13 July 2004

Standard and Poor's cut Italy's Rating

What would happen if any member country of the Euro-zone would have its rating cut to a very low level? Would the present situation of tiny spreads between the government bonds of the various countries be sustainable?Current Spreads are based on a certain euphoria and the fact that most markets are driven by liquidity mixed with a dose of moral hazard. The dominant players are institutions where the majority of traders or fund managers are quite young or have a vested interest (official institutions or those close to the governments).The reality is that at some stage we will see a bursting of the dams, - like in the Asian Crisis of 1998. There it was only wishful thinking that kept the markets going for much longer than was warranted by the facts.When the first country hits the BBB level (or lower) the penny will suddenly drop, spreads will rocket well above 1 percent and an avalanche of money will move into countries that are seen as rock-solid and likely to stay in the Euro-zone. Why hold paper issued in/by the weak countries that may repay you in their devalued own currencies? Those that say that this cannot happen should pause a moment. If the law in any country decides that all obligations will be converted into a new currency who is going to stop it?Wolfgang Muenchau (FT, 12 July 2004) concludes that 'Italian long-term debt is absurdly overvalued'. While we would not have used such strong language we are happy that this commentator sees things in the same way.