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Too-Big-To-Save: Italy Totters on Debt Crisis Cliff

With its 10-year bond yields nearing 7%, Italy's debt is becoming a burden it will no longer be able to handle as it follows the same path as Portugal, Ireland and Greece.

However, Italy's economy – seven times larger than Greece's, nine times larger than Portugal's and 10 times larger than Ireland's – is too big for the Eurozone to rescue.

And because Italy's economy is so large – the third-largest in the Eurozone and the eighth-largest in the world – a default on its sovereign debt would be that much more calamitous.

Yesterday (Tuesday), yields on Italy's 10-year bonds hit 6.77%, a record for Italy in the era of the European Union (EU).

"Now we are really reaching very dangerous levels…We are above yield levels in the 10-year where Portugal and Greece andIrelandissued their last bonds," Alessandro Giansanti, a rate strategist at ING Groep N.V. (NYSE ADR: ING), told Reuters.

The spike in yields reflects rising investor concern that besieged Prime Minister Silvio Berlusconi doesn't have the political muscle to push through the tough budget measures Italy needs, such as pension cuts, to get its debt issues under control.

Those fears were further stoked yesterday when Berlusconi was unable to win a majority on a routine vote on a budget report, but eased when Berlusconi agreed to resign. Yields dipped slightly on Monday in response to rumors that Berlusconi might step down.

"The market's bias is fairly clear. The question is; what comes afterward, assuming he falls?"Peter Schaffrik, head of European rates strategy atRBC Capital Marketsin London, told Bloomberg News.


If Italy's bond yields don't fall significantly, it won't matter who's running the country. The high yields are making Italy's ability to cope with its debt increasingly infeasible.

At 120% of gross domestic product (GDP), Italy's debt load is second only to Greece's among Eurozone nations. Its total debt of $2.7 trillion is the eighth-highest in the world.

As bond yields go up, the cost of rolling over this massive amount of debt increases as well, and is nearing unsustainable levels.

Italy needs to auction $41.5 billion (30 billion euros) of debt less than a week from now, Nov. 14, and another $31.13 billion (22.5 billion euros) in December. Next year Italy will need to borrow $415 billion (300 billion euros).

One advantage Italy has over most of the other Eurozone debt crisis nations is that it is running a "primary budget surplus," which means that if you subtract its debt service costs, it has a surplus.

But even Italy can't keep paying rates at 7% or beyond. Such high rates would eventually take a toll on Italy's economic growth, which would start to enlarge the budget deficit. And Daiwa Securities estimates that the surge past 6% is already costing Italy an extra $4.15 billion (3 billion euros) in annual interest payments.

Many analysts fear that reaching the 7% level on its bonds will trigger a quick move even higher, to 8% or 9%, as happened with the bonds of Greece, Ireland and Portugal.

Such quick spikes can be triggered by increases in margin requirements by middlemen called central clearinghouses in reaction to the increased levels of risk. But higher margin requirements make the bonds even more expensive, creating a negative feedback loop.

One major factor the clearing houses take into account when adjusting margin requirements is the credit default swap market; the cost of insuring Italian debt is 3.5 times higher now than it was in June.

Buyers of Last Resort

In an attempt to rein in the yields on Italy's bonds, the European Central Bank (ECB) has been buying them in large amounts, but the strategy has met with limited success. And even the ECB has expressed doubts about continuing the policy, particularly in light of Italy's political turmoil.

"Knowing that the ECB – just about the only major buyer of Italian public debt – regularly discusses whether they should go on doing so, does nothing for confidence," Kit Juckes, head of foreign exchange at Societe Generale SA (NYSE ADR: SCGLY), told MarketWatch. "It is impossible to see what can be done to restore confidence in [Italy] other than rebuild confidence in Italian public finances, and that is a Herculean task."

The EC may have no choice, however, as a bailout is beyond even the means of the freshly raised levels of the European Financial Stability Facility (EFSF), which voted last month to increase its bailout fund from $609 billion (440 billion euros) euros to $1.4 trillion (1 trillion euros).

"Eurozone policy makers have yet to announce a policy bazooka," Jens Nordvig, an economist at Nomura Holdings Inc. (NYSE ADR: NMR), said in a research note. Nordvig said the structure of the EFSF fund, which involves borrowing much of the additional money, "is insufficient to provide a credible backstop."

Italy needs two things to happen to avoid disaster: An ECB willing to buy as many bonds as necessary to keep yields under control, and political leadership that can muster the will to take the very difficult steps to put Italy on a path to fiscal health. Neither is a sure bet, much less both.

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  1. fallingman | November 9, 2011

    Well done article.

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