Analysis:Italy borrowing costs must fall before big spring bills

ROME Wed Nov 16, 2011 11:06am EST

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ROME (Reuters) - Italy may struggle through to the end of the year even with bond yields at current elevated levels, but after that investors would likely take fright with big redemptions due in the spring, meaning outside help would be needed to prevent default.

The yield on benchmark 10-year BTPs was hovering around 7 percent on Wednesday, roughly stable from their close the day before. They shot to above 7.5 percent on November 9, only to ease back with the help of European Central Bank support.

It is often said that yields are "unsustainable" above 7 percent, yet this is theory and guesswork rather than fact.

There is no precise threshold for Italian debt sustainability, but the real danger is that the combination of high yields and daunting redemptions early next year will trigger a buyers' strike, meaning investors will desert Italy's auctions.

This danger is confirmed by banks acting as primary dealers for Italy's bonds, who have the exclusive right to buy at Italian auctions in return for commitments such as buying at least 3 percent of Italy's annual issuance and bidding for bonds in high volumes on the secondary market.

"The primary dealers are finding it hard because the banks aren't making money and the tail risks are huge, volatility is bad ... All this points to failed auctions," said a senior source at a primary dealer who asked not to be named.

The Bank of Italy calculated last month that even with yields of eight percent and zero economic growth, all else being equal debt -- at a mountainous 120 percent of GDP -- would remain stable for the next three years.

The problem is that, almost certainly, within a few months all else would not remain equal.

Funding needs are modest for the next couple of months but a massive 150 billion euros of bonds mature in February, March and April.

The prospect of selling these amounts with yields at or close to 7 percent is in itself so negative for public finances that it is likely to scare off investors, sending yields higher and causing the auctions to fail.

RECESSION

Moreover, most analysts believe Italy is already in a recession which, with more austerity measures in the pipeline, is only likely to get deeper.

"With these yields and the economy falling into a recession, the debt-GDP ratio is likely to keep rising in 2012, if moderately," said Ricardo Barbieri, chief European Economist at Mizuho.

"This crisis must be resolved within the next few months," he said, because yield levels are already too high in view of Italy's grim economic outlook.

The estimate of a 7 percent yield as the watershed for debt sustainability is based partly on the calculation that above this level Italy will have to pay so much interest that its public debt will rise each year rather than come down as targeted.

Yet this depends on imponderables like economic growth and how much the government spends and garners in tax and other revenues.

Analysts also point out that after Portuguese and Irish bond yields breached 7 percent they quickly accelerated to 8 percent and both countries then sought international bailouts rather than try to auction more bonds on the market.

Italy may have more time available because its cash position is still solid, it has a far wider range of debt instruments to offer, such as zero coupon and inflation-linked bonds, and the market for its debt is traditionally much more liquid.

Moreover around 50 percent of Italian bonds are held by domestic investors who are less likely to abandon auctions than foreign ones, whereas 80-90 percent of Irish and Portuguese debt was held internationally.

CASH

Italy's Treasury now has around 35 billion euros of cash available. This is a reasonably comfortable position, in line with the normal situation at this time of year.

It would probably allow Italy to honors its debts until February, but no later, even under a worst-case scenario in which investors began to desert its upcoming auctions before the end of the year.

Yet even with all these caveats, most analysts now believe Italy will need to seek international help no matter what new Prime Minister Mario Monti manages to do to shore up public finances and improve economic competitiveness.

"We doubt a change in government and even a swift implementation of structural reforms and austerity measures can restore market confidence quickly," said Citibank's Juergen Michels.

"As a consequence, we expect Italy will ask the International Monetary Fund and the (EU's bailout fund) EFSF for financial support."

However, the size of Italy's 1.8 trillion euro public debt means existing bailout mechanisms are insufficient to keep Italy out of the market for more than a few months.

As a result, analysts say the ECB must strongly increase its purchases of Italy's bonds on the secondary market which it began in August.

"In the short term, the only thing that can save Italy is a large scale commitment on the part of the ECB," said Nicholas Spiro of debt consultancy Spiro Sovereign Strategy.

When the ECB began buying Italian bonds on the secondary market in August they hoped in vain to keep yields steady at around 5.5 percent. Only when they return close to that level can Italy realistically hope to have regained market confidence.

(additional reporting by Valentina Za, editing by Mike Peacock)

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