Italy and the Eurozone Crisis

ht

As EU leaders summit on a daily basis to address the
Eurozone crisis, the world is focused on Italy:
a country too big to fail, or at least to bail out. What then, is going on with
Italy
and why is it the perfect centre of the storm?

 

Italy
is in trouble because it may be insolvent. What started as a liquidity crisis
for Italy (not enough investors willing to buy its debt) is now threatening
national default.

 

A country can be said to be solvent if it can service its
national debt out of GDP growth. However, in the past fifteen years, Italian
GDP growth has averaged just under 2% per annum, with flat rates of investment
and consumption. This is classical stagnation. Converely, national debt has
risen to 1.9 trillion Euro or about 120% of GDP.

 

The following interactive map from CNN shows the debt map of
Europe as at July 2011. The first thing which
stands out is that only two countries in the EU, namely Italy
and Greece,
have ratios of debt-to-GDP which exceed 100%. It is interesting to note,
however, that all member states make a commitment to maintain debt-to-ratio
figures of 60% on entry to the EU: in reality, few nations adhere to this
stipulation.

 

As Italy’s
debt soared, bond markets became spooked that the country’s ability to service
its debt was waning. As confidence in the Italian economy diminished, fewer
investors were willing to buy Italian 10 year government bonds, which in turn
drove bond yields over 7% : the level at which traditionally countries become
unable to service their debt. Why? Although there is no hard and fast rule why
7% is the trigger, past experience shows Portugal,
Greece and Spain
have needed bailouts within two months of reaching a 7% yield. This is because
governments raise money to pay their bills by selling bonds. Therefore, the
higher the yield, the more it costs, Italy in
this case, to borrow money to pay its debts.

 

Italy
needs to lower the yield on its government bonds if it is to remain solvent:
and it can only do this if market confidence returns in the Italian economy.
This is one of the reasons Italy
is agreeing to a number of austerity measures and reforms in the coming years.

 

The problem, some economists claim, is that these austerity
measures will slow down economic recovery which even before the crisis was
stagnant at best, and so will not resolve the issue of solvency in the long
term.