Last Updated Jul 14, 2011 2:29 PM EDT
With the so-called PIGS countries (Portugal, Ireland, Greece, Spain) in various stages of distress, Italy's borrowing costs shot up 71 percent in a single day this week on concerns that it may struggle to raise financing to service its â‚¬1.6 trillion debt. Yields on Italian government bonds are spiking. Stocks also have tumbled, with the share prices of two the nation's larger banks, Unicredit (UCG) and Intesa Sanpaolo (ISP), declining sharply amid concerns over their exposure to Greece's debt woes. European banks also are beginning to curb lending to Italian companies.
Standard & Poor's notes that the cost of credit insurance on Italian debt remains far lower than for Greece. Still, widening spreads show that investors are getting nervous that the pattern playing out in the eurozone's "periphery" countries may be moving to the region's core nations. Certainly Angela Merkel is anxious. The German Chancellor last weekend took the unusual step of calling Italian Prime Minister Silvio Berlusconi last weekend to press him to pass an austerity package now worth $68 billion.
Describing the crisis as entering "uncharted territory," the chief economist of the European Bank for Reconstruction and Development says the quarantine European financial officials have tried to set up around the continent's most troubled economies is in danger of failing. He warned:
The source of the contagion seems to be in worse shape.That "source" is, of course, the PIGS countries. Their situation is deteriorating. Ireland this week became the third eurozone nation, after Greece and Portugal, to have it credit rating cut to "junk." These sovereign debt problems are also metastasizing into what could emerge as a pan-European banking crisis.
With European banking officials set on Friday to release the result of financial "stress tests" on more than 90 banks, the early returns are troubling. In Spain, where bond yields also have surged in recent days, as many as six smaller banks are feared to have failed the examination.
That shows how vulnerable such institutions are to a Greek default, an event market participants think has an 80 percent chance of occurring. The catastrophic losses among Greek banks would ricochet into other European banks, requiring costly government bailouts. That would would hit already debt-burdened countries like Italy and Spain especially hard by forcing additional borrowing.
Banking and securities expert Satyajit Das neatly summarizes the vicious cycle facing Europe's "peripheral" economies:
A weak economy increases budget deficits which, in turn, drives higher government debt. This requires even greater cuts in government spending and higher taxes to reverse the deterioration in public finances, leading to further contraction in the economy. This drives a deteriorating credit rating outlook, reduced access to commercial financing and higher funding costs which contributes to a further declines. As some of these countries are also heavily dependent on external financing from banks and investors, around 60-70 percent for Greece, Ireland and Portugal, a financing crisis becomes almost inevitable.So does political turmoil, as the recent Greek protests against spending cuts and wage freezes showed. For now, Italy is quiet on that front (although we'll see how long that lasts). Its parliament is on course to pass the austerity budget, signaling an understanding even among the country's notoriously fractious legislators that Italy is in danger. If the country falls ill, there may be no stopping the disease.