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Italian Debt Clouds over Europe

Author: Christopher Alessi
Updated: November 10, 2011

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Italian Prime Minister Silvio Berlusconi has agreed to resign (LAT) after parliament passes new budgetary measures for 2012 meant to tackle Italy's mounting public debt. Berlusconi's decision came after he lost his parliamentary majority and a critical coalition ally called on him to step down. The looming turnover in Italy came as ten-year government bonds reached a euro-era high (NYT) on Wednesday. Those yields came down a bit on Thursday (Reuters), but concern persists in the markets over Italy's ability to pass needed austerity measures and fend off eurozone sovereign debt contagion.

What's at Stake

The European Financial Stability Facility (EFSF)--set to be leveraged to $1.4 trillion as part of a comprehensive euro rescue plan (BBC) agreed on last month--does not have the means to finance Italy's $2.6 trillion debt. Greece, Ireland, and Portugal all sought financial rescue packages when their respective government bond yields breached 7 percent--a level markets consider unsustainable for a country to borrow money on private markets. Therefore, if Italian leaders are unable to muster the political will to rein in public debt through strict austerity measures, a default could be imminent.

The repercussions of such an event could damage the eurozone's core and devastate Europe's highly exposed financial system. At the end of June, EU banks held just under $344 billion in Italian government bonds. If investors had to take losses on their Italian debt, it could trigger a run on Italian banks (DerSpiegel), creating knock-on effects for the global economy.

The Debate

Italy has been at risk of sovereign debt contagion not just because of its economic troubles, but also because of a dysfunctional political culture. Analysis in the Italian press suggests that with Berlusconi's decision to resign, three different scenarios could play out.

Berlusconi could call for fresh elections next year and stay on until then, the option least convincing to markets but the most probable. Secondly, he could allow for the formation of a new government, led by one of his center-right allies, which would theoretically be able to muster support from some smaller centrist parties that had refused to support Berlusconi directly. Thirdly, Berlusconi could sanction a more technocratic government--led by a candidate who has support from the center-left--that would have a mandate to pass the strict budgetary measures.

The latter is favored by market actors. The prime minister's immediate resignation and formation of a technocratic government would lead to a "favorable reassessment of Italy in the minds of international investors," Nicholas Spiro, head of Spiro Sovereign Strategy, told Reuters.

Policy Options

While Italian public debt is a staggering 120 percent of GDP, the economy is strong in other ways: It has a relatively low budget deficit--4 percent of GDP--and a high private savings rate. "Italy has the resources to draw on," Domenico Lombardi, director of the Oxford Institute for Economic Policy, told CFR.org. The IMF, the European Central Bank, and an enlarged EFSF could offer Italy bridging assistance by providing access to financing while it addresses its debt problems.

But those organizations are waiting for Italy to make the first move, Lombardi says. The EU and the IMF are holding the Italians' feet to the fire to see if they have the political will to implement pension reform, more flexible labor laws, and restrained government spending.

Background Materials:

"Conditional Resignation Offer," Der Spiegel

"Berlusconi Rules out Reelection," Deutsche Welle

"The Nine Lives of Silvio Berlusconi," Foreign Policy

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