The investor exodus from Italian bonds, sparked by the dual political crises in Italy and Greece, raises the most dangerous scenario yet in the euro zone's two-year-old debt crisis.
Yields on 10-year Italian bonds rose to 7.12% Wednesday, a high for the euro era, in the latest sign that investors are fast losing faith in the world's third-biggest sovereign-bond market. Yields might have risen far higher in the past week but for heavy bond-buying by the European Central Bank, economists say.#
The latest surge in Italy's funding costs on Wednesday came after clearing house LCH.Clearnet raised margin calls on Italian bonds, making them more expensive to trade. Portugal and Ireland were forced to seek financial bailouts after their bond yields exceeded 7%, a level many market analysts consider unsustainable.
Reversing the capital flight could require both political change in Italy and massive international assistance.
The first event came closer Tuesday evening when Italy's scandal-hit Prime Minister Silvio Berlusconi said he would resign once Parliament passes next year's budget. But it wasn't clear yet whether the announcement meant his final departure from a political scene he has dominated for nearly two decades—or what policy changes a successor might impose.
Italy may yet need financial aid if the mere announcement of a new government doesn't stop the capital outflow. The funds potentially available to Italy from Europe and the International Monetary Fund are unlikely to meet Rome's needs, however. Failure to halt the crisis could lead, in the worst case, to an Italian debt default that cripples Europe's banks, plunges the region into a slump and roils the global financial system.
With €1.9 trillion ($2.6 trillion) in government debt, Italy accounts for nearly one-quarter of all euro-zone public debt, and could prove too big for other European governments to save.
Italy has long relied on the fact that its debt level, although high at 120% of gross domestic product, isn't rising much, thanks to Rome's relatively small budget deficit. But the country still needs to borrow hundreds of billions of euros a year to repay its debts falling due.
Next year, Italy must borrow enough money to repay more than €300 billion in maturing debts and cover a targeted budget deficit of up to €25 billion. If investors aren't willing to lend Italy such sums, Europe will have to prop up the country with all the money it can muster—with help from the IMF—or risk a global financial crash.
A failure by Italy to honor its debts on time is currently considered a remote prospect, precisely because its impact on Europe's banking system and other government bond markets would be so disastrous, economists say.
"An Italian debt restructuring would be calamitous for the euro-zone economy," says Julian Callow, European economist at Barclays Capital in London. "It would plunge it back into a severe recession and generate global instability."
European policy makers are rushing to draw up contingency plans for an event that seemed unthinkable only six months ago: A bailout in case Italy can't attract enough private capital.
So far, Italy has been able to attract buyers for its debt, albeit at rising cost. When Italy launched a new 10-year bond in August, it paid buyers a yield of 5.22%. When it sold more of the same bond in October, the yield demanded was 6.06%.
A short-term spike in borrowing costs is a manageable problem for Italy, since only a small part of its debts need to be refinanced at a given time. The Bank of Italy estimates that the country could bring down its overall debts next year even if its interest rates for new borrowing are 2.5 percentage points higher than currently expected.
The problem, however, isn't yields, but investors' appetite for holding Italian debt at all. Many investors now fear that Italian bonds will lose further value, inflicting losses on them. That can lead to a self-fulfilling process of investors pulling out of Italian debt, leaving Rome with too few buyers of new bonds.
Some analysts say that is already happening. "Italian yields would have skyrocketed if the ECB hadn't intervened in the Italian bond market," says Jacques Cailloux, economist at the Royal Bank of Scotland in London. "It's already evident that private-sector demand for Italian bonds has died out."
The apparent end to the Berlusconi era could prove to be the first step toward restoring confidence in Italy, but it won't be enough on its own, analysts say.
A technocrat-led government with a reputation for seriousness "would clearly be a step in the right direction," Mr. Cailloux says. "But it wouldn't in itself resolve the Italian economy's structural problems," he says.
Euro-zone authorities are starting to believe that even reforms probably won't be enough, and external financial aid may be needed to tie Italy over until its domestic changes convince financial markets.
At the Group of 20 global economic summit in Cannes, France, last week, European leaders including German Chancellor Angela Merkel and French President Nicolas Sarkozy pushed Mr. Berlusconi to launch deep fiscal and structural overhauls, and to accept outside financial assistance led by the IMF, euro-zone officials say. He agreed only to a limited IMF monitoring role. He told reporters he had turned down an IMF loan.
The challenge for other European governments is that their bailout fund, the European Financial Stability Facility, isn't nearly big enough to meet Italy's borrowing needs for more than a few months. Italy's bond repayments of €64 billion in the first quarter of 2012 are nearly equal to the entire bailout provided to Ireland over three years.
Euro-zone policy makers have already given up hope of using the EFSF directly to lend to Italy. Instead, the plan is to use the remaining money in the fund as a carrot to entice private investors to keep lending. Under two schemes being considered, EFSF money would be put up to absorb a part of any losses that bond buyers might suffer by lending to Italy.
European officials say the approach could work well if investors think the risk of loss is limited. But if investors fear steep writedowns, the little carrot won't help.
While a new Italian government might be more open to IMF support than Mr. Berlusconi was, the fund's available global resources total €280 billion—and Italy would only be entitled to tap a fraction of that. Proposals to boost the IMF's resources have so far been shot down by the U.S. and other countries that would have to pay the bill.
That leaves the one institution with theoretically unlimited firepower: the ECB, which can create and lend new euros. But although the bank has been busy buying the bonds of crisis-hit governments—totalling €9.5 billion last week alone—it has repeatedly said its intervention will be limited in scope and duration.
New ECB President Mario Draghi said last week that the bank won't act as a lender of last resort to euro-zone governments, affirming the bank's stance that its mandate under the European Union treaty is limited to fighting inflation.
However, many observers believe the ECB would help Italy more energetically if Italy did more to help itself.
Restoring financial-market confidence will require a combination of fiscal and broader economic reforms by Italy's post-Berlusconi leaders, plus aid and advice from the IMF and European authorities, says Mr. Callow. "Under such conditions the ECB could feel justified in accelerating its debt purchases" to allay fears of falling bond prices and lure back private-sector investors, he says.
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