Italy saw its cost of borrowing fall by half in a bond auction on Wednesday, as a combination of cheap liquidity from the European Central Bank (ECB) and a new austerity package give investors some hope that the country may be able to pay off its enormous debts.
The country sold €9bn (£7.5bn) of six-month bonds at yields of 3.25%, half of the 6.50% it paid last month on similar debt maturities. The auction was covered around 1.7 times over.
The cost of servicing its debt has pushed Italy close to the edge of solvency in recent months, with its 10-year bond yields rising above 7% in the autumn, as collapsing confidence in the government of Silvio Berlusconi saw investors begin to price in the possibility that the country would need to have its debt restructured.
Berlusconi's position finally became untenable, and in November 'Il Cavaliere' resigned, handing over to a technocratic government, headed by Mario Monti, a former European commissioner.
Monti finally managed to push through a set of severe austerity measures last week, achieving what his predecessor had failed to do - reassure the markets to some degree that Italy was taking its deficit reduction plans seriously.
Italy's debt stands at around 120% of its gross domestic product (GDP).
Before Christmas, the ECB released an unlimited programme of cheap three-year loans to the banking sector, with the aim of freeing up capital for investment - possibly into European sovereign debt. Some saw the initiative as "back door" quantitative easing, using the central bank's resources to indirectly support the bonds of Italy and Spain and keep those countries' costs of borrowing in check.
More than 500 banks took advantage of the scheme, borrowing nearly €490bn at concessionary rates of 1%.
However, the ECB saw more than €400bn in deposits over the Christmas holidays, a record amount which could indicate that, despite a large injection of cheap liquidity into the system last week, banks are still unwilling to risk lending to each other.
While Wednesday's auction is encouraging, the true test may be on Thursday, when Italy tries to sell another €8.5bn in longer-dated debt. The results of that will show the extent to which investors believe that the country will, in the long term, remain solvent and stable, and will indicate whether markets begin 2012 in the same crisis mode that they operated in for most of 2011. If Italy's cost of borrowing remains high, it will serve as a reminder that the euro remains in danger.
"Given that member states cannot continue to secure their unprecedented funding requirements at punitive rates in an economic downturn, 2012 is surely the year when the Euro-zone’s Franco-German leadership decide whether or not to save the euro," BNY Mellon strategist Neil Mellor said on Wednesday. "They must decide whether they should fully commit to the project and embrace all that this will entail for moral hazard, treaty obligations and domestic political popularity, or allow the project to fail with potentially catastrophic consequences."
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