Italy had to pay a steep interest rate to sell government debt on Tuesday, highlighting the growing challenge facing the country as it tries to finance itself in nervous markets amid the worsening euro-zone debt crisis.
The Italian Treasury had to offer investors 5.6% interest to sell €6.5 billion ($8.89 billion) of bonds maturing in five years' time. Italy's borrowing cost was well up from its last comparable auction, in July, when it paid under 5%.
"This is clearly not a sustainable cruising speed," said Luca Cazzulani, a fixed-income strategist at Unicredit in Milan, of Italy's rising borrowing costs.
Economists say such high interest costs won't undermine Italy's solvency quickly, since it still pays a relatively low average interest rate on its roughly €1.9 trillion of total debt. But if sustained, high borrowing costs will add to the country's difficulties in reducing its public debt, which at 119% of gross domestic product is twice the recommended level for European Union countries.
The spread of financial-market jitters to Italy, the euro zone's third-largest economy and for years its growth laggard, is the most serious threat so far to the euro zone's ability to stem the crisis. The country is too big for Europe's bailout funds to save, should the Rome government lose access to capital markets completely. Economists say such a "sudden stop" of funding for Italy isn't in the cards yet, but can't be ruled out if euro-zone governments fail to restore markets' confidence.
Investors are growing more reluctant to hold Italian government debt, despite efforts by the European Central Bank since August to prop up Italian bond prices through market intervention. The unpredictability of Italy's government, which has announced, withdrawn and modified various budget proposals in recent months amid political squabbling, has also hurt investors' confidence in Rome's finances. On Tuesday, the risk premium—the interest-rate differential between Italian debt and safe German debt—rose, for the first time under the euro, to more than four percentage points on bonds maturing in two years or more.
Yields on Italy's new five-year bonds fell to 5.3% in secondary-market trading on Tuesday, indicating that there was demand for the debt after the auction. The drop in yields—reflecting a rising bond price—was a sign that the ECB's bond buying is giving some confidence to investors who believe the euro will survive, according to one banker who was involved in arranging Tuesday's Italian debt auction.
The trend in Italian bond yields remains upward, however. If sustained, the recent rise in borrowing costs will add about €38 billion in annual interest costs to Italy's budget. Such a burden would make it harder for Italy to close its budget deficit and bring down its total debt, canceling out much of the effect of the government's latest fiscal austerity plan, which comprises nearly €60 billion in tax increases and spending cuts by 2013.
A few high-yielding auctions don't have much of an impact on Italy's overall finances, noted Unicredit's Mr. Cazzulani. But clouds are darkening as risk aversion grows along with intensifying doubts about Greece's ability to reduce its budget deficit, the condition of continued international aid for Athens. Fear that Greece could wind up defaulting chaotically on its debts is unsettling financial markets around Europe and beyond, making it harder for some other euro-zone governments to finance themselves at sustainable interest rates.
Spain is bracing for a sale of up to €4 billion in bonds Thursday, although Spanish yields are trading below Italy's across the curve. Italy's fate depends to a large extent on the ability of the rest of Europe to act as a backstop for the country's bond market. The ECB since early August has prevented a deeper sell-off of Italian debt by effectively setting a floor under the price of Italy's benchmark bonds, reassuring some investors who otherwise would have run for cover, analysts say.
But analysts doubt that the ECB can continue to buy enough bonds to prop up the Italian bond market, because the bank's bond-buying program is too controversial—especially with German central bankers. Last Friday's resignation of Jürgen Stark, the ECB's chief economist and the most senior German official at the bank, was a sign of the divisions inside the Frankfurt-based institution. Mr. Stark had argued strongly against bond purchases in August but was overruled by ECB President Jean-Claude Trichet and the majority of other ECB governing council members, according to people familiar with the matter.
Germany's Bundesbank has also expressed strong reservations about the bond-buying program, which critics argue blurs the distinction between central banking and fiscal policy and threatens the ECB's independence from governments.
The ECB is pressing euro-zone governments to quickly enable their main bailout fund to take over its bond-buying activities, as European leaders agreed to do in July. However, national authorities are taking time to ratify this change. In the meantime, the ECB is accumulating a large exposure to the debts of struggling euro-zone economies.
The intergovernmental bailout fund will also have a limited lending capacity of €440 billion, much of it already been earmarked for aid to Greece, Ireland and Portugal. The ECB, in contrast, has virtually unlimited financial firepower through its control of the euro currency.
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