It seems likely that once again, Italy will be the centre of the universe for the coming week (and perhaps longer).The good news is that the transfer of power is happening as expected. Silvio Berlusconi has resigned, paving the way for technocrat Mario Monti to take power.
So lots of balls remain up in the air.
What happens now?
JPMorgan’s Nicola Mai and Malcom Barr are out with a big call, basically predicting that the IMF is in the country’s future.
Evidently the change of power isn’t going to accomplish much. They’re also assuming that the ECB won’t be coming to the rescue as a lender of last resort.
This is their prediction:
It is not easy to identify how the current strains will be re- solved. But it looks increasingly likely that Italy will be forced into an EU-IMF program for at least a 12- to 18- month period. We suspect that such an EU/IMF program will not completely eliminate Italy’s need to issue term debt in markets, but will rather cover around three quarters of the liquidity requirement, leaving the rest to be funded in markets. That would require a commitment of around €240 billion in program funding across the EFSF and IMF to take Italy through mid-2013, assuming T-bills can continued to be rolled over, and that €85 billion can be raised through a combination of issuance of term debt to markets and
Retaining some ongoing requirement for market financing would help to keep pressure on Italy to deliver on budgetary and structural reform. In dealing with Greece, where no market funding was left, official creditors have faced the problem that the threat of withdrawal of official funds is not
credible. But, leaving some need for market financing would also implicitly rely on ongoing involvement from the ECB to ensure that the Italian government can meet it commitments, even if it pays relatively high interest rates on a portion of its debt. With the Italian economy moving into recession, and subject to significant political uncertainty, such an EU-IMF response would not strike many as bring-
ing a convincing end to the crisis. But, it would buy time for Italy to attempt to build credibility in its creditworthiness. And it would not force Germany to accede to a more explicit call on the ECB’s balance sheet, or an increase in German contributions to the EFSF, at this point.
In addition to this IMF access, Italy will need a “big bang” that will look something like this:
The required fiscal adjustment in Italy is challenging, and the liquidity need is very large. Wary of recent experience A one-off wealth tax could be applied to financial and non- financial assets held by households. A 1% one-off tax could raise 3%-4% of GDP (box). Another possibility is to insti-
tute a (lower) wealth tax that is payable every year. This is not easy to apply, but could help with tax evasion, which is another key issue in Italy. A concrete fight against evasion—with legislation that significantly increases penalties, makes tax payments more automatic, and steps up control—
is a priority. Sustaining social consensus behind these changes and the broader reform agenda will be very difficult in a recession environment. Institutions will need to lead by example, and drive change in a culture where corruption is endemic.
Even with all this, it’s very easy to imagine it all failing. The market doesn’t want more firepower or reform, as every attempt to enlarge the latest bazooka has been met with laughs. What’s needed, clearly, is structural reform at the Euro-wide level (you know, fiscal integration, a stepped-up role for the EB, etc.). At best this might buy everyone time.