Italy on the brink as yields soar past point of no return

The eurozone debt crisis has again conformed to pattern this morning; just as one fire abates, temporarily at least – with news of the formation of a government of national unity in Greece – another lights up. Lamentably, this one – Italy – may be too big to douse.

The yield on ten year Italian debt rose to 6.59pc this morning, widening the spread on German bunds to an unprecedented 4.81pc. These are the sort of levels at which Greece, Ireland and Portugal began to find themselves shut out of markets.

Yet this time, there appears nothing there to offer support. The "enlarged" European Financial Stability Facility is not yet up and running. Few seem prepared to offer it the "leverage" required for the mooted €1 trillion of fire power. The European Central Bank under its new president, Mario Draghi, has said it's not its job to act as "lender of last resort" to governments. And the new funds that would allow the International Monetary Fund to step into the breach have not yet been agreed.

Internationally, moreover, there is growing resentment at being called apon to support further EFSF and IMF bailouts. Christine Lagarde, managing director of the IMF, could soon have a full scale rebellion on her hands. From China to Brazil, the now openly spoken mantra is that Europe should sort out its own problems. By what right does one of the world's richest regions call on poorer, and sometimes even more indebted, nations to lend support?

As my colleague, Ambrose Evans-Pritchard, points out in this morning's Daily Telegraph, the problem with Italy is not really one of contagion from the rest of the eurozone periphery. It's much more to do with the fact that Italy is sliding into deep recession, further undermining already stressed debt dynamics.

There's a vicious circle at work, whereby more austerity equals less demand, equals negative growth, equals an even bigger debt burden. Unlike Britain, there is no monetary policy and devaluation to counter the economically debilitating effect of the fiscal squeeze. With growing lack of competitiveness, Italy is in the wrong currency.

At his first press conference last week as ECB president, Mr Draghi said that further bond purchases would be "temporary", "limited" and "justified on the basis of restoring the functioning of meonetary policy transmission channels". At Jefferies International, chief economist David Owen takes the view that whatever Mr Draghi said last week, in practice he'll be forced to change tack and make the promise of "unlimited" buying explicit. But even if he did, would it really do the trick?

Mr Draghi would have preferred to exhaust conventional measures first, in particular cutting interest rates all the way down to 0.5pc, but conditions in the Italian bond market are deteriorating with such speed that he may not be allowed that luxury. When a fiscal crisis developes, it tends to happen very fast, with the rapid ebbing away of what remains of market confidence. That's the place Italy now finds itself in.

Eurozone policymakers think they are already moving at a speed which is only barely compatible with continued democratic support. Yet they are going to have to move even more swiftly towards the introduction of eurobonds and a centralised eurozone treasury function if they are to save the project. Germany and other rich, creditor eurozone nations are going to have to make up their minds; they wanted the euro, but are they prepared to do what it takes to sustain it?

Europe kowtows to the Chinese dragon

Come to this. Few things could be more bizarre, or humiliating, than the sight of eurozone political leaders kowtowing to the Chinese in the hope that a few crumbs might fall from the dragon's table to help prop up the newly enhanced European Financial Stability Facility.

The Chinese threaten to extract a high price; security for their money, open access to European markets and freedom to buy advanced technologies (and there I was thinking they'd already stolen it all). They might also demand, though I have seen no evidence for this in published comments, that Europeans cease all open criticism of Chinese mercantalism, human rights abuse and anything else that tends to concern us over China's ever onwards and upwards rise to superpower status.

A few facts and figures. At $12.2 trillion in 2010, the eurozone's gross domestic product is more than twice as big as that of China and its income per capita is more than four times as high. And yet there's the eurozone's emissory, Klaus Regling, going cap in hand begging for handouts. How can a region be so rich and yet apparently so poor at the time?

It's a paradox which goes to the heart of the problem of global imbalances. What in effect is happening is that the Chinese earn far more than they spend. The consequent surplus in earnings and production is saved and exported. It's a funny old world that has some of the poorest people in the world lending to some of the richest to buy the goods they make but cannot themselves afford to buy, but that's the way it is.

Whatever concessions the Chinese manage to extract from the likes of Nicolas Sarkozy, who's been on the phone to President Hu Jintao, they would be well advised to leave well alone. As the investment guru Jim Rogers said on BBC radio's Today programme, the EFSF is essentially a scam. It might buy a little time, but it cannot solve the eurozone's underlying problems. The bit of it the Europeans want the Chinese to invest in is a "special purpose vehicle" – appropriately known as a SPIV – which is essentially a piece of financial engineering to make the fund bigger than it really is. It's a confidence trick.

It's also a surrogate for what the eurozone should really be doing to add liquidity to distressed peripheral nation bond markets – which is to give the European Central Bank the freedom to act as a central bank is meant to in its lender of last resort capacity and print money to ease the crisis (see this excellent piece by the economist Paul De Grauwe). Only the Germans won't allow it. They'd prefer to dance with the Chinese dragon than do the obvious. At best, they are going to end up badly singed.

