Italy, long considered too big to fail, now looms as the Continent’s biggest possible failure. Amid indecision in Brussels over Greece’s woes and squabbling in Prime Minister Silvio Berlusconi’s Cabinet, Italy’s bonds soared to their highest yields since the euro’s introduction, and its stock market hit a two-year low as investors bet that Europe’s biggest debtor will struggle to pay its bills.
With markets jittery over results of European bank stress tests due on July 15, UniCredit, Intesa Sanpaolo, and other Italian banks have seen their shares suffer. On July 12, Milan trading in UniCredit was suspended after the stock plunged 7 percent. UniCredit later pared its losses, and Bank of Italy Governor Mario Draghi—set to take over as president of the European Central Bank in October—said on July 13 that he was “certain” Italian lenders would pass the tests.
While Italy’s €1.8 trillion ($2.6 trillion) debt pile has long made it seem like an easy target for speculators, until this summer the country had sidestepped the worst of Europe’s sovereign debt crisis. Finance Minister Giulio Tremonti helped trim the budget deficit to 4.6 percent of output last year, less than half the gap in Greece, Spain, or Ireland. Prudent lending meant Italy never had real estate bubbles like those that devastated Ireland and Spain, and more than half its bonds are held at home. Those factors seemed enough to shield the country from market turbulence.
Then on May 21, Standard & Poor’s lowered its outlook on Italy to negative from stable, fretting that political gridlock might slow cost-cutting amid chronically weak growth. Ten days later, Berlusconi’s ruling bloc was routed in local elections across Italy, raising the chances his government may fall before its term ends in 2013, jeopardizing economic reforms. His grip on power slipped further on June 14 when voters in a referendum stymied his bid to end a ban on nuclear power and privatize water distribution. Moody’s Investors Service chimed in on June 17, warning that it, too, may cut its credit rating on Italy. “If these market pressures persist, Italy’s financing costs could soon approach unsustainable levels,” says Vladimir Pillonca, an economist at Société Générale in London.
The defeats sparked bickering in the ruling coalition. They also raised fresh criticism of Tremonti, whose fiscal rigor has never been popular and who is blamed by many for choking the euro zone’s third-largest economy. Tensions spiked after Tremonti was captured on video calling a fellow minister “a moron” and Berlusconi told la Repubblica newspaper that Tremonti “isn’t a team player.”
The bond market rout began on July 4, three days after the government approved austerity measures to balance the budget by 2014. Confusion surrounded the plan, which originally promised €47 billion, a figure later trimmed to €40 billion. Investors, worried that most savings measures kick in after 2013, when a new government will likely be in office, sent Italian bond yields soaring. To calm markets, Tremonti on July 12 departed early from a Brussels summit on Greece and rushed to Rome to push Parliament to approve the government’s austerity plan. While deputies indicated they would pass a modified package on July 15 and yields later eased back from record levels, Europe’s debt crisis had already entered a new phase.