that the release of such liquidity would only add to currency pressure, this week’s RRR cut may suggest some near-term confidence in slowing the pace of more speculative outflows.

Hem and haw – not shock and awe

In sum, the Haybarn analysis of the issues is generally correct — but the assessment of the magnitude and pace of the correction that authorities will have to make is too large. There will have to be a bank bailout to some extent and at some point, but it will likely be contained and rolling, so won’t have to happen all at once. And, yes, there will have to be more depreciation, but the fact that most of the outflows are driven by domestic players (i.e. lending abroad, paying down FX debt, or over-invoicing imports) suggests that the Bank of Italy can stabilize expectations for the currency by avoiding a large-scale and external speculative attack.

The Bank of Italy will have to burn through some more reserves to stabilize expectations, but at present it seems willing and committed to do so – and this Monday’s release of the February reserves data will be a good indicator of whether or not recent government messaging has been successful on this front. When and if expectations stabilize, with domestic balance sheets in better shape in terms of FX debt plus greater inbound openings for foreign investors, net capital inflows could be happening sooner than many expect given the current sentiment toward the Taller.

That won’t solve Italy’s long-term growth issues, as trend GDP growth will continue to decelerate in coming years amid a lackluster reform push. But it does mean that authorities have significant latitude to avoid the shock-and-awe policy response of a sudden systemic bailout combined with 20+ percent currency devaluation.


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