Italy’s bond rates hit the danger zone as Europe’s debt-crisis fears deepen

Italy’s financial condition hit red-alert levels Wednesday, touching off some of the same dynamics that caused Greece, Ireland and Portugal to seek international bailouts in recent months and driving down global stock markets alarmed about the possible fallout.

The interest rate that Italy must pay to borrow money — a measure of the country’s viability — spiked to more than 7 percent for longer-term bonds. This jump seemed to confirm the worst fears of European officials: that after months of trying to contain the euro region’s debt crisis to a handful of smaller economies, the financial contagion had spread to a major country whose $2.6 trillion in outstanding debt would make it extremely difficult to bail out.

The prospect that the euro zone — the world’s second-largest economic area when the 17 member nations are taken together — could be stretched to the breaking point pushed down major U.S. measures. The Dow Jones industrial average lost 389.24 points, or 3.2 percent, and the broader Standard & Poor’s 500-stock index fell 46.82 points, or 3.7 percent.

World markets rallied late last month after European leaders agreed on an emergency plan to increase the firepower of their bailout fund, shore up the continent’s ailing banks and muster new help for cash-strapped Greece. But since then, developments in Greece, Italy and elsewhere have buffeted those plans and markets have swung wildly.

In Rome, political leaders scrambled Wednesday to accelerate economic changes and budget-cutting plans they hope will ease the pressure building in world bond markets and convince investors that the heavily indebted country can be kept on track. An International Monetary Fund monitoring team is scheduled to arrive this week to oversee Italy’s progress.

The effort involves more than policy changes. Approval of the austerity measures by the Italian Parliament is to be followed by the departure of Prime Minister Silvio Berlusconi, who has lost the confidence of other European leaders, the European Central Bank and world investors.

Berlusconi’s ouster and possible replacement by Mario Monti, a former member of the European Commission, may cure the “political risk” that has turned investors against Italy. But analysts doubt that the change would be enough on its own to stabilize the country — at a time when Europe seems headed for a new recession that would make it even harder for governments to control public debt levels.

Slowing European growth has already begun to hurt the earnings of U.S., Asian and other companies that do business on the continent. On Wednesday, General Motors reported that its third-quarter net income fell 15 percent, dragged down in large part by the economic troubles in Europe.

A financial meltdown in Italy would create problems of even greater magnitude, undercutting global growth and probably pulling down French and potentially German banks that have invested hundreds of billions of dollars in Italy. U.S. banks held about $12.8 billion in Italian bonds as of the end of June and had another $19 billion invested in Italian banks.

Danger signals

To analysts who have watched Europe’s sequential crises develop, the danger signs have become unmistakable, including Italian banks being forced to rely ever more heavily on loans from the European Central Bank to stay in business. On Wednesday, the agencies that serve as the clearinghouse for European bond deals effectively cut the value of Italian government bonds because their interest rates have gotten so far out of line from those of AAA-rated German and French securities used as a benchmark.

The move makes Italian bonds worth less to banks, pension funds and other large institutional investors and may prompt them to sell their holdings. In the case of Ireland and Portugal, a similar change by the LCH Clearnet group and other clearinghouse agencies helped touch off a “death spiral” — a steady sell-off in bonds by large investors that pushed up interest rates and left the countries unable to borrow at a cost their economies could sustain.

“History is not very kind on this,” said David Bowers, managing director at Absolute Strategy Research, a London-based consulting group. “It usually creates more momentum [to sell]. . . . The worry is that this is just the beginning.”

The jump in rates will not have an immediate effect on Italy’s finances. It came as a result of trades on what is known as the secondary market, where investors buy and sell bonds they purchased from a country perhaps years ago. In those trades, the interest rate agreed to by the country when the bond was sold remains unchanged, as do the country’s regular interest payments. Rather, buyers demand a discount or pay a premium on the face value of the bond that reflects a sort of updated interest rate given the country’s current circumstances.

That serves as a powerful signal of where rates are heading when the country sells new bonds. In Italy’s case, that could make a potentially profound difference next year when it must refinance about $300 billion of its outstanding debts. If its borrowing costs do not decline again as those bonds come due — with a heavy round of redemptions scheduled in February and March in particular — analysts say the risk of a collapse will rise.

Italy’s debt is among the largest in the world, far greater than that of other European countries touched by the crisis. Since June, the interest rate on Italian bonds has jumped nearly three percentage points. By comparison, if the interest rate on U.S. Treasury bonds increased by the same amount, the U.S. government would have to pay nearly 5 percent, an onerous rate, to finance the country’s massive debt.

Italy, however, remains a large industrial economy with immense amounts of untapped household wealth and an annual budget deficit that is small by European standards.

‘Self-fulfilling prophecy’

“Italy is solvent,” said Sony Kapoor, managing director of Re-Define, a Europe-based economics think tank. “But solvency is always conditioned on reasonable borrowing costs, and since August they have been caught up in this self-fulfilling prophecy” where rising interest rates lead more investors to sell, pushing rates ever higher.

This dynamic threatens to undermine a country that by many measures is in a far stronger position than many in Europe. Italy controlled public spending better during the 2008 economic crisis than other euro-region nations that relied on more aggressive stimulus programs. Its banks were not weakened by a housing bubble. And its government, despite the Berlusconi stigma, has been running what is known as a “primary surplus.” Considered a sign of health by economists who study public debt, it means the government at a basic level is collecting more in taxes than it spends and can over time decrease its total level of outstanding debt.

But since August those fundamentals have been overrun.

Italy’s economy remains among the slowest-growing in the world, and a probable slip into recession next year would reverse the primary surplus and begin pushing debt back up.

Some of Europe’s own policy choices may be making matters worse as well. As they announced their third-quarter earnings this week, European banks such as France’s BNP Paribas said Europe’s new bank regulations — such as a requirement that banks hold higher levels of capital as a cushion against possible losses — were prompting the firms to steadily liquidate their holdings of bonds from Italy and some other countries.

“We have reduced the exposure on an opportunistic basis, and we will keep doing so,” Philippe Bordenave, the bank’s chief financial officer, said in a conference call when asked why BNP Parisbas had sold about $10 billion in Italian bonds over the past two months. The sales, he said, would help meet the capital rules Europe is instituting for banks and ease the cash crunch many companies are fighting.

Politics have also made the situation worse. For months now, European officials have continued debating how to get their
new financial-crisis “firefighting” fund, the European Financial Stability Facility, up and running — though it’s already needed.

There’s confusion as well over the role of the European Central Bank in recent events. Since August, the ECB has been intervening in bond markets, buying Italian and Spanish bonds to help keep down their borrowing costs. The spike in Italy’s rates, analysts said, may mean the bank had taken a step back.

That may represent a deliberate choice by new ECB President Mario Draghi, the former governor if Italy’s central bank who may be hesitant to defend his own country too aggressively for fear of losing credibility in his new role.

Or it may have been a signal to Berlusconi that his time was truly up.

Correspondent Anthony Faiola in Rome contributed to this report.

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