Silvio Berlusconi’s government in Italy could be about to make a serious mistake that would have major ramifications for the euro zone and global markets.
Having seen the bond vigilantes push up the cost of Italian borrowing, an agreement was reached in August that saw the European Central Bank agree to intervene in the Italian bond market in return for stringent new austerity measures aimed at bringing borrowing under control.
The deal bought the Italian government some time and pushed yields on Italian 10-year debt back toward 5 percent, having been trading above 6 percent just weeks ago.
Having agreed to a 45 billion euro austerity program, Berlusconi has made concessions to domestic political interests, delaying tax hikes for the rich, changes to pension payments, and cuts for local authorities. He has not explained to the market or the ECB how the shortfalls will be made up, drawing criticism from European Central Bank President Jean-Claude Trichet and others.
Italian business federation Confindustria said that the austerity package is now “weak and inadequate” following the revisions, adding that it had "strong concern for how the serious situation of Italy's public finances and the economic recovery is being dealt with.”
Jean-Claude Trichet on Friday morning told Italian daily Sole 24 Ore that balancing the budget by 2013 is “extremely important.”
“It is therefore essential that the objectives announced for the improvement of public finances be fully confirmed and implemented,” Trichet said.
ECB board member Ewald Nowotny said the reversal of Italy’s plans to cut its deficit was cause for “great concern.” He reminded Berlusconi that it was “completely clear” that the ECB had only starting buying Italian bonds in the open market because of promises from Rome over austerity measures.
If Italy gets back into trouble with the bond market, then the euro zone debt crisis will become a major problem again, according to Jim McCaughan, the CEO of Principal Global Investors.
“The crisis entered a much more dangerous phase in the last month, with the rising yields on Italian and Spanish sovereign bonds. If these countries can’t fund their debt in the market, rapid fiscal integration will be necessary, though there is some doubt whether it is politically acceptable to Germany,” McCaughan said in an interview with CNBC on Friday.
The ECB’s action to keep Italian and Spanish yields lower helped market sentiment as August progressed, according to McCaughan, who said things may have to get worse before they get better in order for EU leaders to come up with a plan that will address the solvency issues facing Greece and others members of the euro zone.
Others note that ECB support is crucial for sentiment in the euro zone.
“To see a more sustained improvement in sentiment, the ECB will have to remain committed to buying Italian and Spanish government debt” said Peter Possing Andersen, the senior analyst at Danske Bank in a research note.
“Going forward, it is, in our view, absolutely essential that the ECB remains committed to supporting the markets until the EFSF can take over,” said Andersen, who is worried by the lack of U.S. funding available to the European banking industry.
“Access to U.S. dollar funding has tightened among European banks since early June, raising fears of systemic risks,” said Andersen
“The ECB meeting on 8 September will prove interesting also. While the money markets are pricing in a 40 percent chance of the ECB cutting 50 basis point on a six-month horizon, the ECB governor, Jean-Claude Trichet, reiterated over the weekend and on Monday that the ECB needs to anchor inflationary expectations—not exactly indications of a near-term cut,” Andersen said.
“On the other hand, he mentioned that risks are currently ‘particularly high,’ but will he be able to convince the markets that he will take action accordingly?”