* Euro zone's largest borrower loses foothold abroad
* Change to derivatives law offers way back in
* Some say eventual return may prove fruitless
By John Geddie
LONDON, June 26 Italy, the euro zone's biggest
debtor, risks missing out on cheap foreign funding unless the
Treasury can win approval to use controversial derivatives to
protect itself against currency swings.
The euro zone sovereign historically most reliant on foreign
borrowing, Italy has let its foreign currency debt fall to its
lowest level in over two decades, leading some to question
whether it is fully capitalising on a tentative resurgence in
international demand for its bonds.
"This is a good opportunity, why not exploit it?" said
Cosimo Marasciulo, head of European Government Bonds at Pioneer.
But financial regulation and a steady erosion of Italy's
credit rating during the euro debt crisis has ramped up bank
charges for the derivatives the country needs to insure against
the risk of issuing in non-domestic currencies.
Seeking to reduce these swap charges, the Treasury late last
year drafted a law to give the banks it deals with a further
layer of cover against the risks involved.
The law, which also applies to interest rate derivatives
used to manage the duration of debt portfolios, was to be put
before parliament last December but has still not appeared.
Senior bank sources say there is some political resistance
to the changes, but a Treasury spokeswoman declined to comment
on the matter, adding it was still working on the draft.
One of the reasons the Treasury is dragging its feet may be
that the proposed guarantees would probably involve raising
billions of euros to hold in reserve against potential
derivatives losses - money that an austerity-wearied population
might think could be better directed elsewhere.
Besides, Italy has a chequered history with derivatives.
The country was forced to pay Morgan Stanley $3.4 billion
when the bank invoked a clause to break a contract in 2011,
while its 2014 Budget Law banned its local and regional
governments from using derivatives after hundreds of pre-crisis
deals turned sour, ending up in court disputes.
Italy has vehemently denied suggestions that, like Greece,
it used interest rate derivatives to manipulate its debt
dynamics to suit entrance criteria for the euro in 1999.
With consistently higher annual debt issuance than any other
member state in the euro era, Italy has made more significant
use of foreign funding in the past.
Its slipping foothold abroad runs contrary to the Treasury's
commitment to overseas markets.
On its website, the Treasury says its international
programme is "instrumental" for its "objectives of diversifying
the international investor base... therefore containing its
long-term borrowing cost and refinancing risk."
It describes the U.S. bond market - the biggest in the world
- as "the main building block" of this programme although it has
not issued a dollar bond since September 2010.
When Italy redeems two more of its dollar bonds in January
its total stock will be just $12.5 billion (9.2 billion euros) -
a tiny fraction of its total debt of over 1.8 trillion euros,
which is the highest in its history.
Strategists say some euro zone sovereigns have missed out on
considerable savings by not issuing dollar bonds in recent
years, as banks were prepared to pay high premiums to access
dollars in the cross-currency basis swap market.
Germany and France took advantage of this via government
agencies such as development bank KfW and social security fund
Cades, respectively, which each year borrow billions of dollars
in the bond market and exchange them for euros with their banks.
Countries like Spain and Italy do not have such a
sophisticated network of government agencies, but last year the
Spanish Teasury issued its first dollar bond since 2009.
Portugal is now pondering a dollar-denominated bond, which
would be its first such issue since 2010.
Some analysts, however, say returning to foreign markets
should not be a high priority for Italy given the demand at home
which has been bolstered by cash injections from the European
The Treasury "is trying to keep a channel open but it is not
clear how relevant this channel now is," said Luca Cazzulani,
strategist at UniCredit.
But while Italy's borrowing costs over 10 years
have fallen from more than 7 percent at the end of 2011 to
record lows of 2.7 percent earlier this month, the amount of
foreign holdings of its debt have only made a minor recovery
compared to its higher-rated peers.
This is why some strategists say Italy's planned return to
foreign markets could prove fruitless, for now.
With a credit rating just a couple of notches above junk,
Italy may not appeal to ultra-conservative central banks and
official institutions which have tended to be the largest buyers
of euro zone sovereign paper issued in foreign currencies.
"It might be an issue that even if the theoretical funding
cost has become more attractive, you might actually struggle to
find the investor base at present," said Anton Heese, co-head of
European interest rates strategy at Morgan Stanley.
(Graphics by Vincent Flasseur, Editing by Ruth Pitchford)