By Simon Johnson
(Bloomberg News) In recent days, Greece's parliament adopted new austerity measures and Europe's finance ministers approved another round of Greek loans. So the European debt crisis is under control, right?
Probably not. One obvious reason is Standard & Poor's July 4 threat to declare a default if banks roll over Greek government bonds coming due over the next year. That could force everyone back to the drawing board.
Less obvious, but no less worrisome, is Italy. With a precarious fiscal picture, it could be the next to come under pressure. And this time, U.S. banks are in the line of fire, with about $35 billion in loans to Italy and potentially more exposure to risk through derivatives markets.
U.S. regulators should call for a new round of stress tests that assume sovereign-debt restructurings in Europe and take a realistic view of counter-party risks in opaque markets such as foreign exchange swaps. Based on those tests, the biggest banks probably need to suspend dividends and raise more capital as a buffer against losses.
Many market participants believe Greece will eventually attempt an orderly restructuring of its debt, in which European governments, together with the IMF, commit more resources and European banks agree to lengthen bond and loan maturities. The effect on Italy could be significant.
In the most recent International Monetary Fund projections, Italy's headline debt will reach 120 percent of national output this year, and then decline only slightly to 118 percent by the end of 2016. Italian bonds last week yielded about 4.9 percent, with the spread over German bonds widening to about two full percentage points (in contrast, the Greek-German spread is now about 13 percentage points). Further increases in interest rates could push the forecasts for Italy's debt toward Greek levels.
How could that happen? Investors are just beginning to understand that they will soon face losses on loans to Greece. Until recently, the presumption had been that German, Dutch and other northern European taxpayers would bail out failing governments in peripheral eurozone countries, at least to the extent necessary to protect creditors against losses.
This logic made some sense for smaller countries like Greece. It has about 360 billion euros in debt outstanding and the potential credit losses in any restructuring are in the range of 100 billion to 200 billion euros. The amounts are small relative to the EU's 12 trillion-euro economy.
Italy, though, has close to 2 trillion euros in debt outstanding. It's inconceivable that Germany or the IMF could provide a rescue to protect its creditors. Such a package would have to involve loans and guarantees of at least 500 billion, and possibly 1 trillion, euros to impress the markets. This would be a significant fraction of Germany's gross domestic product of about 2.5 trillion euros. With a debt-to-GDP ratio of about 80 percent, Germany's ability to take on new debt is limited.
The Netherlands, Finland and Austria, combined with Germany, have a GDP of about 3.5 trillion euros. France adds 2 trillion more, but its debt, already 85 percent of output, is expected to grow over the next several years.
It all adds up to one sobering fact: Europe does not have enough fiscal firepower to handle an Italian crisis -- at least in such a way as to protect creditors completely. Beyond the difficult numbers, why would Germany or other EU countries lend to Italy, particularly when its politicians show no sign of coming to grips with their new reality?
Once these facts dawn on investors, they are likely to demand higher yields on Italian government bonds. If Italy's economic growth is disappointing or if its recently announced fiscal austerity measures fail to impress the markets, its debt will look even more dubious. Long-term investors hate this kind of volatility and will shift out of Italian assets. By itself, that could push Italian rates up, similar to what happened in Greece, Portugal and Ireland over the last 18 months.
Italy has one major advantage over other eurozone countries: Much of its government debt is held by domestic financial institutions. If foreigners bolt, Italian authorities could pressure local institutions to support new bond auctions. But most Italian institutions have attached a very low -- and perhaps zero -- risk-weight to Italian government bonds. As yields rise, the value of those bonds falls. The losses will quickly threaten to swamp banks' equity capital.
Italian banks aren't likely to fail. Regulators will offer plenty of forbearance, so the banks won't have to value assets at true market values. But the overhang of sovereign-debt losses and a potential ratings downgrade (after a recent warning on Italy from Moody's Investor Service) could cause banks to cut back on private-sector lending. This would lower GDP growth and further worsen Italy's debt-to-GDP projections.
Italian banks will be able to draw on substantial credit from the European Central Bank, especially once Mario Draghi, former head of the Bank of Italy, becomes the ECB president in November. But the entire euro system -- the ECB plus the 17 central banks sharing the euro -- has a combined balance sheet of only about 1.9 trillion euros. It's unlikely that ECB credit can do more than postpone sovereign-debt problems on an Italian scale.
What are the implications for the U.S.? Think about the market turbulence that questions over Greece, Ireland and Portugal caused in the last year, and multiply. And think about an endgame in which moral hazard is really over -- meaning creditors that bet big on bailouts are allowed to suffer losses.
Previous bank stress tests did not factor in such difficult events, so the private sector and policymakers have no information to guide them. They are just guessing. All of this means the U.S. needs another round of stress tests for systemically important institutions. It would be wise for U.S. banks to raise enough capital now to withstand any trans- Atlantic storms.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)