There currently seems to be an assumption in the markets that Italy is going to go the same way as Greece, Portugal and Ireland.  The same script is being followed with Italian 10-year bond yields grinding higher amidst “limited & temporary” buying by the European Central Bank, LCH Clearnet raising margin requirements on Italian debt and the expectation that Italy is imminently going to go cap-in-hand to the EFSF/IMF and ask for a cheap loan.  However Italy is not going to roll over anytime soon but the stresses in European sovereign bond markets are going to force the ECB’s hand.

Ideally the markets would like a quick, clean solution to the current euro-zone sovereign debt problem whereby the ECB makes a statement that it will buy an unlimited amount of the debt of any euro-zone country which the ECB deems to be solvent, and that it will defend a specified yield (say 6%) on that country’s debt.  This would solve the problem instantly and give each euro-zone country time to pass growth-boosting legislation and to bring their budget deficits under control.  This has not happened yet for many reasons, including Germany’s historical opposition to central banks printing money to finance governments (c.f. Weimar hyper-inflation) and the total failure of several euro-zone countries to keep their budget deficits within reason.  The ECB is unable to force countries to bring their budgets into balance and therefore the ECB does not want to get drawn into lending to countries over which it exercises no control.  The Stability & Growth Pact was drawn up when the Euro was created to try to avoid precisely the current situation by requiring countries to keep their budget deficits below 3% of GDP and their sovereign debt below 60% of GDP.  The SGP has been broken by almost every euro-zone country, including Germany and France.

So now the euro-zone has invented the EFSF, which can lend to member countries, drip-feeding money to countries quarter-by-quarter only if they behave.  The problem is the EFSF is not big enough to convince the markets that it could bail out Italy if needed.

This is a game of confidence.  If the EFSF were big enough to bail out Italy then it would never be called upon to do so because Italy is a fundamentally sound, strong economy which already runs a primary budget surplus (i.e. before debt interest payments).  Italy’s government needs time (and a proper leader) to boost its GDP growth and to start slowly shrinking its €1.9 trillion debt pile.

The ECB has so far spent €183 billion buying government debt of the PIIGS.  Their justification for this Securities Market Programme buying is that it is supposed to smooth the transmission of monetary policy across the euro-zone.  Clearly the SMP has failed thus far for the simple reason that it has not been big enough to force bond yields lower in the targeted countries.  The EFSF is supposed to take over this bond-buying role from the ECB but so far the AAA-rated EFSF has raised just €16 billion by issuing bonds (their latest €3 bln 10-year bond issued this week carried a 3.5% coupon whilst Germany currently borrows 10-year money at less than 2%; but ominously France is charged 3.5% by investors).

Another problem for the ECB is that the further government bonds fall in price, the more capital euro-zone banks will have to raise by end-June 2012 because the European Banking Authority has now decreed that banks must have Core Tier 1 capital ratios of 9% after marking their sovereign bonds to market.

This death-spiral between banks and sovereign debt cannot be allowed to continue for much longer.  Markets are moving far quicker than the 17 sets of euro-zone politicians can respond.  Given the history of back-sliding by politicians the ECB has quite rightly been reluctant to act but now events are starting to get out of hand and consumer confidence is faltering across Europe.  The rest of the world does not want Europe to fall into an avoidable recession which would otherwise depress global GDP.  The ECB will soon be forced to take truly dramatic action to stop the rot and buy time for the politicians, the EFSF and many other institutions right across Europe.