Euro-Update (26): What happened to Italy?

The crisis in Europe continues to deteriorate. Last week contagion seemed to progress towards Italy and to make further inroads into Spain. Some commentators wonder about the timing of the contagion. Others wonder about why Italy has been targetted, rather than Japan.

On the issue of location I believe that the currency union issue is well pointed out. To me the main curiosity is why it happened to Italy, rather than Spain or Belgium. Regarding the timing, my information comes from FT Alphaville (here, here, here), among others.

I believe that the ongoing problems can be traced back to Greece, which faced a crisis in the beginning of June, when the troika reviewed it’s performance and found it lacking. This was partly due to the unrealistic growth assumptions of the programme (a problem likely to also be present in Portugal) and partly due to the unwillingness of Greek officials to pursue privatisations. The result was that Greece found itself needing another bailout. This made Mrs Merkel renew her calls for a private bail-in which further disturbed the markets, because she must “be tough”. As this demand came to dominate the discourse, a French proposal for a banking bail-in was advanced. This seemed to receive a very dim view from ratings agencies who considered it akin to a selective default (A similar view was taken by Fitch about the Vienna Plus initiative). As that proposal continued to dominate the European public debate, the ratings agencies considered it to be a serious policy path and in anticipation of a Greek restructuring, downgraded Portugal and Ireland, further compounding the problems there.

From then on, it was only a matter of time before markets would move on to dumping their next weakest link. It seems a combination of rumours that Unicredit would fail the stress tests and bad timing on the behalf of the PM’s criticism of the Finance Minister, on the eve of a important auterity package vote conspired to cement uncertainty about the future of Italy.

The way I see it, when risk (calculable probability of a “Loss event” occurring) becomes uncertainty ( impossible to know whether it will occur or not) holders of that contract will attempt to sell it in order to obtain a better (calculable) contract. As uncertainty spreads, we have a sell-off.

Last Friday’s stress test results (Here for the original and here and here for FT Alphaville coverage) seem to have done very little to bring back confidence to the markets and to the sovereign.

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