WSJ: New Fears on Italy Jolt Europe

EUROPE NEWS JULY 11, 2011, 7:13 P.M. ET
New Fears on Italy Jolt Europe

By ALESSANDRA GALLONI and MARCUS WALKER

ROME—Italy, long a bystander to the euro-zone's debt woes, was thrust into the eye of the storm on Monday, as investors fled the country's bonds and Europe's leaders struggled to keep the crisis from infecting the Continent's third-largest economy.

Fears over Italy's solvency and political stability, compounded by market frustration that Europe's leaders haven't yet come up with a solution to Greece's deepening debt problems, sent Italy's 10-year sovereign bond-yield spreads jumping by more than 100 basis points, to a record high of 285.6, against safer German Bunds, compared to a week ago.

Trying to stem the panic, Italian Prime Minister Silvio Berlusconi has promised to avoid the political dithering that so often thwarts Italian policy-making, and speedily get through parliament a package of austerity measures unveiled two weeks ago, aimed at balancing Italy's budget by 2014.

The measures "will be approved in just a few days as the government has a solid majority," Labor and Social Policies Minister Maurizio Sacconi said in an emailed response to questions on Monday evening.

Even that, however, may not be enough to quell market turbulence.

"The experience of Greece, Ireland and Portugal shows that market confidence can unravel pretty quickly," says Marchel Alexandrovich, economist at Jefferies International in London. "Italy's fundamentals are stronger than, say, Spain's, but if the market loses confidence in a country, then such things don't matter."

Most of investors' jitters have their roots beyond Italy's shores; the market is fretting that European leaders are still at odds over a second aid package for Greece and that a possible default in Athens could engulf larger economies.

With no consensus on how to share the burden of a new Greek bailout with the troubled country's private-sector creditors, European finance ministers struggled at a meeting Monday to make progress on a fresh aid package.

Arriving in Brussels, officials offered widely divergent views on how to proceed. The Dutch finance minister said burden-sharing by private-sector creditors was a pre-condition to fresh aid; the Spanish finance minister warned of "instability in the markets" and said the Continent ought to think first of preventing the crisis from spreading beyond Greece, Ireland and Portugal.

At the heart of the issue: credit-rating companies have made clear that any significant effort to make private creditors feel pain would be treated as a debt default by Greece. Most top officials—chief among them European Central Bank President Jean-Claude Trichet—have said letting that happen is unacceptable.

That leaves Europe with a stark choice: Either make European taxpayers responsible for funding Greece indefinitely, or shift some of the burden to private creditors and suffer a debt default.

After months of trying to find a middle ground, none has emerged, and it is becoming clear a breakthrough before the August summer holiday is unlikely. Still, there were faint signs that some European policy makers were coming to accept that a debt-default verdict from ratings companies, however distasteful, mightn't be a calamity.

"I am more searching for a solution than a rating," Belgian Finance Minister Didier Reynders said. "If it's with a negative reaction from the rating agencies, that's not a problem."

But Italy's long-running deeper problems—a debt load of 120% of gross domestic product coupled with anemic growth and a volatile political system—are also coming to the fore after two years in which Italy was largely left unbothered by the Continent's debt crisis.

"The objective component that's fueling these market pressures is Italy's sovereign-debt load. It's like a fuse that is unsettling markets and leading to a situation that is worse than Italy's fundamentals deserve," says Fabio Pammolli, professor of economics at the University of Florence.

A psychological aspect is also compounding the situation: While a bailout of Greece, Ireland, Portugal and even, potentially, Spain wouldn't break Europe's bank, an Italian financial meltdown could well bring down the euro zone, economists say.

The danger for Italy would be if bond markets turn their back on the country completely, refusing to lend it the amounts it needs even at higher interest rates. Greece and Portugal succumbed to such a shutdown of bond markets.

"In that case Italy would have a serious liquidity problem," says Daniel Gros, director of the Center for European Policy Studies, a Brussels think tank.

