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Italy after Berlusconi will still have a debt crisis

Silvio Berlusconi’s departure is seen as long overdue if the country wants to show it is serious about fixing its fiscal woes and corralling its soaring debt.

Charles Platiau/Reuters/Charles Platiau/Reuters

Markets may be cheering the promised resignation of Silvio Berlusconi, but Italy's flamboyant Prime Minister has left his successor with the herculean task of saving Rome from its debt crisis in the midst of a severe economic slowdown.

Mr. Berlusconi's departure is seen as long overdue if the country wants to show it is serious about fixing its fiscal woes and corralling its soaring debt. And he is expected to be replaced with someone who has more credibility both at home and abroad.

But the new leader will have to work furiously to rebuild the shaken confidence of the markets. This will mean rebuilding political bridges and winning broad public support for tougher austerity measures – a tall order even if the economy were not hurtling toward recession.

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Mr. Berlusconi's decision to resign removes the last leader of the heavily indebted euro zone countries known as the PIIGS who held power when the European sovereign debt crisis exploded last year. Greek Prime Minister George Papandreou is also on his way out and the leaders of Portugal, Ireland and Spain have been replaced by their parties or the electorate.

None of the other departures did much to boost their countries' fortunes or improve market perceptions of their battered creditworthiness. And Italy is likely to be in the same boat, despite the initial positive reaction to the end of the embattled Mr. Berlusconi's tenure.

Some analysts argue that handing over the reins to someone with better skills at forging public and political consensus for reforms could translate into more receptive markets for Italian government and corporate financings.

"Leadership really matters," said Daniel Schwanen, vice-president of trade and international policy at the C.D. Howe Institute. "If you have a consensus builder versus a divisive figure, it's a good thing."

A change of leadership would help Italy to regain the support of other governments that question its political resolve, Mr. Schwanen said.

But others say Italy's problems are too deep-seated to be solved merely by a change at the top.

"The hope will be that Italy can quickly gain a new government with the stomach and the ability to implement major structural reforms. But this alone will not solve Italy's woes," Ben May, European economist with Capital Economics in London, said in a note.

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"The recent run of weak economic data suggest that Italy will soon fall back into recession: We expect the economy to contract by 1.3 per cent or so next year and about 2 per cent in 2013. Against this backdrop, the government will struggle to balance its budget by 2013," Mr. May wrote.

"We focus far too much on individual personalities," remarked Errol Mendes, a law professor and international business law expert at the University of Ottawa.

The fundamental problem is that Europe's sovereign debt problems far exceed the measures so far proposed for the euro zone, Prof. Mendes said. Italy's €1.8-trillion ($2.5-trillion) debt alone dwarfs Europe's proposed €1-trillion bailout fund for the 17-member euro area. And financial derivatives linked to sovereign bonds could exacerbate potential contagion.

"Greece is just a minor problem compared to what could happen to Italy," Prof. Mendes said. "Is Berlusconi relevant? No, he's just a diversion."

Still, the market is taking his departure "as a generally positive sign," said Mark Chandler, head of Canadian fixed income and currency strategy at RBC Dominion Securities. "The most positive would be if they ended up getting a strong consensus [on reform]"

Meanwhile, any positive reaction in the bond market is bound to be muted, particularly if members of Mr. Berlusconi's inner circle remain in positions of influence. And bond yields, which have already spiked to record euro-era levels in Italy and the smaller peripheral euro members, could rise even more sharply in coming days and weeks.

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Italian yields, which hit 6.77 per cent on Tuesday, "are headed toward 10 per cent, with or without Berlusconi," said Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y.

Investors will be demanding the higher premiums, in the wake of a ruling by the International Swaps and Derivatives Association that so-called voluntary haircuts of 50 per cent on Greek debt held by European banks do not constitute an actual default. That means credit default swaps purchased as insurance for the bonds will not be triggered. As a result, holders of Italian and other troubled euro-zone debt will seek wider yields to replace the swaps hedges that could end up being worthless.

Europe's woes go way beyond Italy and Mr. Berlusconi, said Carleton University business professor Ian Lee. To become competitive, Italy, Greece, Spain and Portugal must all radically restructure their economies by selling off government-owned businesses, increasing labour mobility and allowing more foreign competition.

As the rest of the world grapples with the European crisis, key financial leaders may meet earlier than expected. The G20 finance ministers are scheduled to meet in Mexico in February.

"France is the chair of the G20 now until the end of the year, and the French may decide to have us meet again," Finance Minister Jim Flaherty said Tuesday.

The chief issue, he said, resides in determining "the exact size of the European facility and how it will be used in order to construct a firewall that will protect the rest of the European countries."

The concern, he added, is global "contagion arising out of the sovereign debt situation in certain countries and the consequences of that on the banking system in Europe."

With files from reporter Nathan VanderKlippe in Calgary.

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