Ever since the EU and the IMF 'bailed out' Greece in May last year, the eurozone has fought a desperate rear-guard battle to stem contagion to other countries - with little success. Ireland and Portugal have since been bailed out, and Cyprus could be next. The most disquieting development, however, has been incipient contagion to larger economies like Spain and Italy. Unless this contagion is arrested, the eurozone could face a potentially terminal crisis. For the past year, the Spanish government has been battling valiantly to persuade financial markets that it will not be the next domino in the chain. But the change in sentiment towards Italy has been more recent - and is perhaps more alarming. What explains it?
Until early July, Italy had just about convinced the financial markets that it was not the 'next Greece'. A cynic might justifiably wonder why. The country's structural problems, after all, are as profound as they are well-known. It has a rapidly ageing population. Its ratio of public debt to GDP is the second highest in the eurozone (after Greece). Productivity has barely risen over the past decade. Rising wages have consequently pushed up unit labour costs, eroding the country's trade competitiveness. Governance, moreover, is notoriously weak: because of the dysfunctional nature of the political system, few eurozone countries have done less in recent years to improve the supply-side performance of their economy.
Given these longstanding weaknesses, why did sentiment towards Italy not sour earlier? Until recently, Italy was thought to have several advantages over other countries in the eurozone's troubled geographical periphery. Unlike Ireland and Spain, it did not experience a domestic credit boom in the run-up to the global financial crisis. Private sector balance sheets are therefore stronger: households are not over-indebted, and Italian banks fared well in recent stress tests. Italy, moreover, has been running smaller budget deficits than Greece or Portugal; in 2011, it is expected to run a primary budget surplus. Unlike in Greece and Portugal, budget deficits did not seem to pose a threat to Italy's public debt sustainability.
Since July, however, market sentiment has changed alarmingly. At the time of writing, the yield on 10-year Italian government bonds stands at 6.12% - up from 4.73% at the end of June (and from 3.73% in October 2010). The spread over German bunds, which had fallen to almost zero in 2008, has now widened to 370 basis points. As in Greece, heightened perceptions of sovereign risk are hitting sentiment towards Italian banks (which have large exposures to their home country's sovereign debt). Even banks that fared well in the EU's recent stress tests have not been spared: the share prices of all Italian banks have taken a pummelling. Why has sentiment towards Italy soured so dramatically over the past month?
It is tempting to pin all the blame on political infighting and paralysis. It certainly does not help that the government is hamstrung by a small majority in parliament, or that relations between the prime minister and the finance minister are poor. Nor does it help that Silvio Berlusconi seems more inclined to use the office of prime minister to advance his private interests than the public one. But it is not as if these factors became apparent only in early July. Besides, Spain, whose government has shown greater focus and determination than Italy's over the past year, has also experienced rising borrowing costs. So a strong political commitment to reform is necessary to restore confidence in Italy. But it may not be sufficient.
