Italy sucked into the crisis one way or another

Italy has quickly been drawn into the euro crisis over the past few days as prime minister Silvio Berlusconi and minister of finance Giulio Tremonti have openly fought over the austerity package put before parliament. Ten year Italian government bond spreads over the comparable German bunds hit a record high of 236 basis points last Friday and the FTSE MIB index fell sharply. The eurogroup has decided to hold an emergency meeting this morning to discuss, among other things, recent developments in Italy. Is this just short-lived market panic, or could Italy really be in trouble?

Italy has so far remained decoupled from the other PIGS for a number of reasons. It has chronically high public debt levels and chronically slow growth, but Italy’s budget deficit has remained low, its banking sector has been reasonably healthy and its private sector has relatively low indebtedness (122% of GDP in 2010, compared with 210% of GDP in Spain, 194% of GDP in Portugal, 217% of GDP in Ireland and 116% of GDP in Greece).

A liquidity problem can quickly become a solvency issue at the whim of the markets, however. For Italy, the risk is not just that investors might shun Italian debt. It would also be detrimental for Italy if investors were to decide to shun Spanish debt.

Back in mid-January, Eurostat announced that the funds raised under the European Financial Stability Facility (EFSF) must be accounted for on member states’ balance sheets. As a result, as money is raised under the EFSF, euro area countries’ gross public debt will rise according to the proportion they are required to contribute to the lending facility. Most of the burden will fall to Germany, followed by France, Italy and Spain.

If Spain were to request access to the EFSF and max out the fund’s lending, the burden on Italy’s public finances would be significant. I assume that any countries with access to lending facilities will “step out” of their commitment to guarantee the EFSF and that the contributions of the remaining countries will maintain the same relative proportions. If the EFSF is used to bail out Ireland, Portugal, Greece and Spain, Italy’s debt stock would rise by €96.3bn. Italy already has extremely high debt levels and low growth prospects over the next few years. This additional burden would increase Italy’s public debt stock by around ten percentage points of GDP by 2013.

Concerned about Italy’s debt sustainability, markets would be likely to demand ever higher yields to buy Italian government debt. If Italy were to need a bailout, the core countries would not be able to cobble together enough funding to make a material difference for such a large economy. Italy is “too large to bail”, and it could mark the beginning of the end of the eurozone if Italy is dragged into the centre of this crisis.