Berlusconi Talks Italian Economy Into Big Trouble

Silvio Berlusconi is no stranger to scandal and controversy. From Bunga Bunga parties to causing international incidents via some choice of use of words, the Italian billionaire and prime minister has earned himself a reputation as the loose cannon of European politics.

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Late last week, Berlusconi managed to undo years of work aimed at keeping Italy out of the sights of the bond vigilantes when he was reported to have launched a scathing attack on his fiscally conservative finance minister, Giulio Tremonti.

Quoted in an Italian newspaper Berlusconi said Tremonti was not a “team player” who just “spoke to markets” who “thinks he is a genius and thinks everyone else is a cretin.”

Over the weekend, Berlusconi and his PR machine attempted to undo the damage but the market had already taken fright, betting that if Berlusconi and Tremonti have fallen out then the tough fiscal stance taken by the finance minister could be in jeopardy and his hopes of balancing the budget by 2014 dashed.

Tremonti is not one of Europe’s most visible finance ministers and has not spoken to CNBC since the World Economic Forum meeting in January 2009 when he walked out of an interview with Geoff Cutmore, who had angered him by asking about Italy’s largest bank, Unicredit.

Watch Tremonti walk out on CNBC - was it something we said?

Tremonti, though, definitely speaks the language the market wants to hear and has skillfully until now been able keep Italy out of trouble in the bond market despite his country's huge national debt and anemic growth rates which have done so much to hit Italian competitiveness.

Tough Sell: Austerity

With the Italian people unwilling to accept major cuts in their standard of living, austerity has been a tough sell for Berlusconi’s government but by avoiding the fate of Greece, Ireland and Portugal the cost of servicing a national debt that is 129 percent of GDP, Tremonti has managed to make a bad hand work.

The huge jump in Italian borrowing costs in the last few sessions, sending the spread versus the German bund to its highest level since the creation of the euro, is a game changer. Berlusconi’s comments added to a warning from S&P on Italy’s debts mean Italy is now front and center for investors.

Italy’s banks have traded sharply lower in recent sessions and shares in Unicredit where suspended following another big drop at the open on Tuesday. In late May the new boss of Unicredit, Federico Ghizzoni, told CNBC that Italy is no Greece and made the case that due to low holdings of Italian debt by foreign creditors, Italy would avoid falling into the same debt trap that Greece is currently struggling with.

Watch the CEO of Unicredit talk to CNBC.

Analysts are now warning Italy could follow Greece, Ireland and Portugal into trouble with grave implications for global markets.

“As the third largest bond market in the world, after Japan and the US, Italy could be systemic. Funding pressures in Italy, and even more so a sovereign crisis, would have implications, in our view, that would extend well beyond the euro zone,” said Athanasios Vamvakidis, an FX strategist and at Bank of America Merrill Lynch Global Research in a research note on Tuesday.

“If Italy needs official assistance, the European stability mechanism will prove inadequate. A substantial increase in the EFSF funds would be needed, and potentially the use of the EFSF to intervene in the secondary sovereign debt market,” he added.

Systemic Implications

Getting access to funds would, in Vamvakidis' view, be only possible if Italy threatened to trigger a wider crisis.

“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. Markets appear to currently underestimate such risks: volatility remains low and the euro relatively strong,” he said.

Italy’s future could now be in the hands of the euro zone’s politicians whose record on resolving crisis is as poor as Berlusconi’s reputation outside Italy.

“We believe that unless the euro zone leaders strengthen considerably the EFSF without further delay and Italy resolves its recent political disputes and adopts a credible and more frontloaded fiscal consolidation plan, accompanied by ambitious structural reforms, the latest trend in the Italian bond market could potentially snowball into a major crisis for the global economy, weakening substantially the euro,” said Vamvakidis.

I am not sure if Giulio Tremonti is a team player but would say he understood this risk and did everything in his power to avoid such a fate. S&P’s warning following years of spending above its means and some ill-chosen words from his Prime Minister mean Tremonti’s - and Italy’s - luck has changed.