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Moorad Choudhry: How to Deal With Contagion

I'm just back from summer holidays and at the risk of coming across as one-track minded, we’re going to talk about the eurozone once more. Its worries are still with us (not that they are going away, this year, next year or even by 2021. Not until they have fiscal, as well as monetary policy, union. But that is for another day!), and we can’t ignore them.

Euro bills and coins
AP
Euro bills and coins

But everything is connected. This week we observe Italian bond yield spreads and credit default swap (CDS) prices rising to new 12-month highs, on the back of contagion sovereign debt worries about the southern eurozone. We’ve discussed Greece already in this column, and further comment on that subject is now superfluous: we know what needs to be done, they just need to go ahead and do it. Of course politics, and not economics, is the issue there. But what about Italy?

It’s strange, the use of the word “contagion” with respect to financial markets. If a man with an infectious airborne disease sits in the same carriage on your train, then contagion is a real worry for you. But if the chap living next door is declared bankrupt, you won’t have too much concern on the financial front unless you are a large creditor of his. What’s behind the sell-off in Italian markets prices? And can policymakers do anything about it?

Risk aversion is everywhere around us. It is apparent that there is a palpable stall in the US recovery, which is driving negative sentiment worldwide. Recent US economic statistics are disheartening, especially the unemployment ones, and we need look no further then US 3-month T-Bill rates currently at zero (well, 1 basis point) to realise the extent of this negative sentiment.

In April I had suggested that “QE3” was not on the cards from the Fed in 2012, only a continued zero interest rate environment; however if the statistics continue to remain uninspiring then it does appear that we will observe printing of more dollars. This should be clearer by the time we are in the fourth quarter of 2011.

Cross over the Atlantic and this negative sentiment manifests itself in lower prices for anything that is removed from “safe haven” status. That will impact Italian sovereign assets. In common with virtually all EU banks, Italian banks do hold southern euro zone sovereign debt, but a lower amount than French and German banks.

Italian sovereign debt has always been a healthy percentage of its GDP, but the current administration has at least attempted to run a prudent fiscal policy. Further budget cuts are currently awaiting parliamentary ratification. In a volatile market, such moves appear not to be enough. Is the Italian economy in danger territory a la Greece, Portugal and Spain?

Clearly Italy isn’t in the same space, but it is approaching Spain in terms of market pricing, which is an economy that is not only in a stagnant condition, with unemployment at over 20 percent, but has yet to see the full fallout from its housing market crash.

But from the prices, Italian sovereign debt isn’t in default territory, not by a long way. The critical X-factor is confidence. Euro zone problems, which highlight the structural issues with the euro that make it (in its current form) untenable in the long run, create sentiment issues that always feed through into market prices.

In a risk-averse environment, anything that is not genuine AAA will be sold off, as institutional cash seeks the safe haven. Hence the US T-Bill yield, which hits zero as cash seeks the ultimate safe haven. This has hit Italy, which has seen its bond yields rise, and if things continue on their present path will hit other EU countries with sovereign debt worries as well – look out for Belgium, currently at 153 bps for its 3-year CDS, and with similar high debt-to-GDP ratios.

The UK should be safe because its government is talking tough on the fiscal front, but of course if its public borrowing numbers in 2012 show no material improvement and the economy is still flat (as it appears second quarter GDP will be), then it too will be in the firing line.

How does one deal with sentimental, as opposed to airborne, contagion? By addressing the confidence issue.

The biggest driver in this respect is the government fiscal deficit; how much of it is structural and how much related to the business cycle? One needs to tackle both aspects, but the former takes a long time to fix, whereas the latter can be addressed for shorter-term impact. On the expenditure side recognising that the Bismarck-originated social welfare system, from a time when life expectancy was at 55 and not 85, is no longer tenable and needs radical reform, is the long-term solution.

On the revenue side, reducing the unemployment number takes people off welfare and gets them paying taxes. As we said, everything is connected. Tackle the debt issue through labour market “supply side” reform and talking tough on the deficit, and you should find investors take just a little more comfort in holding your paper compared to other sovereign debt whenever there is a desire for “flight to quality”. Crossing one’s fingers and hoping that time is on your side will only see your sovereign spreads widen at the merest whiff of danger. It’s all down to confidence.

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Dr Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.

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