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During 2013 Spanish and Italian bonds have had a strong rally, with yields falling to long-term lows. If one looks at MFI balance sheet data from the ECB, the conclusion is that the fall in prices can be attributed to domestic banks using deposit inflows in order to buy government bonds.


Spain MFI Balance Sheet Items - Flows - 201206 - 201303

The Spanish data show that domestic banks were strong net buyers of government securities through out 2013, with a total of €28.7bn in purchases. These were financed by increased deposits due to inflows by retail customers. Spanish banks do not appear to have been successful in accessing the money and capital markets with both deposits to MFIs and Debt Securities issued flows being negative.


Italy MFI Balance Sheet Items - Flows - 201206 - 201303

The Italian data are quite similar, with banks increasing their holdings of government securities even more than Spanish banks (a total of €34.1bn during 2013). Domestic credit institutions had a very strong inflow of funds during February and March (almost €60bn), mostly from retail deposits but also from money markets (at least during February). Capital market flows (debt securities) were negative almost €30bn.


Given the ongoing recession in both Italy and Spain and the increasing share of NPLs, domestic banks seem to have adopted a policy of investing any deposit inflows on government securities in a search of yield and relative principal protection (although taking a duration risk). Foreign investors seem to be increasing their positions at a steady pace or at least maintaining them (data on holders for Spain and Italy). As long as deposits keep returning to Spain and Italy and foreign investors are calm the above policy seems to be wining and providing significant capital gains.

Since it’s been a few months since I took a look at periphery NCB balance sheets, it’s time to examine trends during 2013.


Spain seems to be the one driving overall Open Market Operations (OMOs) usage down:

BDE balance sheet Mar 2013

Since December, OMOs have declined from €357.29bn to €270.94bn (-€86.35bn) with 80% attributed to a fall in LTRO usage. It seems that Spanish banks are confident to repay a significant part of their LTRO borrowing from the ECB which, given the low interest rates of LTRO funding and the relaxed collateral rules, imply that market conditions have improved strongly. During the same period, the consolidated Eurosystem OMO funding to European banks has dropped €225bn which means that Spanish banks account for almost 40% of the relevant fall (with another large part accounted by French and German banks).

Looking into the balance sheet at more detail, one observes that use of the deposit facility was €44.2bn in December and only €10.94bn during March, reflecting much lower safety buffers for Spanish banks. This is linked to the drop in Target2 liabilities, from €352,4bn in December to €298.3bn in March (-€54.1bn). Still, liabilities continue to be high, almost 28% of Spanish GDP although they are much lower than their maximum of €428.6bn in August 2012 (a fall of €130.3bn).

The drop in Target2 liabilities is related to the increase in non-residents government debt securities holdings, with registered holdings increasing €30bn since October, from €209.6bn to €240.4bn in February (an almost 15% increase).

Overall, credit conditions have clearly eased during the last few months. Nevertheless, both the situation in the real economy and current NPL figures point to large risks ahead for the Spanish banking system. Spanish banks will probably keep low quality collateral (such as credit claims) parked at the ECB and only use high quality securities in order to borrow in the repo market at low interest rates   (since current repo rates are close to 0.02-0.03%).


The Italian case seems to be a bit more muted than Spain. Since December, bank borrowing from the central bank of Italy has dropped only marginally from €271.8bn to €268.2bn with a somewhat larger fall in LTRO usage from €268.3bn to €262bn. This is mainly explained from the fact that Target liabilities only dropped from €255.1bn to €242.9bn. It seems that Italy has decoupled from Spain, probably due to the results of the recent national elections and the inability to form a stable government as well as the fact that government debt figures are moving close to the 130% GDP figure.

This is also reflected on the general government debt statistics which illustrate the fact that non-residents holdings of securities have been extremely steady during the last few months and are much lower than 2011 figures.

The ECB released the latest monetary developments data for September 2012. As always I tend to focus on the asset side (loans) rather than the liabilities (deposits and debt securities). 

What we see is that loans to households are still in a negative path while loans to non-financial corporations registered a significant negative flow of -€20bn for September. That’s equal to more than 0,2% of Euro 2012 GDP. The total quarterly figure for private lending (adjusted for sales and securitisation) is close to -€15bn which point to rather weak internal demand.

The ECB also released MFI balance sheet data per country. I ‘ll focus on Spain and Italy.


