When Italy's president Giorgio Napolitano called on Mario Monti to form a government in November 2011 the country was on the brink of a financial and economic collapse that threatened its position in the eurozone, and, because of its size (too big to bail out) the eurozone itself. Mr Napolitano skillfully managed that political crisis, which put an end to the right-of-centre coalition government led by Silvio Berlusconi, and since his appointment Mr Monti and his government of technocrats have steadily carried out a wide-ranging programme of reforms aimed at improving Italy's public finances and competitiveness to try to boost its dire economic growth prospects.
With no little help from the provision by the European Central Bank (ECB) of cheap loans to the European banking system, Mr Monti's reforms helped to reduce the pressure on Italian government bond yields. On the secondary market benchmark ten-year bond yields fell from the unsustainable levels of 7-7.5% that were reached briefly in late 2011/early 2012 to 4.8% in mid-March. However, uncertainty about Greece's survival in the euro area, the spill over of the banking crisis to the sovereign in Spain and signs of renewed political instability in Italy have driven yields up again to around 6% since the end of May.
At these levels every debt auction has become a test of government credibility and investor confidence. In Italy, as in Spain, the sovereign has had to rely almost exclusively on local banks to buy debt, using mainly the cheap liquidity that was provided by the ECB. The suspension since March of the ECB's Securities Market Programme (SMP), under which the ECB bought the government bonds of financially distressed eurozone countries on the secondary market, combined with the lack of foreign interest has meant that demand remains weak and interest rates high. Moreover, there is growing concern that this trend is reinforcing a dangerous loop between the banking sector and the sovereign, which could destabilise both. On this front there was a rare piece of positive news on July 17th when the Italian Treasury announced that foreign investors had bought 54% of a three-year government bond issue held a few days earlier.
It remains to be seen whether this will be repeated in forthcoming auctions, but it seems unlikely if the determining factor is investor confidence. Mr Monti and his government will probably survive until the next general election, which is due in April 2013. This should ensure implementation of most of Mr Monti's reform programme. However, with elections on the horizon, it has become increasingly difficult to pass legislation, exposing the shortcomings of a technocratic government. Moreover, the likelihood is that from the next election a broad, fractious coalition government will emerge. Even assuming it will not reverse the Monti government's reforms, there is a considerable risk that this may not be sufficient to maintain investor confidence in Italy's ability to meet its financing needs.
In addition to Italy's weak public finances and its structural economic deficiencies, investor confidence will also be affected by developments in other distressed euro area countries, especially Spain and Greece, and by the financial markets' perception of the effectiveness of euro area policymakers' efforts to put in place institutional and financial frameworks to prevent the break-up of the single currency area. If the situation in the eurozone deteriorates further as the Italian general election gets nearer, there is a high risk of severe financial market turmoil that could push Italy back to that brink of financial and economic collapse where it found itself last November.