The Italian Job

Italy looks too big to rescue yet is too big to fail. The country has around EUR 1.9 trillion in public debt (around 5 times that of Greece) and is the third largest country in the eurozone. Therefore it cannot be as easily dealt with as Greece.

Italy needs to raise around EUR 18 billion per month to cover its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable. Higher collateral haircuts on Italian debt are adding to the pressure.

Although Italian Prime Minister Berlusconi has said he will step down in the wake of reform measures to be voted on by the Italian parliament the vote on the measures may not take place for weeks. Moreover, Berlusconi may attempt to seek re-election after stepping down, which could bring the situation back to square one.

In the meantime speculation that Italy may be the next country to need to a bailout will intensify. However, with only around EUR 270 billion remaining in the EFSF bailout fund and details of how the fund will be leveraged to a planned EUR 1 trillion still lacking, doubts about whether it will have sufficient resources will grow. Press reports that Germany and France have begun talks to break up the eurozone due to fears that Italy will be too big to rescue will only add to the malaise.

Focus over the short term will turn to today’s 12 month auction of EUR 5 billion in Italy. Last month’s 12 month auction saw an average yield of 3.57% but this time around yields could rise above 6%. Worryingly it appears that even with the European Central Bank (ECB) buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s reluctance to become lender of the last resort to European peripherals, any support from this direction will be limited. Against this background the EUR remains highly vulnerable to a further drop. Indeed, the EUR’s recent resilience looks all the more misplaced. A test of the 4 October low around EUR/USD 1.3146 is on the cards over coming days.

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