Spain saw a continued decline in loans to the private non-financial sector, with the total loan assets (not adjusted for sales and securitisation) dropping -€5,1bn, compared to a -€14.9bn decline in August and -€13.1bn in July which could be regarded as stabilization. Holdings of general government securities increased in September by €11.6bn reversing course from a fall of €12.7bn during July and August, pointing to a helpful effect from the ECB OMT announcement. On the other hand, holdings of ‘Other euro area residents’ securities continued falling. They lost €35.8bn since June (and €3.8bn in September) which makes one wonder if the increase in government securities holdings had more to do with portfolio rebalancing.

On the liability side, Central  Government deposits increased to €51bn (compared to €32.1bn in August) while deposits saw a healthy increase of both deposits and repos. Debt securities issued saw a decline of almost €8bn during September.


In the case of Italy private non-financial sector borrowing remained negative, falling €6.3bn this month after a fall of €10.6bn in August. Only Non-monetary financial intermediaries saw an increase in their loans. After stabilizing their holdings of government securities during the summer, Italian MFIs also increased them by €9.9bn during September with holdings of other euro area residents securities declining €4.4bn in the same month.

Regarding liabilities, both deposits and repos saw an increase by €22.8bn and €7.3bn respectively with debt securities issued declining only slightly.

In general, the OMT effect seems strong in the case of Italy and Spain but euro area credit creation is negative and the monetary union appears to remain in recession.

Along with aggregated Euro area monetary data, the ECB also released the per country MFI balance sheets for July. In the case of Italy developments were rather mute. Categories such as loans to non-financial corporations and households, holdings of securities, private sector deposits and debt securities issued were either stable or increased a bit.

In the case of Spain though, the figures released were more worrying. Deposits to other euro area residents posted a large drop of €74.2bn. After correcting for repos, the net drop is still €60bn, or close to 4% in one month. If retail depositors start moving funds outside the country then the banking system financial situation will worsen pretty quickly. Central government deposits were down to €38.5bn from €42bn in June. It’s another sign that (especially given the bailouts of regional governments) the government’s buffer is running low and will not be able to cover any shortfalls when €20bn of bonds mature in October.

Holdings of securities other than securites also dropped significantly by €32.3bn. Although most of the drop was in the ‘Other Euro area residents’ category, general government also saw a drop of €9.4bn, a negative development since holdings decreased to February 2012 levels.

Loans to Other euro area residents were down by €30bn (-1.7%), driven by lower lending to non-financial corporations and other lending to households (mortgage loans were actually stable).

Bank of Italy released the Italian balance of payments data for June:

The trade balance has clearly improved by a large amount, with trade in goods registering a surplus of €2.85bn for the 12-month period ending at June 2012, compared with a deficit of €25.24bn during the corresponding period last year. Services registered a deficit of €5.35bn,almost half than €9.06bn a year ago, while the total current account balance was -€30.06bn compared with -€59.85bn.

What is worrying is the financial account. Portofolio investment made a very largw swing from +€61bn to -€84.4bn, mainly due to outflows of €95.6bn in securities (especially medium/long-term). Other investment is only positive due to a positive balance of €279.08bn from Bank of Italy. There’s actually a very large capital flight out of MFIs which instead of a positive €30.8bn balance now have a deficit of €123.7bn (a change of more than 150bn) with assets and liabilities all playing their part, while ‘other sectors’ had a €8.9bn reduction in foreign assets.

Although the Italian real tradable sector shows very strong signs of improvement, the capital flight out of Italy is very large.

Bank of Italy released the government debt statistics for June. As always a few entries are not quite up to date but they still allow for some important conclusions.

Table 5 includes monthly statistics by holding sector. ‘Resident MFIs’ increased their holdings during 2012 from €515,58bn in December 2011 to €607,69bn in May (+€92.11bn), ‘Other Resident Financial Institutions’ from €291,48bn to €315.21bn (+€23.73bn) and ‘Other Residents’ from €261.87bn to €333.91bn in April (+€72.04bn). It is clear that resident MFIs and other residents were the main drivers of the increase in resident holdings of Italian government debt. On the other hand, ‘Non Residents’ decreased their holdings from €739.51bn to €619.34bn in April (-€120.17bn or 16% of their holdings). In December 2011 residents held 61% of total government debt while in April the percentage increased to 68%, a change of more than 6% in 4 months time.

