GETTING the gold out of Italy isn’t easy. Just ask Michael Caine. However, if as some commentators are now speculating, there is no other option, the only thing worse than trying to sneak it out in a coach along treacherous Alpine roads would be trying to sell it. The odds of getting anything close to fair value for it are low, let alone the implications it would have on sentiment both inside and outside of Italy. That does not mean, however, that this isn’t gold’s chance to shine.
The Eurozone now seems comfortable with the idea of using leverage to plug the debt gap. This is in effect what has been suggested in the “first loss” structure of the EFSF. Buy-side investors though, worry at the lack of details from the EFSF, the quantum of the fund and the issue of “what happens when that first loss goes?”.
Countries such as China are reluctant to expose themselves to what would effectively be a lose-lose scenario. If Italy went, despite the “first loss” cushion, they would likely incur losses not only on the bonds, but also on the devaluation, or worse – break up, of the euro. But if Italy could somehow use its carefully guarded gold to provide enough short term liquidity while it pushes through its budgetary reforms, that might create enough breathing space to send yields below the magic 5 per cent.
So how might they do that? Well, one suggestion is to combine the idea of a “first loss” mechanism, with that of the only collateral in town members seem to like – gold. It could look something like this.
Italy “sells” its gold and its debt into a Special Purpose Vehicle (SPV). That SPV in turn issues bonds. To make things transparent to the investor, the only assets of the SPV are the gold and Italian sovereign debt. This should also help avoid some of the issues with the “negative pledge language” in existing bonds.
In return for the sale, the Bank of Italy receives a European style warrant which can only be exercised at the maturity of the bonds, and only on the condition that the debt has been has been fully repaid. The warrant is struck at zero, so the Italian government pays nothing to get the gold back. The opportunity cost is low since, as we all know, gold only glisters, it doesn’t yield. Italy could always retain the right to call the bonds back after a period of time, should it be in a position to do so.
In the instance that Italians do blow the bloody doors off and default, the bondholders recover the market value on Italian sovereign debt, but also take possession of the gold. One might legitimately expect gold to be trading higher by that stage. After all, if gold has any value it is surely when the world’s second largest currency zone is effectively falling apart. So for the investor, the overall value of money they recover is higher and consequently the risk of owning Italian debt through this type of structure is lower.
Could this be done in meaningful enough size to make a difference at this stage? Well, possibly. Italy is thought to hold around 2,500 tonnes of gold or around €100bn. If that gold were to be pledged as 25 per cent first loss, that would mean that Italy could source €400bn (of course, that ratio is getting tighter all the time).
But who would be the buyer and could it be done quickly? It is of note that the Chinese currently hold less than 3 per cent of their foreign currency reserves as gold. I imagine that they are not overly enamoured with the idea of being exposed to more euros given the status quo. This type of structure however, would offer them a liquidity point to get exposure to large amounts of gold. If the euro goes, they have diversified into another asset. If it holds, they have exposure through the sovereign debt in the SPV (at quite attractive rates of interest, no doubt) and of course, they do not have to do all €400bn. The merest suggestion that the Italians have found a way to finance 20 per cent of their total debt would be enough to bring buyers out of the woodwork. The Chinese may only have to underwrite it and receive a handsome fee for doing so.
And the best part? At the new rates of interest and with a following wind on the reforms process, the Italians should never have to see the gold walk out the door. Certainly there are issues with whether the Italian banks would let the Bank of Italy pledge the gold to go in the first place and some circles of economic thinking are not comfortable with the idea of gold reserves being turned into money. However, unless we think Berlusconi’s successor is going to say “Hang on a minute, lads; I’ve got a great idea,” it may well be worth considering.
James Conway is a partner at Portman Capital. Michael O’Connor, another partner at Portman Capital, also contributed to this article.