Italian shock might blow a hole in stronger Piigs risk profile

Safer hands: but investors could still get their fingers burned

It was a decent third quarter for most of the highly indebted eurozone periphery in purely economic terms.

Greece racked up a second consecutive quarter of expansion, producing a 1.5% year-on-year GDP growth rate.

Spain’s economy has kept going, too, despite the political crisis stymying policymaking, with a bumper tourism season spurring growth of 0.7% quarter-on-quarter and 3.2% y/y.

Portugal also delivered a welcome surprise. The economy grew by 0.8% q/q and 1.6% y/y.

And with confidence indicators signalling the recovery has kept going into Q4, with unemployment rates slowly falling, those countries still having to make huge fiscal adjustments are painting a brighter picture for 2017.

Reasons to be cheerful

The experts seem to agree.

Risk scores for Spain and Greece in Euromoney’s country risk survey have risen this year – where a higher score equates to lower risk.

Plus, Ireland’s risk score of 66.6 points is now bang on the average for the eurozone.

The sovereign borrower has climbed 16 places in Euromoney’s country risk global rankings since 2010, including two places this year to 30th out of 186 countries surveyed.

Figures released by Eurostat show the gross debt burden falling sharply to just below 78% of GDP at the halfway mark of 2016. That compares with a peak of 120% of GDP in 2012.

Yet this remarkable turnaround has been assisted by some unexpectedly large GDP figures arising from multinational companies booking their profits in Ireland to take advantage of favourable tax rates.

Its underlying position is somewhat less secure, with a fragile minority coalition contributing to a lower government stability score.

Don’t ignore risks

In fact, the Piigs are all still riskier prospects since the sovereign debt crisis ensued in the wake of the financial storm of 2008.

Ireland’s risk score is 10 points lower since 2010, and Greece’s by a whopping 36, as it continues to manage a huge debt burden amid instability risks stemming from a three-seat parliamentary majority for the government, and deep divisions within the main ruling party Syriza.

In other countries, sovereign liabilities continue to rise, and Spain has now joined the three-digit club, with its gross debt burden topping 100% of GDP.

France-based ECR expert Norbert Gaillard, an independent economist and sovereign ratings analyst, is nevertheless sanguine about the prospects for Ireland and Spain.

On the latter, he says: “Political risk is lower now that [prime minister Mariano] Rajoy has managed to form a government, and unemployment is falling.”

Spain has moved up six places in Euromoney’s global risk rankings this year, and Ireland is two places higher.

Greece remains the laggard. Its public debt is unsustainable.

“But another haircut seems likely in return for more reforms, without triggering another crisis in the eurozone,” says Gaillard.

Focus on Italy

Portugal has its fair share of problems, too, but the main sticking point most experts agree on is Italy, where a referendum to be held on December 4 will weaken prime minister Matteo Renzi if voters reject his political reforms.

Italy has some of the lowest political risk indicator scores of the Piigs grouping, bar Greece. They include corruption, the regulatory and policymaking environment, and the stability of the government that Renzi’s reforms are aiming to address.

Its capital-access score has plummeted this year, and benchmark 10-year bond yields are some 55 basis points above their Spanish equivalent, with five-year CDS spreads widening to 170bp, compared to 87bp for Spain.

Italy has fallen below Spain in Euromoney’s risk rankings to 51st, making it a riskier prospect than China, Colombia or Uruguay.

Moreover, the financial system is a negative factor for Italy’s sovereign rating, with bank stability the one economic indicator to be marked down this year.

Euromoney’s Bank Risk Survey shows UniCredit in a more precarious position compared with leading Spanish and Portuguese banks:

And the eurozone banks are encumbered by higher-risk contingent liabilities compared with, say, Canadian or Turkish banks:

In-depth analysis from Crédit Agricole explaining the issues at stake in the referendum points to a 20bp-to-40bp widening of the Italian 10-year yield spread if it is rejected, depending on what happens next, ie whether Renzi stays or is replaced, or snap elections take place.

This will push down the euro/dollar rate by up to 1.7%, the report suggests.

The region is recovering, assisted by the European Central Bank’s liquidity tap keeping yield spreads quite tight, but as Portugal illustrated earlier in the year, bond yields might begin to respond more forcefully to political risk factors.

A political crisis combined with a banking crisis in Italy, and possible shock outcomes at the elections to be held in the Netherlands (March), France (second round presidential in May) and Germany (October), would surely see the periphery dragged down.

And the risks would be more acute if the US Federal Reserve opts for a larger tightening of monetary policy, attracting capital outflow from Europe.

Investors should be prepared.