Merk Commentary: European Bonds for Italy?
Axel Merk, Portfolio Manager, Merk Funds
July 11, 2011
European countries have been too slow in embracing structural reform and European financial institutions too slow in repairing their balance sheets; the markets are not waiting for them to get their acts together. Italy has become the most recent focus; what's different about Italy? It has a positive primary balance: before interest payments, the Italian government is generating a surplus of 1.8% as a percentage of GDP. Except, of course, with a debt to GDP ratio of 119%, after interest payments, that surplus becomes a deficit of -4.6% of GDP.
With other peripheral Eurozone countries, bond markets have already pressured governments to engage in structural reform. While Italy could and should be more aggressive in engaging in further reform, a primary surplus is what other weak Eurozone countries are dreaming of.
In our assessment, the current dynamics may finally lead to a large-scale introduction of pan-European bonds. European policy makers may decide that any country that meets certain criteria, such as a primary account surplus (eventually watered down to a primary deficit not exceeding x%) may be a beneficiary of bonds backed by the entire Eurozone.
The market is extremely hungry for such bonds, as they promise high quality and liquidity. Germany may be the most reluctant to embrace such bonds, keenly aware they might challenge German bundsí benchmark status for Eurozone bonds down the road.
With Italian markets under pressure, pan-European bonds appear to be an ever more likely step in an effort to achieve a more "comprehensive" solution for weaker European countries. While such bonds may be an extension of the European Financial Stability Facility, a key difference to tap into the bonds may be that they come with fewer, if any, strings attached, potentially making them a general purpose funding mechanism down the road. To some it will be another bailout; to others, it will be milestone towards close fiscal integration in the Eurozone.