Even Italian banks are dumping Italian government bonds. New statistical data from the investment bank Jefferies LLC has revealed a startling new trend that could have major implications for Europe’s economic future: Italian banks have begun dumping unprecedented volumes of Italian sovereign debt. Holdings of government debt by Italian financial institutions slumped by a record €20 billion in June, almost 10% of the tota, after €9.4 billion of sales in May. As the FT reports, the selling by Italian banks is the most emphatic example yet of a broader trend: banks sold €46 billion of government paper in June across Europe, taking the total reduction since the start of this year to €257 billion. The banks’ mass sell-off is probably being driven by two main factors: first, as an attempt to preempt a pending Basel III reform package that could eliminate the equity capital privilege for EU government bonds, and second, to position themselves for an anticipated autumn announcement from the ECB that it will begin tightening monetary policy. “Maybe we are seeing an indication of Italian banks catching up with what their counterparts in Spain have known for a long time, that sovereign debt is not the place to be in a world of rising interest rates, said Jefferies’ senior European economist, Marchel Alexandrovich.
But then: who’s buying it?
The answer, in the case of Italy, is the ECB and its Italian branch office, the Bank of Italy, where Italian bank deposits rose by €22 billion in June and €50 billion since the start of 2017. The ECB “overbought” Italian government debt in July with purchases of €9.6 billion, its highest monthly quota since quantitative easing began.
As Italian banks offload their holdings, the ECB, with Italian native and former Bank of Italy governor Mario Draghi at the helm, is picking up the slack. In doing so, the central bank surpassed its own capital key rules by which member state debt is bought in proportion to the size of each country’s economy. By contrast, the ECB’s German Bund purchases slipped below its capital key rules for the fourth month in a row, which further depressed the spread between Italian and German 10-year debt to 152 basis points, its lowest level of the year.
This spread is artificial, derived from the ECB’s binge buying of European sovereign bonds, particularly those belonging to countries on the periphery.
A report published in May by Astellon Capital revealed that since 2008, 88% of Italy’s government debt net issuance was acquired by the ECB and Italian Banks.
At current government debt net issuance rates and announced QE levels, the ECB will have been responsible for financing 100% of Italy’s deficits from 2014 to 2019. That was before taking into account the current sell-down of Italian bonds by Italian banks.
In other words, Italy’s government has grown wholly dependent on the ECB for funding at artificially low rates. In that time, the country has become home to the largest public debt pile in the EU, worth €2.279 trillion in May, despite being the region’s fourth largest economy (behind Germany, France and the UK). The European Commission has repeatedly threatened to impose fines for breaching EU budget rules, but if it ever did, it would be the ECB that would end up paying them.
Clearly, this arrangement cannot last forever. Over the coming months, if Italian banks continue to reduce their holdings of Italian debt, the ECB will have to continue buying these bonds. After all, there’s virtually no one else in the market left to pick up the slack.
But even the ECB has its limits: it can only buy up a maximum of 33% of a given nation’s debt. In the case of Italy, it’s already approaching the 25%-mark. According to Alleston, once the limit is reached, the only way for the game to continue is if over the following six years non-banks, the very same investors who used QE as the perfect opportunity to offload the immense risk of holding Italian liabilities onto the Bank of Italy, and then onto the Eurosystem, increase their purchase activity up to seven times that of the past nine years.
That is not going to happen.
It is for this reason, as well as the unresolved issues in the banking sector, the over €400 billion of Target 2 debt the government owes the ECB, the rising public opposition in Italy to Eurozone membership and the growing likelihood of political instability as elections approach in 2018, that Italy remains the Eurozone’s weakest link. And with each passing day, as the economy grows more dependent on ECB funding, it grows weaker. Desperate Times, Desperate Measures....