Italy's Woes Signal 'Dangerous Phase' in EU Crisis: El-Erian

Italy's debt woes signal "a new, even more dangerous phase in Europe's debt crisis," Mohamed El-Erian, co-chief investment officer at PIMCO, said Wednesday.

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El-Erian, who helps oversee more than $1.2 trillion at PIMCO, home to the world's largest bond fund, told Reuters that the European Central Bank can act as a circuit breaker but can only be effective if its actions are supported by a host of other measures.

PIMCO had $4.8 billion in exposure in Italian debt , according to the latest filings compiled by Thomson Reuters Ownership intelligence data.

"Domestic politics are undermining already complex relations among Italy and it's external creditors," El-Erian said.

The ECB, meanwhile, needs to ramp up its bond-buying program by five- or six-fold to relieve the market pressure gripping Italy and threatening the entire euro project.

With Italy facing a policy vacuum between the impending resignation of Prime Minister Silvio Berlusconi and elections in February, the ECB is under growing pressure from world leaders to do more in the absence of an effective political response.

The central bank bought 2-year and 10-year Italian bonds aggressively on the secondary market on Wednesday, traders said. 

But Italian 10-year bond yields still shot above the 7 percent level widely deemed unsustainable after Berlusconi's promise to resign failed to raise optimism about the country's ability to deliver on long-promised economic reforms. 

As the euro zone's EFSF rescue fund will not be ready for deployment until December at the soonest, markets are looking to the ECB to intervene on a greater scale with its bond-purchase program, which has so far totaled 183 billion euros. 

"A five- or six-fold increase is the sort of magnitude I think that would be needed," said Andrew Bosomworth, senior portfolio manager at Pimco.

"To stabilize Italy, along with Spain and everybody else — Belgium and France could be next — you are looking at having to move the purchases up to a trillion euros," he said. "Italy must contribute its part too via structural reforms and budget consolidation."

Ramped-up ECB bond-buying could offset capital flight and refinancing costs.

A Reuters Breakingviews calculator shows that if Italian yields stay at the euro era high of 7.50 percent they hit on Wednesday, Rome would need a 6 percent primary surplus just to keep its debt/GDP ratio static — and that is assuming it meets its growth forecasts. 

Alternatives to increased ECB intervention would be severe spending cuts in Italy — an unlikely immediate prospect given the political leadership vacuum — or EU/IMF bridge financing, which would meet political resistance in Germany, or default.

Reluctant Savior

Despite the intensification of the crisis the ECB has been reluctant to deliver the kind of 'shock and awe' intervention that could calm markets.

Last week, the central bank upped its bond purchases to 9.52 billion euros, still well below the 22 billion it spent when it reactivated the program in August, and not enough to relieve the pressure on Italy.

The situation is complicated because Italy's Mario Draghi has succeeded France's Jean-Claude Trichet at the ECB's helm and the new president does not want to be seen as going soft on his home country and jeopardizing the bank's cherished independence.

He faces stiff resistance to the very concept of the ECB purchasing government bonds in Germany, where the "wise men" panel of economic advisers warned the bank in a report published on Wednesday that it risks losing credibility by buying the debt of heavily indebted euro zone states. 

The warning followed the resignation earlier this year of Bundesbank chief Axel Weber over the bond program. Another German ECB policymaker, Juergen Stark, is also quitting the bank this year in what sources say is a protest at the plan.

A German-led minority opposed the reactivation in August of the program, a policy tool which can lower government borrowing costs if pursued with sufficient vigor.

The split on the ECB's 23-member Governing Council caused by the plan has left the bank facing its biggest internal rift in its 13-year history. 

Draghi insisted at his debut news conference as ECB president last week that the bond-buy plan was temporary and limited, and that it was pointless to think yields could be reduced for a protracted period by outside intervention.

But the bank has crossed red lines before. It initially resisted embarking on the bond-buy exercise at all and only did so after Trichet extracted a promise from governments to set up the EFSF. The intense pressures now facing Italy will likely force it to compromise its principles again.

"Ultimately, I think they may be forced to step up their bond purchases to prevent a new escalation of contagion risks across the system," said RBS economist Nick Matthews.

Quantitative Easing

To date, the ECB has distinguished itself from the U.S. Federal Reserve and the Bank of England by refraining from embarking on a policy of 'quantitative easing' — code for printing more money.

Instead, the ECB sterilizes its bond buys by conducting weekly liquidity absorbing operations equal to the cumulative size of its debt purchases.

So far, the ECB has only failed to fully sterilize the bond buys on a handful of occasions but if could not attract sufficient funds to offset a vastly increased purchases sum, it would effectively be engaging in quantitative easing.

Rabobank said at any point in time in a non-crisis context, there is approximately 500 billion euros in ECB monetary policy lending in the European banking system, 200 billion of which is generally parked at the ECB to meet reserve requirements.

The amount left for 'structural sterilization' is therefore around 300 billion euros. Given that the ECB has already purchased close to 185 billion euros since the beginning of the SMP program, it has some 115 billion euros left to play with.

"If you look at the past two months, they have bought about 5.5 billion euros each week, so continuing that trend actually would mean that they run out of fuel somewhere around the first quarter of next year," Elwin de Groot, senior market economist at Rabobank said.

After a couple of months, discussion would then have to be opened to whether the bank is willing to do this in an  way, de Groot added: "In a sense this is seen as the nuclear option."