Is Italy Living on Borrowed Time and Money?

Italy is back in the spotlight as the focus for market concerns once again, with bond yields higher than Ireland’s and increasing concern about the political situation in the euro zone’s third-largest economy.

Piazza Venezia, Rome, Italy
Panoramic Images | Getty Images
Piazza Venezia, Rome, Italy

Its 10-year bond yields increased to 6.01 percent on Friday, reflecting fears that European Unionattempts to reduce soaring borrowing costs for peripheral Europe are not enough. At the bond auction of two, five and ten-year bonds, markets showed failing confidence In Italy with yields up to 3.97, 5.22 and 6.03 percent respectively.

The auction came a day after major banks cut interest rates and despite Italy announcing a series of budget cuts. Alongside the Bank of England and the People’s Bank of China, the European Central Bank cut its main interest rate to a record low of 0.75 percent and cut the deposit rate in an effort to encourage lending.

Italy’s situation is particularly concerning because of the size of its economy — only Germany and France are bigger in the euro zone.

Opposition to Prime Minister Mario Montiand his technocrat government has been growing despite his attempts to keep Italy’s economy afloat in the tumult of the euro zone crisis, as well as placating Europe and an increasingly disaffected Italian population facing enforced early retirement and pension cuts. The unemployment situation is worsening, with the unemployment rate at 10 percent, rising to 30 percent for young people.

Italy is now facing a deeper and protracted recession and Monti faces an “uphill battle to regain the confidence of financial markets,” according to economists from Nomura. They slashed their growth forecasts for 2012 from to -1.7 percent to -2.2 percent, and predicted that Italy’s economy would remain flat in 2013, instead of returning to growth. Nomura added, however, that negative bond auctions could help maintain the pressure on Italy to implement tough political and labor market reforms.

“We believe that Germany and its allies…will be quietly pleased if spreads on Italian sovereign debt remain wide enough to keep Italy’s professional politicians mindful of the dangers inherent in domestic political wrangling and/or instability,” the report said.

Italy’s government met on Thursday to approve 4.5 billion euros ($5.58 billion) of spending cuts for 2012 that it said would cut the size of Italy’s public sector spending and help it avoid an unpopular hike in VAT (value-added tax) until mid-2013.

Announcing the emergency legislation, Monti announced that the “decree” that set out cuts to public sector jobs, healthcare provision and regional funding, will “reduce public spending without hitting services to citizens.”

Although the unpopular rise in VAT (value-added tax) of 2 percent has been stalled until 2013, the size of the cuts was bigger than the initially anticipated 4.2 billion euros ($5.1 billion) originally forecast for this year and labor unions are threatening to hold a national general strike.

As his popularity hit its lowest level since November (it is now half the 71 percent approval rating he had when he took office) Monti and his cabinet last week agreed to European Union demands that Italy implement tough measures to cut its 1.95 trillion euro ($2.4 trillion) debt pile.

After last week’s euro zone summit there was hope that other leaders were taking a more flexible approach to helping Spain and Italy reduce their borrowing costs, with an agreement that rescue funds could be used to stabilize bond markets, without forcing countries to adopt extra austerity measures or reforms. Monti’s measures to appease the European Union come ahead of the euro zone meeting in Brussels next week when officials are expected to finalize details of the bond deal.

However, the drop in the euroand latest debt auctions indicate market dissatisfaction with the ECB’s actions. Concerns have also increased after ECB President Mario Draghi said that euro zone growth was weakening.

It was hoped that the united front shown at the EU summit, the ECB’s rate cut and Italy’s budget cuts would reassure financial markets that the country was taking control of its finances. The stark contrast between borrowers paying to hold German debt as yields turned negative, while yields soar for Italy and Spain, suggests that markets fear not enough is being done to stop the momentum of recession building.