Italian balancing act on the high wire

As fears intensify conerning the European stress tests on Italian banks, Italy is no longer just a minor contagion risk

If Greece were a newspaper, Rupert Murdoch would have shut it down by now to protect the rest of his business. Then he’d probably turn his attention to Portugal, Ireland and Spain as well.

Until last week, Italy would have been regarded as a minor contagion risk, but that all changed last Friday (July 8) when Italian government bond yields shot up, on fears that Italian banks would fail the European stress tests.

By Monday, the yield on Italian 10-year bonds had risen to 5.4%, not that far behind Spanish bond yields of 5.80%, and closing in on the 7% rate that is generally regarded as unsustainable.

While bond yields headed up, Italian share prices took a dive, led by banks. The Italian financial market regulator (Consob) responded by ordering short sellers to reveal the extent of their short positions when they account for more than 0.2% of a company’s issued share capital.

This sort of restriction was last imposed at the height of the credit crunch. It may make the markets less volatile but it won’t alter the direction of travel, and that direction is currently in a southerly direction.

All of which is very worrying, not just for Italy, but for the European Union (EU) as a whole. It is generally accepted that the EU cannot afford to bail-out Italy, but as far back as the 1990s, Italy has been regarded as a country likely to break the back of the single currency experiment, because it is a high debt, low growth country.

Gross public sector debt in 2010 was higher than annual gross domestic product (GDP), another warning sign for economists. Meanwhile, the economy poodles along, growing at less than 1% per annum, putting the Italian government in a quandary: it needs to raise more in tax revenues while not endangering a fragile economic recovery. Cutting government costs is taken as read, and devaluing the currency is not an option, which is a shame for Italy as the Italian economy is an export driven one.

Much is riding on the fiscal plan presented by the Italian government last week. Mario Draghi, Governor of the Bank of Italy, said: “The fiscal package is an important step towards fiscal consolidation. Anticipating the implementation of fiscal measures makes credible the target of balancing the budget deficit by 2014 and of reducing public debt (as a percentage of GDP)".

Natacha Valla, the Goldman Sachs economist, also strikes an optimistic note. “We expect the primary balance to turn into a surplus from 2011 onwards, which should help to stabilise the debt to around 120% of GDP over the next two years. Having said that, determined action to implement growth-enhancing reforms and further fiscal consolidation to reduce the structurally high expenditure components is essential”.

It is a piece of advice that could apply to several European countries, not just Italy.