What does Italy’s downgrade mean?

21 September 2011

Standard and Poor’s downgraded Italy from A+ to A, the country’s first downgrade in five years. Yet the event has been largely ignored by markets and some questions remain unanswered.

S&P cited weakening economic growth, a fragile economy and political differences for the downgrade, apparently unconvinced that the 54 billion-euro (A$73 billion) austerity package that Italy passed this month, which aimed for a balanced budget by 2013, was enough to quell doubts about Italy’s debt burden.

The yield on Italy’s 10-year bond rose 9 basis points to 5.67% after the rate cut on Tuesday, 387 basis points above equivalent German bonds. In recent weeks, the European Central Bank has bought Italian and Spanish bonds to stem rising yields on concerns the countries are going the way of Greece, Ireland and Portugal, which have already received bailouts.

The news comes as Italy’s debt auction last week was met with tepid demand. S&P had not placed Italy on review for a downgrade and now rates Italy five steps above non-investment grade and three notches below Moody’s (which was widely expected to be the next mover on Italian debt). The reaction from markets today has been muted – indeed equities rallied.

What are investors worried about?

Italy’s downgrade is not a game-changer. The key issue remains the extent of contagion from a disorderly Greek default, which could spread to Italian and Spanish government bonds – these have been heavily bought by French and German banks.

The worst-case scenario is a new credit crisis if banks stop lending and money markets freeze. Stresses are now appearing in Europe’s interbank market – the euribor-OIS (a key gauge of unsecured interbank lending that measures the difference between the three-month euro interbank offered rate and overnight index swaps that banks use to lend to each other) has widened materially. It shows European banks are less willing to lend to each other.

France’s largest banks are heavily exposed to peripheral debt. Siemens has reportedly withdrawn its deposits from Société Générale in favour of the ECB. However, France is unlikely to let its largest banks fail.

Towards an orderly default?

Five central banks, including the ECB, the US Federal Reserve and Bank of England, have teamed together to provide extra US-dollar liquidity using three-month loans to support banks. This is on top of an already existent US-dollar swap facility offered by the ECB. European banks use US dollars, not euros, for much of their daily business.

Eurozone authorities appear to be building up the financial infrastructure to contain the contagion that would arise from a Greek default. We can expect more of this in the coming weeks and the success or otherwise of this endeavour would be key to how global financial markets cope with any Greek default.

Alberto Chiandetti, Portfolio Manager of Italian equities at Fidelity, says it’s important to recognise that while the downgrade has brought Italy into focus, this is not a single-country issue but a Europe-wide problem. “This serves as another alarm bell to European politicians and the ECB to understand the urgency of finding a path towards halting these debt issues and the resulting market contagion.”

Financial information comes from Bloomberg