Azad Zangana, Schroders

ECB to continue buying bonds despite Italian downgrade

The European Central Bank (ECB) will continue buying bonds despite Standard & Poor's decision to downgrade Italy's sovereign debt rating from A+ to A, says Schroders' Azad Zangana…

Yesterday, Standard & Poor’s (S&P) cut Italy’s sovereign debt rating to A with a negative outlook, from A+. The primary two reasons for the downgrade are: Italy’s weakening growth outlook and; Italy’s weakening ability to carry out its fiscal reforms/consolidation in the face of rising political uncertainty related to the European sovereign debt crisis.

S&P has also downgraded its forecast for Italian GDP growth, and now forecasts 0.4% growth in 2012. This is more optimistic than our forecast figure of -0.3%, as we are forecasting a small but significant recession in the country caused by extra fiscal tightening and a weak regional environment.

On fiscal reforms, S&P cited the view that the government’s projection of nearly EUR60 billion in fiscal consolidation through 2014 may not come to fruition because of the impact the measures would have on growth, and therefore on tax receipts.

It is worth noting that S&P have kept Italy’s outlook on negative watch, signalling that further downgrades are possible. Given our more negative view on growth in Italy, we think further downgrades appear likely.

In addition, Moody’s, one of the other top three rating agencies, is also currently reviewing Italy’s rating, which is three notches above that of S&P after the downgrade. It is now more likely that Moody’s follows S&P in downgrading Italy.

In terms of the impact on the real economy and the crisis, we do not think this downgrade, and future downgrades, change the path of the eurozone crisis in their own right, but they do reflect the growing risk of a disorderly outcome.

At the end of July and beginning of August, Italian and Spanish bond yields started rising sharply without any real domestic trigger behind the deterioration. In our view, this was in reaction to developments (or lack of them) with regards to Greece. As the Italian and Spanish bond markets are more liquid, speculators appear to have been expressing their views through them rather than directly in Greek bonds.

The current phase of the crisis, where higher bond yields are feeding back on countries that were looking relatively healthy only a few months ago, is very serious, particularly given the size of the eurozone’s third and fourth largest economies.

Looking ahead, we think the ECB will continue buying bonds regardless of the rating, but investors are now focused on the next Eurogroup and EcoFin meetings (3rd and 4th of October) where European leaders must agree to extend the bail-out for Greece as originally agreed on 21st July, or risk allowing Greece to run out of money next month, and possible opening Pandora’s box.


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