The collapse of confidence in Italy's economy has created a hazardous situation for the world economy, analysts said on Wednesday, as the Berlusconi government's failure to reassure markets pushed yields on its 10-year government bonds past 7%.
The country could be heading towards needing a bailout that the European Union cannot afford.
Yields passed 7% on Wednesday, and the spread between German and Italian debt widened to 5.5%. The clearing house LCH.Clearnet raised its margin calls on Italian debt - effectively signalling that they believe a default is more likely.
The company took similar action on Portuguese and Irish debt shortly before those countries needed bailouts. Italy, however, is a far bigger economy than Greece, Ireland or Portugal. Italy has €300bn worth of debt to rollover in the near term - more than twice the total size of Greece's second bailout package.
"There is no absolute number cast in stone but having reached this figure [7%], along with changed collateral requirements imposed by [LCH.Clearnet], there is greater risk of investors seeking to reduce positions and avoiding pending auctions. A loss of confidence and imbalance to the markets is in danger of feeding on itself in a rapid downward spiral," Alexia Ash, deputy head of political risk forecasting at Exclusive Analysis said.
There is a growing consensus amongst analysts that the Italian situation has pushed the world economy into a dangerous place, and confidence is very shaky. Investors continued to shed equities during the day, with the FTSE 100 and German Dax down around 2% and the French CAC40 down 2.25%.
The root of the turmoil was Greek Prime Minister George Papandreou's decision on 2 November to hold a referendum on a critical bailout package, which wiped out the gains made in the euphoria of the previous week. The original eurozone agreement, shaken out at 4am on 27 October, saw markets finally start to believe that the main actors in the eurozone would be able to transcend parochialism and come to an agreement that would manage each aspect of the unfolding crisis, from Greece's debt to bank recapitalisation.
Papandreou threw all that into turmoil by saying that he would turn the Greek portion of the deal - including a 50% haircut on Greece's debt and deep austerity measures - over to the electorate. It was an ultimately doomed strategy to try to add some domestic political legitimacy to a package handed down from a supranational body, and, with party members deserting him and the country's international backers threatening ejection from the eurozone, Papandreou abandoned his cause and resigned from his position. The house speaker, Filippos Petsalnikos, was confirmed as interim prime minister on Wednesday.
"What [Papandreou's referendum call] did is focus investors on political credibility," Simon Derrick, chief currency strategist at BNY Mellon said. That, naturally, meant that markets started to look a lot more closely at Silvio Berlusconi's government. What they found did not reassure them.
As Derrick said, there are two things that keep investors from heading for the exit door on Italian bonds. One is that they believe the country will be able to reform adequately to continue to service its debt, the other is that the international system will be able to support it through a bailout until it is able to do so.
There is a very pronounced lack of a safety net. The European Financial Stability Facility (EFSF) was to be given significant extra firepower to deal with much needed bank recapitalisation, through a combination of financial engineering and funding from emerging markets. However, the G20 meeting in Cannes saw no concrete commitments, leaving the facility still enormously underfunded. If Italy does need a bailout, there is probably not enough firepower in Europe to deliver it.
China, in many ways the best hope for the eurozone's capital needs, seems unwilling to become involved. As Nicholas Consonery, Asia analyst at the Eurasia Group, said on Tuesday, the country is facing domestic challenges - including slowing growth and economic imbalances - and would be unlikely to commit without a quid-pro-quo, probably reform of international institutions. The Chinese government does not currently believe that Europe can solve its own problems, he added.
"Put simply, Beijing is unwilling to take on a leadership role in resolving Europe's debt woes. If anything China is still looking for US leadership to lend legitimacy to any meaningful efforts to make Europe solvent--and indeed Beijing would be more likely to participate if the US was leading such an effort. But in the post-financial crisis world, that leadership is not coming. And Beijing is in no mood to supplant it," Consonery said.
The International Monetary Fund is also seeking to put together mechanisms to be in a position to support Italy and other large economies. The UK is among the countries that are in talks to help build a "firewall", but that is not in place yet.
Without that safety net, the only thing holding the Italian markets together is their own government's failing credibility.
"If you'd asked me 48 hours ago, I'd have said Italy would have had the common sense to know they had to win investor confidence over," Derrick said. "I was wrong."
Ash agreed. "Italy needs to find a mechanism that restores market confidence in its debt. If it cannot do so, we are concerned that the EFSF and IMF do not yet have mechanisms in place that could cover the very sizeable needs of Italy for finance to roll over maturing debt service in 2012," she said. "In the absence of renewed confidence and a suitable support mechanism, Italy could then face the need to consider a haircut.
"An Italian haircut would increase the risk of additional countries needing rescue soon after, and would place significant pressure on the global financial system through the very large exposures to affected countries. Italy would be a much more damaging country to undertake haircuts than Greece given its far larger size. A quasi-default in Italy would push Europe towards significant recession, and damage global economic growth, while leaving the European banking system facing the need for heavy recapitalisation."
Italian debt is on the books of many of Europe's major banks, and on those in the US. The very notion of a sovereign default of that scale was unthinkable two years ago, but just the marginal possibility has caused considerable disquiet. Insurance companies and pension funds are big holders, and were the country to undergo a haircut or partial default, the losses would cascade across the financial sector.
The timing is now critical. Italy's finance bill should be in place within two to three weeks, and Berlusconi, if he sticks to his word, will resign immediately afterwards. If a technocratic government is named, which some believe is likely, then the markets may be sated for long enough to start to build a firewall. However, the prime minister has made noises suggesting that early elections will be called.
"That spooks investors, largely because an election would mean a couple of months of campaigning, which would leave Italy rudderless for a couple of months at a time when they need a government to take additional steps," Robert O'Daly, economist at the Economist Intelligence Unit, said. With the politics where they are, it is also likely that there could be different majorities in the country's two tiers of government, meaning that decisions on austerity would be at risk of being bogged down.
The hope might be that Berlusconi and his allies make the political calculation that they would be soundly beaten in any election, and that the president, Giorgio Napolitano, decides to opt for a safe pair of hands for an unspecified interim period, O'Daly said. "It is in nobody's interest to hold an election," he added.
The European Central Bank is providing some support through the purchase of Italian and Spanish bonds, but the bank has indicated that it will not do so indefinitely. Clarity on the EFSF is needed, and needed soon.
Uncertainty is driving a flight from risk. The real possibility of a second banking crisis and a second recession across Europe has left even previously optimistic investors looking for safe havens. Gold prices - an indicator of fear - edged up 0.6%.
"No one knows what the endgame is," Derrick said.