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“We’ve been gradually feeling better about Europe.” “The breakup sentiment is diminishing.” “The expectation of a doomsday scenario in the euro region has passed.” That’s what the experts were saying in mid-March after a successful Greek debt writedown. So much for springtime flights of fancy. Three months later, a doomsday scenario for Europe is back in the headlines, and the focus of fear is now on Italy.
The euro zone’s third-biggest economy is seen as the next domino at risk of toppling after the European Union’s June 9 deal to lend Spain $125 billion in bank bailout funds. Yields on Italy’s 10-year government bonds reached 6.2 percent on June 13, up from just 4.8 percent in March. By pushing up Italy’s borrowing costs out of fear of default, investors are making a default more likely. “The loser in the Spanish deal is Italy. It’s now the only southern European country that is standing alone” without official support, says Marc Chandler, chief currency strategist at Brown Brothers Harriman.
Italians are joking grimly that winning the UEFA Euro 2012 soccer tournament, which runs through July 1, might not be auspicious, considering that the last two victors were Greece (2004) and Spain (2008). The hottest new politician in the country is a stand-up comic, Beppe Grillo, who questions Italy’s membership in the euro zone and whose 5 Star Movement just won the Parma mayor’s office.
What investors failed to see back in March was that Italy had already begun to lose control of its fate. Private capital was quietly fleeing even as bond yields fell (chart). With private investors unwilling to risk their capital in Italy, the country must lean on the rest of the Eurosystem—the network of 17 central banks of countries that share the euro. In June 2011, the Bank of Italy had a small net credit of $6 billion with the Eurosystem, whose hub is the European Central Bank. By this May it had a liability of $275 billion. There is no statutory limit to how much a central bank can owe, but Germany’s Bundesbank, as the system’s biggest creditor, is worried that if the euro zone fragments it won’t get paid.
In Italy as in Spain, the government and the nation’s banks have an unhealthy interdependence. In the 12 months through April, says the Bank of Italy, Italian banks’ holdings of government securities rose 59 percent, while their holdings of each other’s bonds rose 63 percent.
In Spain, weak banks imperiled the government, while in Italy the risk is that losses on government bonds will imperil the banks. Italy’s ratio of gross government debt to gross domestic product, at about 120 percent, is the second highest in the euro area, after Greece, according to the International Monetary Fund.
Prime Minister Mario Monti came into office with a plan to fix Italy’s finances so it would never need official aid. He narrowed the budget deficit but chilled growth as well. The economy shrank 0.8 percent in the first three months of the year, the third consecutive quarterly decline, the government reported June 11. The tax increases that lowered the deficit have angered Italians while approaching the point of diminishing returns. Receipts of the value-added tax, which ex-Prime Minister Silvio Berlusconi raised in September, have fallen to 2006 levels.
Italy’s collapse isn’t a foregone conclusion. Even at 6.2 percent, its 10-year bond yields are below the peak of 7.3 percent in November, before Monti took office and the ECB ladled out three-year loans to European banks. “I am not worried for the time being,” says Francesco Daveri, an economist at the University of Parma. But financial markets have a mind of their own. Economists at Citigroup (C) wrote on June 8 that “the situation could rapidly become critical, because the country is highly vulnerable if the sovereign debt crisis persists or intensifies.”
Alberto Mingardi, director general of the pro-free-market Bruno Leoni Institute in Turin, says Monti should have pressed harder to pay down the debt by selling state-owned businesses. At this stage, says Mingardi, “Italy will continue to consider itself basically at the mercy of what’s going to happen at the European level.”
The country’s best hope now is strong support from European Union leaders at a June 28-29 summit. Something has to happen soon. Even foreign tourists are failing to do their part. “People used to spend with a lighter heart,” says Andrea Orlandi, the owner of a shop selling artisanal ceramics near Rome’s Trevi Fountain. Now, he says, some will pick up a €5 item, consider it, then put it back. “There are dead months,” he says. “You’re grateful if you’ve covered your expenses.”
The bottom line: With government debt at 120 percent of GDP, Italy is vulnerable to a spike in yields on its sovereign bonds.