Why the summit to end all summits solves nothing

Angela Merkel at the Justus Lipsius building in Brussels (Photo: AFP/Getty)

Will the grand plan cobbled together by eurozone leaders in the early hours of Thursday morning work in saving the euro? As Sir Mervyn King, Governor of the Bank of England, remarked before it had been signed, it might buy a little time, but it is no kind of long-term solution.

Before explaining why, let's first pick some holes in the plan itself, which amounts to pretty much a clean sweep for the German view on how to proceed and poses almost as many questions as it answers. The only bit which is done and dusted is the banking recapitalisations, where 70 banks have been stress tested and some very precise numbers have been put on the required additional capital.

The overall impact of the banking package is none the less somewhat underwhelming. The stress tests are widely thought wanting by many market participants and the additional capital therefore inadequate. BNP Paribas for one should be able to achieve its €2bn through earnings retention alone. The tests seem once again to have been designed so as to bring about the least possible commitment of new public money rather than once and for all to underpin banking solvency.

Furthermore, the statement seems to imply enforced bail-ins of subordinated debt holders before sovereign support is tapped. This is only going to further unnerve debt holders and will likely further enhance the difficulties many eurozone banks face in accessing wholesale market funding.

On Greece, nothing is done and dusted at all. The suggested 50pc haircut amounts to no more than a statement of intent. Persuading private creditors to accept such a write-off voluntarily will remain an uphill struggle. Many of the banks with big holdings of Greek sovereign debt have hedged themselves against default through CDS contracts. They thus have a positive incentive not to agree the haircut and instead force a "credit event". Only in these circumstances can they claim compensation through the CDS contracts.

There is a sense in which they are damned if they do and damned if they don't. If they agree the haircut, they lose the full amount and cannot reclaim it through the CDS. Yet if they trigger the CDS, they create market mayhem and may therefore end up even worse off. Nobody knows for sure what an uncontrolled default would do, but given the experience of Lehman Brothers, it is perhaps best not to try and find out.

A voluntary deal on the other hand in effect amounts to a breach of the CDS contract. In such circumstances all CDS insurance on sovereign debt essentially becomes worthless. Either way, someone, somewhere is going to lose a lot of money.

But the main strictures must be reserved for the European Financial Stability Facility, the main eurozone bailout fund. Here's what this morning's euro summit statement said about it.

We agree on two basic options to leverage the resources of the EFSF: • providing credit enhancement to new debt issued by Member States, thus reducing the funding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market; • maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets.

This is fine as far as it goes, but as the statement makes plain, investors will be required to pay for the insurance option. It's not clear, given what's just about to happen to CDS contracts on sovereign debt, that they will be willing to do this. What markets now aptly refer to as the "SPIV" option looks a little more promising, but even if it works in leveraging the fund to the €1 trillion policymakers are looking for, it will still fall short. This is what the economics team at Royal Bank of Scotland had to say about it this morning.

To put this number in perspective, if EFSF 3 was to continue buying Italian and Spanish bonds at the same pace as that of the ECB, this would give only 2 years of purchasing power, assuming no other country would require help from the EFSF.

Precisely so. It's nowhere near enough. And this really goes to the heart of the problem. The EFSF is no more than a fig leaf, a wholly inadequate alternative to the European Central Bank, which is precluded from providing the limitless liquidity which would undoubtedly do the job by the German veto.

Think of it like this. In countries such as the UK with their own sovereign currencies, there are certainly risks attached to buying public debt, but default risk is not one of them, since in extremis the central bank can always print the money to redeem the debt at maturity. The default risk only materialises if the sovereign starts raising debt in a foreign currency. In such circumstances, it cannot print money to pay it back.

That's the situation the eurozone periphery nations find themselves in. They have effectively borrowed money in a foreign currency – the euro. Now of course it wouldn't be a problem if the ECB were able to buy the debt without limit, as effectively the central banks of the US and the UK have been.

But scorched by the memory of Weimar, Germany will not allow any such nonsense. The ECB is expected to be the keeper of the Bundesbank tradition in maintaining sound money. It's all very admirable on one level, but it's the wrong policy for a liquidity crisis. There are risks in sanctioning the ECB to let rip with massive QE – moral hazard, inflation and possibly catastrophic balance sheet loss – but it's the only way the eurozone will ever finally lance this sovereign liquidity/solvency problem. Unfortunately, Germany is too stuck in its ways to allow it. Instead, we have the wholly inadequate alternative of the EFSF.

Nor does any of this address the underlying problem of widely divergent competitiveness between the eurozone core and its periphery nations. The sort of governance, structural and budgetary reforms suggested by the statement – including, astonishingly, the creation of yet another European President to manage the affairs of the eurozone – will take years if not decades to make inroads into these imbalances, and that's making the heroic assumption that they are infact implemented. Again Germany is the only country in any position to solve the problem. If it were massively to reflate its own economy, that would help. The chances of this happening are zero.

Big things have been agreed overnight, but policymakers remain in a state of intellectual denial. On the present policy mix, the euro cannot survive.