Overall, government debt increased by €75.06bn during the first half of 2012, compared with €58.76bn in the first half of 2011 and €55.74bn for the whole of 2011, an increase of more than 4.75% of GDP from 120.1% to 124.9% GDP. Given the fact that Italy is already in a deep recession (with quarterly GDP dropping 0.7-0.8% in 2012Q1 and Q2) government debt is on a path to quickly reach 130% of GDP (although around 6% will be held by Bank of Italy).

Based on OECD data, if this pattern of a loss of 0.7% of GDP quarterly continues, Italy will be back to 2001 GDP levels by the end of 2012 and pre-Euro in the mid-2013.

There’s a paper published from the OECD which tries to calculate the sensitivity of government accounts to changes in the output gap using regression analysis, in order to determine the ability of Euro countries to adhere to the Maastricht 3% deficit rule. The authors include a table containing coefficients for the main Eurozone countries:

Using OECD output gap estimates for the period between 2005 – 2013 i will use the above coefficients to make a rough analysis of Euro periphery fiscal stance during the expansion of 2005 – 2007, the fiscal stimulus response in the depths of the Great Recession as well as deficit and debt dynamics for the immediate future:

What is immediately clear from the above table is the depth of defficient demand (evident by output gaps) in recent years. Output gaps have quickly reached double digits, pushing the corresponding economies into severe recessions (or depressions as is the case of Greece). Calculating the difference between the actual primary surplus (deficit) and the one projected based on OECD coefficients (assuming that zero output gap corresponds to a zero primary deficit) can help in drawing some basic conclusions about each country:

  • In Greece, fiscal policy was quite expansionary during the boom years but ever since 2010 the output gap has grown so large that real stimulus is required. Unfortunately, although fiscal deficits are quite impressive, they are mainly used to pay interest on government debt, while actual primary deficits are recessionary.
  • Ireland had a balanced fiscal stance but quickly reversed course to very large primary deficits as a result of the house market meltdown and the national banking sector capital needs.
  • Italy has actually been highly restrictive during the whole period, with the government sector most probably contributing to slow growth and the current recession.
  • Portugal seems like a Greek replica.
  • Spain had the most restrictive policy of all periphery countries during 2005 – 2007 (a total of 8,5% of GDP) with a completely opposite course since 2008.

One can now look at debt interest payments (based on ECB data) for the above countries and try to project fiscal deficits for 2012 and 2013 using the OECD coefficients to calculate primary surplus (deficit). In the table below, interest payments of 2011 have been kept the same for 2012/2013 (so this is an unrealistic, optimistic scenario), 2% for Ireland (no recent data is available) and lowered to 4% for Greece:

It is quite evident that, even with this very rough estimate, the projected fiscal deficits for 2012 and 2013 are considerable. Given the current GDP growth projections and low inflation environment (apart from Italy probably), debt sustainability is questionable, due to a clear inability to achieve primary surpluses without pushing the economy into recession (IMF projections for Greek primary supluses of 4% are more of a dream than realistic goals). Based on the current yield curve for both Italy and Spain and the interest burden which that creates (Italy will probably face interest payments larger than 5% of GDP, while Spanish average interest rate on its debt is already over 4%) one could probably already argue in favor of a restructuring in terms of NPV with a significant reduction in interest rate paid.

One of the main decisions of the recent Euro summit was to make the ESM a ‘market participant’ which can intervene in sovereign bond primary and secondary markets (although details have not been laid out yet), a commitment that was mainly requested by Italy. Although it will seem strange, i am not in favor of this idea, given the current ESM structure.

In the case of central bank liquidity operations there are basically two alternatives. In the first, the central bank calculates the banking sector’s liquidity needs (mainly due to reserve ratios and autonomous factors) and provides the calculated amounts at a given lending rate. Any excess needs (which should be small) are covered by use of the marginal lending facility. This mechanism provides for precision on the interest rate target and tight control of the central bank balance sheet but requires that private money markets are working smoothly and all participant institutions have equal access to liquidity (with haircuts on collateral and credit spreads on counterparties compensating for risk).

The other alternative is to provide liquidity with full allotment and act as a ‘market maker’ in times of acute market stress. The central bank balance sheet will expand according to market needs and control of the interest rate is limited, with movements mainly constrained by the central bank corridor system (deposit facility – marginal lending facility). Still, the credit system can continue to function without breaking down, as would happen if the central kept providing liquidity using the first mechanism.

One can evaluate the ESM using the above framework. The current ESM scheme basically resembles mechanism no. 1. It can be used as a bank recapitalization – deposit insurance mechanism and a general backstop in good times. Since its ‘cost of capital’ is high, seniority is important. In bad times, a buyer/lender of last resort must have complete balance sheet expansion flexibility in order to be credible. That means that the ESM should have a banking license (to be able to leverage with the ECB) if it were to participate in the sovereign bond market as a buyer.

