QE Created Dangerous Financial Dependence, Italy Hooked, Withdrawal Next, ECB Warns

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“Who will purchase the €275 billion of government debt Italy is to issue in 2019?”

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

The ECB, through its army of official mouthpieces, has begun warning of the potentially calamitous consequences for Italian bonds when its QE program comes to an end, which is scheduled to happen at the end of this year.

During a speech in Vienna on Tuesday, Governing Council member Ewald Nowotny pointed out that Italy’s central bank, under the ECB’s guidance, is the biggest buyer of Italian government debt. The Bank of Italy, on behalf of the ECB, has bought up more than €360 billion of multiyear treasury bonds (BTPs) since the QE program was first launched in March 2015.

In fact, the ECB is now virtually the only significant net buyer of Italian bonds left standing. This raises a key question, Nowotny said: With the ECB scheduled to exit the bond market in roughly six weeks time, “who will purchase the roughly €275 billion of government securities Italy is forecast to issue in 2019?”

With foreigners shedding a net €69 billion of Italian government bonds since May, when the right-wing League and anti-establishment 5-Star Movement took the reins of government, and Italian banks in no financial position to expand their already bloated holdings, it is indeed an important question (and one we’ve been asking for well over a year).

According to former Irish central bank governor and ex-member of the ECB’s Governing Council Patrick Honohan, speaking at an event in London, when the ECB’s support is removed, “the yield on Italian government bonds will be much more vulnerable.”

In Brussels, the chair of the Supervisory Board at the ECB, Danièle Nouy, put it even more ominously, telling her audience to “keep [their] fingers crossed” for Italian banks amid fears that the widening spread between Italy and Germany’s 10-year bonds could sow mayhem on their balance sheets. “So far I don’t think the spread has reached a level of serious concern for the banks, but we don’t know what the future will bring,” she said.

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Coming from a person whose job is ostensibly to ensure the stability of Europe’s rickety banking system, these are not comforting words. Nor are they meant to be.

The risks are huge. And they keep growing. A rise in Italian bond yields doesn’t just hurt the Italian government; it also hurts Italian banks, which have significant exposure to Italian debt, as Bloomberg reports.

An increase of 100 basis points in the sovereign spread between Italy’s bonds and Germany’s bunds reduces the Common Equity Tier 1 capital of Intesa Sanpaolo SpA and Unicredit SpA, the country’s two largest banks, by 35 basis points, according to a note by Citi Research. For UBI Banka SpA and Banco BPM SpA, two mid-sized lenders, this is larger — standing at 56 and 66 basis points.

Mid-sized Banca Carige last week received a €400-million emergency injection of cash to stay afloat after failing, against the current backdrop, to raise new, much-needed funds on the market. The money was provided by Italy’s interbank deposit guarantee fund (FITD), sparking accusations that Italy’s government was once again gaming the EU’s resolution laws.

Here’s how the operation worked: the FITD, with money stumped up by Italy’s largest, least unhealthy banks, committed to buy €320 million (for now!) of a new tier-2 bond issue, all of which will convert to equity in March. The alternative was to let Carige, with its €25 billion of assets, go down, and run the risk of sparking financial contagion across Italy’s perilously fragile banking system.

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But Carige, to all intents and purposes a gone concern even after its latest life-line, is not the only Italian lender struggling to raise capital at semi-affordable rates. Majority state-owned Monte dei Paschi is also having difficulties, as are many smaller Italian banks. The more those banks struggle, the more likely investors are to dump Italian bonds, heaping further pressure on Italian banks.

Perhaps the biggest risk the ECB runs in this latest escalation of tensions with Italy’s populist government is in reminding investors just how much governments in the Eurozone have come to depend on the ECB’s QE program.

But it’s not just Italian bonds that are hooked on QE. In the past three years the ECB has spent €512 billion gobbling up German bonds (current 10-year yield: 0.35%); €416 billion on French bonds (10-year yield: 0.76%); €256 billion on Spanish bonds (1.62%); €114 billion on Dutch bonds (0.52%); €72 billion on Belgian bonds (0.83%); €57 billion on Austrian bonds (0.61%), and €36 billion on Portuguese bonds (1.98%).

As a result of the ECB’s boundless generosity, Euro zone countries have enjoyed record low borrowing costs. They have also been able to issue record amounts of long-dated debt to smoothen out their debt profiles. Most importantly, QE has helped to maintain the essential illusion that the public debt of Eurozone economies has roughly similar risk weights. Once QE comes to an end, that illusion is unlikely to last. By Don Quijones.


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