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Bond sale puts Italy to the test

Italy faces a crucial test tomorrow as the technocrat government of Mario Monti launches its first big auction of long-term bonds since a disastrous upset a month ago.

The outcome will set the tone for a string of debt sales through early 2012 that risk stretching the eurozone bond markets to breaking point.

The EU authorities are hoping commercial lenders will use last week’s flood of cheap liquidity from the European Central Bank to soak up southern European debt and bring yields back under control, starting with Italy’s €8.5bn (£7.1bn) sale of 10-year bonds today. The country must raise €440bn in debt in 2012, beyond the current fire-fighting power of Europe’s bail-out machinery.

Rome managed to sell €9bn of six-month bills at 3.25pc yesterday – half the rate paid in near-panic conditions last month – but there was no follow-through to longer-term maturities and the rally in Europe’s equity and credit markets quickly spluttered out. “Even bankrupt states like Greece can sell bills: what matters is the long end of the credit curve, and this hasn’t moved much,” said Jacques Cailloux, Europe economist at RBS.

The German DAX index and Spain’s IBEX both fell 2pc, and the Dow Jones was off 1pc in New York in early trading. The euro fell sharply to almost €1.29 against the dollar, the lowest since January, as markets digested news that eurozone banks had parked a record €452bn in overnight deposits at the ECB for safe-keeping on Tuesday.

The flight to safety exceeds the most extreme moments of the Lehman crisis in 2008. Although the picture may have been distorted by the Christmas holiday, it is clear large parts of Europe’s financial system remain under acute stress.

The interbank lending market is broken. The ECB is having to step in as intermediary to do the lending that banks won’t do for each other,” said Mr Cailloux.

The ECB lent banks €489bn last week at 1pc for three years in an unprecedented long-term repo operation (LTRO) to head off a credit crunch, but the level of fear remains so high that the banks have in effect lent the money back to the ECB at just 0.25pc (annualised) for a small loss.

Europe’s politicians had hoped that lenders would use a chunk of the ECB funds to carry out a back-door rescue of eurozone governments in trouble without breaching the ECB’s legal mandate. Italian, Spanish, and French banks have all been under political pressure to buy their own government debt, and take advantage of the fat yield spread on offer known as the “carry trade”.

Bundesbank chief Jens Weidmann described the ECB operation as “bridging help” for banks to keep them going until the sovereign debt crisis abates. “We think household income will rise 3pc next year, so it is not as if the world is collapsing,” he said.

In Italy, Mr Monti won senate backing for €30bn in austerity measures last week but it is far from clear whether investors believe that this can alone lift Italy out of its debt trap – or even if it is the right policy at all.

Italian bank Intesa SanPaulo said fiscal tightening will equal 3.6pc of GDP in 2012, pushing the economy deeper into recession. The business lobby Confindustria said the economy will contract by 1.6pc next year, and concerns are mounting that the shock therapy will cause tax revenues to plunge and prove largely self-defeating.

The latest package includes a petrol tax, duties on luxuries, a financial stamp tax and a property levy of 0.4pc on first homes, but so far lacks the structural reforms and labour shake-up needed to help Italy cope with the rigours of euro membership.

In Spain, home loans plunged by 44pc from a year earlier, the sharpest fall since modern data began. It is a reminder of how hard it will be to clear almost a million unsold properties. Luis de Guindos, a former Lehman banker now serving as economy minister, warned that Spain is on the cusp of a double-dip recession. “Make no mistake, the next two quarters are not going to be easy,” he said.

http://www.telegraph.co.uk/finance/financialcrisis/8981570/Bond-sale-puts-Italy-to-the-test.html