If Italy were to lose access to capital markets, the rest of Europe would probably struggle to raise enough funds to keep the country liquid, say economists and officials because Italy is "too big to save." Then only the European Central Bank would be able to prop up the country, by printing money, which is it loath to do.

Most economists don't believe a complete loss of market access is imminent or likely. "I think the panic will stop beforehand. Italy has objective problems but this is a bit exaggerated," says Mr. Gros.

For one thing, rising bond yields won't dent Italy's finances in the short term, because most of its debts don't fall due for many years. In the longer term, significantly higher interest rates could push Italy's total debt to an unsustainable level, given the country's chronically weak economic growth—which has been less than 0.25% over the past decade compared with 1.1% across the euro zone.

Italy currently pays an average interest rate of 3.8% on its roughly €1.6 trillion ($2.3 trillion) of capital-market debt. Even if it had to pay an extra two percentage points to raise the roughly €90 billion it still needs to borrow this year, the extra burden on the budget would be only €1.8 billion—an insignificant amount for a major economy.

Italy also has several strengths that distinguish it from euro members that have already needed a bailout, such as Portugal.

First, Italy has a "primary" budget surplus, meaning that its tax revenues exceed government spending excluding interest costs. This means Italy can more easily bring down its total debt and stay solvent. Countries such as Greece and Portugal, which have deficits even before interest, are struggling with much faster rises in their overall debt.

Second, Italian households and companies are significantly less indebted than their counterparts in other Southern European countries, which means the Italian private sector doesn't have to trim its spending. In Greece and Portugal, the private and the public sectors are being forced to reduce their debts at the same time, leading to recessions.

In addition, Italy's foreign borrowing accounts for only about 45% of its debts, a lower share than in other indebted euro members, which makes the country somewhat less vulnerable to the volatility of international financial markets. Italy's relatively small trade deficit means that the country as a whole is less dependent on foreign financing that Portugal, Greece or Spain.

And Italy's banks are carrying far fewer bad loans on their books than in many other European countries, because they lent conservatively during the boom years and Italy didn't have a real-estate bubble. Italian banks' main handicap is that long term, they face a battle making profits on their core business—lending to companies and individuals across their homeland—because the euro crisis is pushing borrowing costs up faster than the prospects of Italian economic growth.

Still, the focus of investors over the past few days has been as much political as economic. Italy's austerity package is centered on around €40 billion of deficit-savings measures between now and 2014 that include increases in medical fees and fewer money transfers from the central government to local administrations. Most of the cuts kick in after 2013, however, which is when Italy is due to hold a general election—timing that many economists say is dangerous because no politician likes to be seen as cutting back in an election year. Still, the government, and other supporters, say the measures had to be calibrated in order not to thwart the little chances of growth that Italy does have.

"Unlike France, Spain and the UK, which had stimulus programs, Italy is coming out of a long period of deficit-cutting. Introducing more tightening measures too early would have had a recessionary effect," says Mr. Pammolli, the University of Florence professor.

However, the bigger concern—in both Italy and abroad—is that Mr. Berlusconi's government doesn't have the political strength to get the bill through parliament quickly. Italy's billionaire premier has steadily been losing popularity, suffering a resounding setback in Italian local elections in May and then being defeated in referenda weeks later.

Reports of tensions between Mr. Berlusconi and his finance minister, Giulio Tremonti—who has largely been praised for fiscal rectitude over the past few years in Italy—have also led to a sense that the premier's coalition no longer has the strength to pass legislation. Reports of strain between Mr. Berlusconi's party and the formerly-secessionist Northern League Party—whose support the government needs to pass legislation – have also fueled concerns.

One positive sign for the government came on Monday, however, when Italy's three main opposition parties said they would not stand in the way of the austerity measures being approved. Even German Chancellor Angela Merkel on Monday said that she was confident the measures would be approved, allowing Italy to "send a signal that it feels committed to consolidation and fighting debt."

—Sara Schaefer Muñoz
and Charles Forelle contributed to this article.
Write to Alessandra Galloni at alessandra.galloni@wsj.com and Marcus Walker at marcus.walker@wsj.com