I ‘ve already posted a table with holders of Italian debt, based on available official data. I ‘m reproducing it here:

It is clear that during the period of Oct-2011 – Feb-2012, non residents reduced their holdings of Italian debt by more than €80bn to a bit over €700bn. This was compensated by an increase from domestic MFIs (€40bn) and other residents (€50bn). The increase in holdings by residents was financed by the two 3Y-LTROs by the ECB and it is quite possible that it has reached its limits in terms of balance sheet exposure by domestic institutions. Lowering their exposure by another 10% is not something remote for non residents, given the current quality of Italian macro. In addition, foreigners also decreased their exposure to Spanish government debt by €37bn in 2011Q4 and 2012Q1.

The possibility that the ESM will have to act as a buyer of last resort for almost €100bn of Italian and Spanish sovereign debt within the next months is far from negligible. Given the existing commitment of €100bn for Spanish banks recapitalization, such ‘market making’ would eat all ESM available capital, since (with current schedule that i am aware of) paid-in-capital will be €32bn between July 2012 – 2013 and ESM lending capacity limited to €210bn.

In my view, current sizes are just not credible. Secondary market bond buying should be left to the ECB (although that leads to bond holders subordination in a future PSI) or the ESM should become a bank. Otherwise, the market will test the commitments and given current RoW holdings, the fight will be quickly lost.

Bank of Spain released its balance sheet for May today. The basic observations are as follows:

  • Target2 liabilities continued to increase growing to €318.6bn, a change of €34bn in a month. On the other hand, the deposit facility dropped further to €36.8bn.
  • Lending from the ECB increased in May through the MROs (which closed at €9.2bn compared to €1.8bn in April) while the LTRO remained unchanged.
  • Government deposits dropped from their high level of €24bn to €11.2bn.

Overall it is clear that capital flight is steady at around €30bn/month. Spanish banks excess liquidity (acquired through the 3Y-LTROs) has dropped to alarming levels, while the MRO borrowing shows that the banking system is already facing liquidity problems. Furthermore, the government deposit position is now low and cannot function as a balancing factor.

If this level of capital flight continues in June as well, Spanish banks will need to use short-term MRO lending from the ECB to cover the liquidity leakage. Bank of Spain daily interbank rate statistics point to very limited and expensive (especially compared to eurepo rates) access to interbank lending and only in very short maturities (overnight for unsecured lending, one month for repo loans). The recent increases in MRO usage visible in ECB’s weekly statements might be a result of Spanish banks lending.

As far as the Spanish banking system is concerned, a third 3Y-LTRO is quite needed by now.

On the Italian front, Bank of Italy released data on Italian debt. Table 5 contains details of holdings of securities by sector:

Although the data does not contain the most recent monthly details for all categories it is quite evident that, especially after the 3Y-LTROs, domestic MFIs were the main buyers of government securities, coupled with other financial (Other residents did the same in the second half of 2011). On the other hand non residents continued their exodus from Italian debt which amounted to €95.8bn during 2011 and another €24.6bn in the start of 2012.

Unfortunately, data for non residents only reaches February but an extrapolation clearly shows that resident MFIs/financials probably only managed to match outflows from non residents. Judging from the recent increase in Italian yields they aren’t successful any more.

Overall, the data point to a stressed environment but they aren’t recent enough to draw clear conclusions.

Bank of Italy released its latest government debt statistics. Government debt holdings by sector are included on page 11. Stock numbers for June 2011 onwards are presented in the following table:

* Data refer only to securities (millions of €)

Its is quite evident that both Bank of Italy and domestic MFIs increased their holdings substantialy during 2011. Bank of Italy posted an additional increase of €10.8bn during the first two months of 2012 and domestic MFIs used LTRO funding substantialy by acquiring another €24.3bn of securities in January. Other residents did not change their holdings much, although there were some marginal swings up and down after August. On the other hand, foreigners were strong sellers of government debt securities, reducing their portfolio by more than €94bn during 2011 (unfortunately no data is available for 2012).

The following graphs depict changes more clearly, especially of the different paths for MFIs and other domestic financial institutions:


It seems that only the central bank and domestic banks support their government’s debt, with foreigners being very strongly risk averse and lowering their holdings by more than 10% in 6 months.