“We are now in the most critical phase of this crisis,” says Nicholas Spiro, founder of Spiro Sovereign Strategy. The contagion has engulfed heavyweights Spain and Italy. The latter, an economy around the same size as Britain, accounts for a sixth of eurozone output with a GDP of $2trn. Spain’s GDP is $1.2trn.
Early this week both Italian and Spanish ten-year bond yields jumped to euro-era highs of more than 6% (reflecting plummeting prices), and hence a sharp rise in Italy’s implied borrowing costs. This 6% “is too close for comfort to the 7% level beyond which investors become reluctant to fund sovereign borrowers”, says Lex in the FT. Shares in Italian banks (which, as Patrick Hosking of The Times points out, “hold heaps of Italian bonds [and] would struggle if these bonds were to fall much more”) have slumped.
Italy: an accident waiting to happen
“Italy was an accident waiting to happen,” says James Mackintosh in the FT. It has managed to keep a lid on new borrowing in recent years: its budget deficit was a relatively small 4.5% in 2010. But its overall debt pile is massive at 120% of GDP and the economy “is worse than sclerotic”. Last year GDP per head stood at 1999 levels.
So Italy’s odds of growing fast enough to make a dent in its debt pile are poor, especially since it has seen its competitiveness deteriorate steadily since it joined the euro. A note from the investment bank Jefferies points out that the prices of Italy’s manufactured exports have climbed by 50% since 1999. Given Italy’s huge debt load, it depends on market confidence to keep its interest rates affordable, especially as it needs to refinance €500m of debt, compared to a total load of €1.6trn, by 2013.
A botched austerity package
None of this is news, but over the past few days market confidence has dived due to scepticism over a €40bn austerity package announced earlier this month. Italian prime minister Silvio Berlusconi tried to subvert it to allow one of his companies to avoid a fine, while many of the measures are set to kick in after the next election and the opposition has rejected them.
Berlusconi is at loggerheads with his finance minister, Giulio Tremonti, and there is also no sign of reforms to boost productivity and the labour market, and hence growth. “The main element behind the turbulence [is] political disagreement… they should get themselves in line and push through the necessary measures,” one European official tells The Times.
It hardly helps overall confidence that policymakers, still going round in circles over Greece, appear to be in “a full-scale flap” over how to respond to this latest crisis, says foreign-exchange broker Fxpro.com. What’s more, the global stakes are higher this time. Italy’s huge bond market would be “a source of widespread financial infection”, says the Schumpeter column on Economist.com. “A full-blown Italian debt crisis would be cataclysmic.” And Italy is too big for Europe’s bail-out fund to save.
Is Spain next?
Europe could barely afford to bail out Spain, whose “vulnerability” has “never gone away”, says The Economist. Italy has reminded investors of this. One worry is that the state will have to pump a lot more than its estimated 2.5% of GDP into the banking system in order to help it cope with Spain’s “epic” housing bust.
The murky finances of Spain’s largely autonomous regions, which account for a third of spending, are another headache. The new government in one region says the deficit is twice as high as the previous government’s figure. And “the tempo of reform” needed to boost growth is slowing, says The Economist. “Politicians have repeatedly declared victory” over this crisis, says Toby Nangle of Baring Asset Management. But now it’s worse than ever.