Ambrose Evans-Pritchard: 'Italy Could Need EU Rescue Within Six Months'

So read Ambrose Evans-Pritchard's column in the Telegraph Tuesday morning.

The headline relates to a report issued from Italy's second-largest bank, Mediobanca, that the Italian financial situation is deteriorating quickly and that Italy may need another bailout in less than six months.

1992 All Over Again

Mediobanca's report highlights its proprietary sovereign risk indicator as sign that Italy is "flashing red" currently. In the past quarter alone, about 160 large Italian corporations have gone insolvent, the bank noted, which will force strains on both the private banking sector and the public sector as these institutions are wound down.

In an effort to reinforce the brevity of the situation, Mediobanca compared the current situation to 1992, when Italy was blown out of the Exchange Rate Mechanism, the prelude to the euro. In 1992, currency traders wiped out the preset currency bands and sent the Italian lira plummeting. Italy very nearly was unable to join the euro and only relaxed rules on currency bands followed by wider trading bands helped keep Italy in the ERM.

Debt Burden

Many forget that Italy is the third most indebted nation in the world and has the most debt of any European nation. Total government debt exceeds $2.75 trillion, only behind Japan and the United States. Thus, stress in its debt markets threatens to reignite the eurozone crisis and that is why the recent spike in yields is worrisome.

Italian 10-year bond yields have climbed over 100 basis points from the low in the beginning of May to the current 4.81 percent. "But Mediobanca is particularly concerned about the gap that has emerged between yields on short-term bills (BOTs) and longer-term bonds (BTPs) near maturity that expire at the same time," wrote AEP. "BOTs retiring on July 31 are trading at a yield of 0.48, while the equivalent BTP is trading at 0.74pc."

In English, the spread between short-term and longer-term yields is widening, a clear sign that investors are pricing in higher default risk. In bankruptcy, bills tend to be paid out before bonds, and thus the yield differential and steeping of the yield curve are sending negative signals.

Banking Union Failure

The failure of leaders to reach an agreement on a banking union and a bank failure mechanism over the weekend has not made the situation any better. The Italian banking association said it was bitterly disappointed by the latest break down in eurozone talks on a banking union; the trade group believes that the break down in talks leaves Italian banks extremely exposed to negative market conditions.

Mediobanca said the trigger for a blow-up in Italy could be a bail-out crisis for Slovenia or an ugly turn of events in Argentina, which has close links to Italian business. “Argentina in particular worries us, as a new default seems likely.” Should any of these events metastasize, without a banking union to backstop the finances of the banks, then it would fall on the government to once again bail out the banks. This would further strain sovereign finances and would place the solvency of the Italian government into question.

10 Years to Correct Imbalances

The large debt load combined with Italy's inability to devalue itself back to competitiveness via an external devaluation (devalue the currency) means that the debt load cannot be inflated away, like it was in 1992. Rather, the government needs to implement market reforms and the economy needs to suffer a massive amount of deflation of wages and see productivity tick up for the economy to become competitive again.

Mediobanca says that this adjustment could take a decade to fully take affect, signaling that Italy may be in for a lost decade unless the debt problems are addressed quickly. "The euro straitjacket is clearly not providing a similar currency flexibility today. With the lira devaluation Italy managed to inflate debt away, which it cannot do today. It could take more than 10 years to revert to pre-crisis output levels."