Wobbling Domino What Comes Next for Troubled Italy?

Italy appears to be moving toward political stability with reports that respected banker Mario Monti may become the country's next prime minister. But can he succeed in reversing years of political stagnation? If he doesn't, Rome's problems could spell the end of the European currency union.
Italy now holds the keys to the euro crisis.

Italy now holds the keys to the euro crisis.


It was Wednesday, the day after the political fate of Italian Prime Minister Silvio Berlusconi appeared to have been sealed, and people were astonished -- and deeply concerned. Many had felt that the financial markets would cheer the approaching departure of the Italian premier. But they were sadly mistaken.  Instead of declining, the interest rates Italy must pay for new sovereign bonds rose sharply on the day after Berlusconi announced he would soon resign . Yields on 10-year bonds were intermittently as high as 7.45 percent. Portugal and Ireland turned to the bailout fund for assistance when their bonds reached that level in 2010.

Even after the announced departure of Il Cavaliere , Italy -- it became clear this week -- remains the biggest threat to the euro zone. The question of whether the currency area will survive hinges on the country, the euro zone's third-largest economy. Italy's debts exceed €1.9 trillion ($2.58 trillion), which is 120 percent of the country's annual economic output. Only in Greece is the debt-to-GDP ratio higher.

Short-term spikes in bond interest rates, of course, are not a huge problem. But should investors continue to demand record returns, the Italian budget will face tremendous burdens. Next year alone, Italy will have to refinance €300 billion in maturing bonds. Furthermore, the Italian economy is also sluggish and expected to grow by only 0.5 percent this year. By comparison, the German economy is expected to end 2011 with 3 percent growth.

Crucial for Survival

Politically, at least, Italy appeared to be working toward a solution on Thursday. Many of the Wednesday market jitters came about due to a lack of faith that Berlusconi would indeed swiftly depart  as promised. But throughout Thursday, support grew for respected economist Mario Monti to lead an interim government. Italian President Giorgio Napolitano nominated Monti, a former European competition commissioner, as senator for life on Wednesday and said that far-reaching economic reforms could be passed as early as this weekend. Both moves appeared to pave the way for Monti to step into the premiership sooner rather than later -- a prospect that sent interest rates on Italian bonds plummeting on Thursday.

Still, even if Monti's arrival cheers the markets -- and eliminates the need for new elections, which many feared would delay reforms even further -- Italy's economic and debt problems remain real. Rome's progress toward solving those problems is crucial for the survival of the European common currency.

So what happens next? There are three possible scenarios.

Scenario One: Italy Recovers on Its Own

Monti is able to quickly gain the backing of a broad range of political parties in Rome and creates a stable national unity government made up of economic experts. He forcefully implements the austerity goals promised -- but not delivered -- by Berlusconi, including raising the retirement age to 67, privatizing government-owned businesses and pushing through significant cutbacks in the public sector. In addition -- and of equal significance -- credibility would be restored to the Italian government.

The above scenario would allow Italy to quickly regain the confidence of the financial markets, the rates on new debt would continue to retreat to a tolerable level, and the acute danger would be averted.

At least Italy's fundamentals are encouraging. The economy is highly developed and diversified, the budget deficit is relatively small and the banks are healthy. "The commotion in the markets is greatly exaggerated," says Jens Boysen-Hogrefe of the Kiel Institute for the World Economy.

Besides, says Jürgen Matthes of the Cologne Institute for Economic Research (IW), "in recent years, Italy has learned to cope with high debts and low growth rates."

In 1995, Italy had a debt-to-GDP ratio of 121.5 percent, higher even than it is today. By 2007, it had reduced its mountain of debt to 104 percent of GDP, even though the economy only grew at a snail's pace. "Italy's budget is geared toward weak growth," says Boysen-Hogrefe.

The European Commission anticipates a budget deficit of 2.4 percent for next year. "Without the consequences of the 2008/2009 recession, Italy would even have reduced its debt load, as it did in the years prior," says Boysen-Hogrefe. When adjusted for interest, the government even has a budget surplus. Italy has promised a balanced budget for 2013, which would mean that at least its mountain of debt would not continue to grow.

Scenario Two: Italy Muddles Through

The hopes that everything will improve are based primarily on Berlusconi's departure. But what happens if the new government does not meet expectations? In light of the weak growth of the last 15 years and the country's fossilized political structures, it is conceivable that Italy will still need several more years to solve its problems.

In that case, the country could be reliant on its partners in the euro zone and on the International Monetary Fund (IMF). Indeed, the IMF reportedly offered Berlusconi a modest credit line worth €50 billion at the G-20 summit in Cannes, France, last week. Such short-term aid could remove Italy from the financial markets' line of fire for a few months. That, in turn, would enable the country to avoid punitive interest rates on its bonds, should investors remain wary.

Berlusconi initially turned down the offer in Cannes. But if bond yields remain at or near 7 percent -- instead of the 4 percent they commanded last year -- Italy could be tempted to accept the aid. It is, however, unclear whether such a loan would reassure investors, or whether it could even heighten mistrust. Many experts, in any case, are skeptical about this solution. "Interim financing can only work if the markets are convinced that, within a few months, Italy can refinance itself independently in the long term," says Boysen-Hogrefe.

Either way, persistently high bond yields would cause significant problems for Italy. The European Commission has warned that the rate rise jeopardizes the country's growth prospects because a loss of investor confidence doesn't just affect the government, but also companies. For them, it becomes increasingly difficult to borrow new money. In the worst case, this could lead to a credit crunch. Weak growth could quickly turn into a recession.

The risks would also increase in the euro zone in such a scenario, and the possibility of Spain, Belgium and even France becoming infected would grow. Italy could also see itself needing additional loans from its euro-zone partners, which would require German taxpayers to provide guarantees.

Scenario Three: Italy Goes Under

Should Italy prove unable to convince markets of its fundamental economic health and follow the route that Greece has, it would most likely spell the end of the currency union. And the danger certainly exists. The €440 billion European Financial Stability Facility (EFSF) -- even now that it has been enlarged -- is simply not big enough to prop up Italy. At the moment, the EFSF has €250 billion available, with around €200 billion already committed elsewhere.

Even if the EFSF is leveraged to €1 trillion, as euro-zone leaders agreed to pursue at the end of October, financing Italy would be virtually impossible. In the worst cast, the country would face an uncontrolled bankruptcy, with catastrophic consequences for the financial system and the global economy.

"The international financial system would collapse," warns Jürgen Matthes of the Cologne Institute for Economic Research. A series of other countries could be threatened by bankruptcy, with Spain, Belgium and possibly even France being the next likely candidates.

Banks throughout Europe would be on the verge of collapse, and even German lenders could only be saved through extreme intervention -- by the European Central Bank or the German government. But then yields on German government bonds could also increase drastically.

The third scenario would also be devastating for the global economy. In fact, says Boysen-Hogrefe, the consequences would probably be even worse than those of the 2008 Lehman Brothers bankruptcy.

The only good thing about his worst-case scenario is that all players are aware of the disastrous consequences were it to become reality. Despite all speculation over what happens next for Italy, it seems clear that euro-zone leaders will do everything in their power to stabilize the country.

Translated from the German by Christopher Sultan
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