Bond Rally Gives Italy Free Pass Skirting Reforms: Euro Credit

Europe’s periphery-nation bond rally is giving Italy a free pass, raising concern that the pressure for reforms will dissipate.

The drop in borrowing costs, spurred by gains in euro-area manufacturing and retail sales, threatens to halt a two-year push to restore growth that has made scant progress in eight months under Prime Minister Enrico Letta.

“Italy lacks the self-discipline to truly overhaul its economy, unless placed under extreme market pressure,” said Raj Badiani, an economist at IHS Global Insight in London. “The fall in Italian bond yields has decoupled from the grim realities facing the country.”

The additional yield investors demand to hold 10-year Italian bonds instead of benchmark German bunds on Jan. 3 narrowed to below 200 basis points, the least since July 2011. That allowed the government to dismiss criticism of its agenda and say its program, which has focused on budget discipline and the labor market, was paying off. Economists urged renewed attention to implementing changes, saying lessened pressure was due more to European-wide growth expectations.

Euro-area factory output rose at a faster pace than economists forecast in December, while retail sales increased 1.4 percent in November from the previous month, helping to reduce chances of a debt spiral in the region’s peripheral nations.

Delay Risk

“Letta’s administration has hesitated so far,” Nicola Borri, assistant professor of Economics at Rome’s LUISS Guido Carli University, said in a telephone interview. “The risk is that reforms once again will be delayed.”

Italian businesses are pressing for improved flexibility in the labor market, speedier enforcement of contracts in courts and a reduced tax burden. Italy ranked 65th out of 189 countries globally in the World Bank ease-of-doing-business survey released in October.

Rewriting the rules in Italy will be a challenge for Letta as he struggles to keep his unruly coalition intact. The premier is seeking to build consensus around a new program that he hopes to finalize this month. Matteo Renzi, the head of Letta’s left-leaning Democratic Party, has called for cuts to the public administration and a labor reform to ease firing rules while giving more protection to workers who lose their jobs.

Spanish Bonds

The borrowing improvement since the start of the month continues a year-long trend for Italian and Spanish bonds. It was a pledge in July 2012 from the European Central Bank to step in if needed that started the contraction in spreads over comparable German bunds. Now, signs the region’s economy is recovering are fueling optimism that the worst of the crisis is over, increasing appetite for higher-yielding assets.

“We don’t have the panic like before,” said Raffaella Tenconi, an economist at Bank of America Merrill Lynch in London, said by telephone. “Now it’s not like 10 basis points more or less in the spread are going to make the difference” to push reforms forward.

The yield on 10-year Spanish notes on Jan. 9 slid to 3.67 percent, the lowest since September 2006, before closing at 3.81 percent on Jan. 10, while Italy’s 10-year bonds yielded less than 4 percent compared with more than 7 percent in 2011. The yield on Greece’s 10-year bonds fell 13 basis points, or 0.13 percentage point, to 7.71 percent on Jan. 8, the lowest since May 2010, when the country received its first international bailout.

Record Low

Italy’s borrowing costs dropped to a record low at an auction of three-year debt today on the renewed confidence in peripheral euro-area countries. Italy sold a total 8.2 billion euros, the biggest bond auction since May 2011. The country sold 4 billion euros ($5.5 billion) of a new three-year note maturing in December 2016 at 1.51 percent, down from 1.79 percent at the previous auction Nov. 13.

Letta, 47, has dedicated his time in office to maintaining budget discipline and appeasing his allies in parliament as the Italian economy continued to fall short of expectations. Suffering businesses closed shop as restructurings were hampered by rigid labor market rules, and entrepreneurs withheld new investments as the courts failed to provide timely enforcement of contracts.

Employers’ lobby Confindustria predicted the nation’s gross domestic product would increase 0.7 percent this year.

“We need to pick up the pace,” Confindustria Chairman Giorgio Squinzi said Dec. 19. “There’s no other country inside or outside Europe in which the hands of the clock have gone back in time so much because of the crisis.”

The reform push got a jump start in December 2011 after 10-year yields above 7 percent galvanized parliament and gave Letta’s predecessor, Mario Monti, the support he needed to pass a pension reform package raising the retirement age and introduce a tax on primary residences.

Tapered Momentum

Momentum tapered off in the following months as bond market pressure eased. Labor reform in 2012 failed to live up to expectations and Monti cited it as a disappointment from his time in office.

Unemployment, deemed by Letta “the real nightmare of our times,” is at a record 12.7 percent, the highest since Italy’s statistics office Istat started collecting data in 1977. With no policy changes, it may rise above 15 percent by 2015, said Tenconi of Bank of America.

After a two-year contraction, Italian gross domestic product was flat in the third quarter compared with the previous three-month period, and the government expects it to have returned to growth in the three months through December. Still, consumer confidence unexpectedly dropped in December as the recovery has yet to have an impact on households.

“There is little evidence to suggest that without financial market pressure, specifically a very sharp spike in BTP yields, that the very necessary structural reforms that Italy needs will materialize,” said Marc Ostwald, a strategist at Monument Securities Ltd. in London, referring to Italian bonds.

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