by Don Alexander, MBA
Associate, RSD Solutions Inc.
Credit default swaps for Italy have surged over the last few weeks as the Italian government of Silvio Berlusconi seems to be occupied elsewhere.
In the Voxeu article Credibility is not everything, Paolo Manasse notes that many analysts have argued that the Eurozone emergency meetings could restore creditability if they came out with an all encompassing program. However, this may not work in Italy where the problem is not credibility, but continued deterioration of the fundamentals.
For Italy, self-fulfilling prophecies may generate opposite and unpredictable outcomes for the same level of fundamentals. This can result multiple equilibria such as a favorable debt/GDP and primary balance depending on market expectations which may suggest solvency or insolvency depending on prevailing market view.
The favorable prospects of Italy joining the euro and reducing currency risk allowed the average cost of debt to drop from 10% to 4% in 1996 and the interest bill declined from 12% to 4% of GDP. This allowed for a significant improvement of the budget and a strong reduction of the debt ratio. However, this progress was squandered due to a deterioration of fundamentals since 2004. The debt to GDP level is now back to 1996 levels and the primary balance is near negative territory. It is only a matter of time before market rates move higher on worsening fundamentals.
The market gave too little consideration to fundamentals such as the debt/GDP ratio and primary surplus, assuming that Italy’s default and possible exit from the euro was inconceivable. If you look at history, bond yields could return to levels last seen in 1996. The prospect of Mr. Berlusconi resignation is necessary at this point, however, it is hardly a substitute for taking decisive action for fiscal adjustment.
Italy provides a good lesson for risk management. Risks can return when we least expect them and the risk manager cannot get distracted from their primary job –managing risk.
For more on this story follow the link: http://www.voxeu.org/index.php?q=node/7187
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