Is the Problem With Italy Solvency or Liquidity?

Italy's problems looked far from over Wednesday as its stocks fell sharply (FTSEMIB) and the yield on Italian 10 year bonds shot above the important 7 percent mark.

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The selloff continued despite the news that Silvio Berlusconi has finally agreed to step down as Prime Minister.

There appear to be multiple drivers of the negative market sentiment. Some London-based analysts pointed out to CNBC that the wider problems facing Italy, including a debt-to-GDP ratio second only to Greece's in the euro zone, have not changed due to Berlusconi standing down. There is still the prospect of an election in Italy and all the uncertainty that brings with it.

Other analysts point to the decision by clearing house LCH.Clearnet to raise margin requirements for those trading Italian bonds.

Some believe that the questions being raised over Italy should be simplified to one single conundrum. Is Italy facing a solvency or liquidity problem?

“There are two classic reasons for a rapid rise in sovereign yields – a solvency or liquidity problem,” Laurence Boone, European economist at Bank of America Merrill Lynch , wrote in a research note on Wednesday morning.

“Italy’s situation is less clear cut: solvency depends on a combination of interest rates, the growth outlook and the gap between expenditures and taxes.”

If Italy could create a large budget surplus—a big if given the current political environment—Boone suggests that the country could manage borrowing costs in double figures.

“The instability of Italy’s political situation could increase market anxiety levels before rates got even close to double digits, and at 7 or 8 percent Italy could find it was unable to raise sufficient money on the bond market. In short, a confidence issue could turn into a liquidity issue,” said Boone.

Ominously, he believes the euro zone is in no position to support Italy at this point.

Others argue that Italy is not facing a liquidity crisis but a basic solvency crisis given its debt-to-GDP ratio of 119 percent.

“Italian debt is starting to spiral out of control, and it is too late for political reform to make any difference now," Matthew Lynn, the founder of Strategy Economics wrote in a note on Wednesday. "Even if a new Prime Minister can push through structural reforms that lift the growth rate significantly—and there is no reason to think they can—that will take years to work. Italy doesn’t have years."

Lynn believes the only solution for Italy is for it to restructure its debts via a voluntary agreement with its creditors or leave the euro for the lira, its old currency.

European leaders have recently acknowledged the possibility that Greece may leave the euro, but have not said the same about Italy, the third-biggest member of the euro zone.

“The scale of the losses will prompt vast losses across the global banking system,” said Lynn.

“The only real surprise about the euro debt crisis is that it has taken as long as it has to strike Italy.”