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If Italy fails to enact needed reforms, the impact will be catastrophic

Italy's Prime Minister Silvio Berlusconi is interviewed at the end of an euro zone leaders summit in Brussels on Oct. 23, 2011.

SEBASTIEN PIRLET/Reuters/SEBASTIEN PIRLET/Reuters

Like a nervous crowd watching a tightrope walker, Europe's leaders fear that Italy, with its enfeebled government and worsening fiscal and economic plight, will be next in line for financial help. And if that happens, it could be another body blow to the embattled monetary union.

As a result, Italy, not insolvent Greece, has become the focus of attention as European leaders gather in Brussels Wednesday for yet another critical summit on how to resolve the deepening euro-zone debt crisis and cushion their banks from the fallout.

Before signing off on a deal that would more than double a planned European bailout fund to at least €1-trillion, Italy's European Union partners sought assurances that the Berlusconi government would impose tougher austerity measures and enact structural reforms needed to cut its ballooning debt and get its fiscal house in better order. Some already expect Italy will seek help from the newly enlarged fund, known as the European Financial Stability Facility.

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The pressure the Italians "have been put under is clearly very significant," said Jens Larsen, chief European economist with Royal Bank of Canada in London. "I think they will fall in line, as they usually do. In order to be able access any of these [loan]facilities that they're dreaming up, they'll have to meet conditions."

Italy is in little danger of outright financial collapse. Unlike smaller peripheral countries such as Greece, Portugal and Ireland, Italy has a much larger and more sophisticated economy – the fourth-largest in Europe – a stable banking system and low levels of private debt. But its export-driven economy is headed into recession, and its costs of financing its massive public debt are soaring to unmanageable levels amid the fallout from the debt crisis.

Italy's public debt reached 116 per cent of GDP last year, ranking second in the euro zone only to Greece. And this is expected to climb to 120 per cent by next year, double the target set in European Union guidelines.

At the same time, Italy is being priced out of the debt markets by the high premiums demanded by bond investors – part of the fallout from the Greek crisis and its own fiscal mismanagement.

"Markets in the past have been comfortable with Italy having such high public debt levels," said Raj Badiani, a senior economist with IHS Global Insight in London. "But it presents a significant risk for Italy going forward. And Italy is always vulnerable to any large external shocks."

Mr. Badiani joined other Italy watchers in downgrading ratings on the country's bonds last week, which will put further pressure on government finances and those of Italian banks.

If Italy fails to get its costs under control and its economy moving, the risks to the rest of the euro zone dwarf anything stemming from a possible Greek default, analysts warn.

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Even a 10-per-cent writedown on Italian debt would trigger a combined capital shortfall across the entire European Union of more than €213-billion, said Constantin Gurdgiev, a lecturer in finance at Trinity College in Dublin.







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