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Does Italy Deserve Bond Vigilante Attack?

Gold is surging, the euro zone is considering an emergency meeting and the bond vigilantes have a new target, Italy, in their sights.

Some ill-chosen words from Silvio Berlusconi about his finance minister and a warning from S&P have seen Italian bond yields soaring and investors across the globe beginning to fret over the world’s third biggest issuer of government debt.

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The scale of the potential problem was highlighted by Bank of America Merrill Lynch Global Research on Tuesday.

“Given Italy’s systemic implications, a further deterioration in its bond market could be a threat to the global recovery and even lead to tail risk scenarios for global financial markets," FX strategist Athanasios Vamvakidis wrote in a widely read research report on Tuesday.

"Markets appear to currently underestimate such risks: volatility remains low and the euro relatively strong,” Vamvakidis added.

But other analysts question whether Italy needs to be seen as a problem despite needing to refinance well over 100 billion euros ($140 billion) worth of debt before the end of September.

“Now, we are not going to be the ones to tell you that Italy’s 120 percent of GDP debt burden is not too high…it is” Carl Weinberg, the chief economist at High Frequency Economics, wrote in a research note on Wednesday.

“We will not make the case that Italy’s credit rating is right, considering its fiscal and political setting, and considering the potential performance of an economy saddled with so much debt,” Weinberg added.

Fiscal Plans on Track

While these are, in Weinberg’s view, things to worry about, he is less concerned about Italy’s refinancing needs.

“The gross funding requirement of the government is not significantly different from what was accomplished a year ago, at interest rates only about 50 basis points less than where they were before this recent sell-off. Italy is well within the range of normal experience…at least for the moment,” he added.

Analysts at Credit Suisse share Weinberg’s view, saying Italy’s fiscal plans are on track.

“Italy's deficit reduction plans are on target. Italy managed to limit the increase in its borrowing requirements during the 2008-9 crises and has respected the timetable for lowering its deficit up to now,” Credit Suisse euro zone economist Christel Aranda-Hassel said.

“In 2010, it stood at 4.6 percent of GDP, down from 5.4 percent in 2009 and better than the initial five percent official target. This year, data available up to June are consistent with a further reduction of the deficit to below four percent of GDP,” Aranda-Hassel added.

The problem according to Credit Suisse lies with the inability of the politicians to get ahead of the debt crisis.

“We believe that the fragility of the Italian situation stems mainly from the European political crisis – rather than from domestic developments,” they said.

“While Italy needs to vote and implement reforms and fiscal measures as already announced – and might need new, growth-enhancing measures to make the adjustment somewhat more robust – the exit from the current crisis probably happens only when the wider euro area crisis gets resolved – starting with a satisfactory and definitive handling of the Greek case,” they added/

Such an outcome is highly unlikely according to Weinberg. ”The world needs a concrete plan, not just a promise of a concrete plan at some vague date in the future, if financial crisis is going to be averted,” he said.

“There can be no dispute that this huge drop in value of Italy’s debt instruments, that is, what we have already experienced, will make a visible dent on the balance sheets of the financial system if it is marked to market. There can be no dispute that a default by Italy would have catastrophic consequences for euro land’s banking system,” Weinberg warned.