Soaring borrowing costs push Italy to the edge

Borrowing costs in Italy rose above 7 percent, pushing Italy to the edge. Investors are concerned that they would not get their money back at borrowing costs this high. This comes after the news of Italian Prime Minister Silvio Berlusconi's promise to resign. staff
Posted: Wednesday , 09 Nov 2011

Italian borrowing costs reached a breaking point on Wednesday after Prime Minister Silvio Berlusconi's promise to resign failed to raise optimism about the country's ability to deliver on long-promised economic reforms.

Italian 10-year bond yields shot above the 7 percent level that is widely deemed unsustainable, reflecting investors' concerns that they may not get their money back, prompting German Chancellor Angela Merkel to issue a call to arms.

Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.

Portugal and Ireland were forced to seek EU-IMF bailouts when their borrowing costs reached similar levels and clearing house LCH.Clearnet sounded another alarm by increasing the margin it demands on debt from the euro zone's third largest economy, effectively raising the cost of holding Italian bonds.

Stocks in Europe and the U.S. tumbled amid worries about the growing debt crisis. Mohamed El-Erian, well-respected co-chief investment officer of top bond manager PIMCO, said Italy's debt problems signaled "a new, even more dangerous phase in Europe's debt crisis."

The European Central Bank can act as a circuit breaker but can only be effective if its actions are supported by a host of other measures, El-Erian, who helps oversee more than $1.2 trillion at PIMCO, home to the world's largest bond fund, told Reuters.

The European Central Bank, the only effective bulwark against market attacks, wasted no time intervening to buy Italian bonds in large amounts.

"The ECB is buying aggressively," one trader said.

Italy has replaced Greece at the center of the euro zone debt crisis and is on the cusp of requiring a bailout that Europe cannot afford to give. Unlike Greece, an Italian default would threaten the entire euro project.

Having lost his majority in a key parliamentary vote, Berlusconi confirmed he would resign after implementing urgent economic reforms demanded by the European Union, and said Italy must then hold an election in which he would not stand.

He opposed any form of transitional or unity government -- which the opposition and many in the markets favor -- and said polls were not likely until February, leaving a three-month policy vacuum in which markets could create havoc.

Later Wednesday, Italian President Giorgio Napolitano tried to reassure markets that Berlusconi would indeed step down amid concerns among investors that Berlusconi was trying to buy more time to keep his job. Napolitano said Italy will either have a new government or early elections soon.

Even with the exit of a man who came to symbolize scandal and empty promises, it will not be easy for Italy to convince markets it can cut its huge debt, liberalize the labor market, attack tax evasion and boost productivity.

"There is no guarantee (Berlusconi's) successor will be able to do a better job. Just keep your eyes on the Italian yield for now," Christian Jimenez, fund manager and president of Diamant Bleu Gestion, said.

While Italian bonds blew out, worries that the debt crisis could be infiltrating the core of the euro zone were reflected in the spread of 10-year French government bonds over their German equivalent blowing out to a euro era high around 140 basis points.

Policymakers outside the euro area kept up pressure for more decisive action to stop the crisis spreading.

Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade.

"Our sense is that if we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand ... we could run the risk of what some commentators are already calling the lost decade."

Berlusconi has reluctantly conceded that the IMF can oversee Italian reform efforts.

Euro zone finance ministers agreed on Monday on a roadmap for leveraging the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.

But there are doubts about the efficacy of those complex plans, and with Italy's debt totaling around 1.9 trillion euros even a larger bailout fund could struggle to cope.

Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.

Euro zone officials said they had no plans for a financial rescue of Italy. "Financial assistance is not in the cards," one euro zone official said, adding the euro zone was not even considering extending a precautionary credit line to Rome.

The euro zone bailout fund, the European Financial Stability Facility (EFSF) will be able to extend such a precautionary credit line to countries which may be cut off from markets, once euro zone finance ministers agree on technical and legal details of the operation by the end of November.

The EFSF will also then be able to buy bonds on the primary and secondary markets, using various insurance schemes that would boost four to five-fold its currently free funds of around 250 billion euros.

But the size of the potential bailout for Italy, which needs to repay 326 billion euros in maturing debt only in the next 12 months, is too big to handle for the EFSF.

It would be up to Italy to reassure investors it would pay back what it borrowed, the official said.

"They will just have to prove that the yields are not justified, because they aren't," the official said.

Many outside Europe are calling on the ECB to take a more active role as other major central banks do in acting as lender of last resort. German opposition to that remains implacable, seeing it as a threat to the central bank's independence.

German central bank chief Jens Weidmann, a key member of the ECB, rejected a separate proposal to use national gold and currency reserves or IMF special drawing rights to boost the bailout fund, welcoming opposition from Merkel to the same.

But with the ECB just about the only buyer of Italian bonds, according to traders, it will have to act more aggressively to contain the latest wave of crisis, despite internal opposition to its bond-buying program.

It could call on limitless power if it began printing money as the Federal Reserve and Bank of England have. But for it, and Berlin, that is a step too far.

With the markets' fire turned firmly on Italy, Greece's struggle to find a new prime minister became something of a sideshow, but one which demonstrated the difficulty in taking decisive action anywhere within the euro zone.

Greek political leaders scrambled to agree on a new premier to lead the country back from the brink of bankruptcy, after a plan to name a former ECB official appeared to fall apart.

The aim is to establish a "100-day" government to push a 130 billion euro bailout plan, including a "voluntary" 50 percent writedown on Greece's debt to private sector bondholders, through parliament by February.

The socialist and conservative parties had wanted former ECB vice-president Lucas Papademos to lead a government of national unity but he appears to have made demands about his level of influence which they could not swallow.

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