Global financial markets have been enjoying a temporary calm over the European summer, but already investors are beginning to brace themselves for more turbulent times ahead.
In particular, investors are becoming increasingly anxious whether Italy will be able to continue to meet the interest payments on its massive €1.95 trillion debt burden as the country slides deeper into recession. According to OECD forecasts, Italy’s debt-to-GDP ratio is set to hit a worrying 122.7 per cent this year, higher than the 121.6 per cent forecast for Ireland.
Markets are also worried about Rome’s failure to take more decisive steps to address its most pressing problem – how to refinance the €500 billion in Italian debt that matures by the end of 2013.
Rome was presented a brief window of opportunity to deal with this problem when Italian bond yields dropped after European Central Bank boss, Mario Draghi, said he would do whatever was necessary to save the euro. Investors, believing Draghi was hinting at a massive program of Italian and Spanish bond purchases, responded by snapping up Italian and Spanish bonds, which pushed their yields sharply lower.
But instead of taking advantage of favourable market conditions to refinance short-term debt, Rome decided instead to launch a political offensive. Italian prime minister, Mario Monti, embarked on a tour of European capitals, in the hope of drumming up support for more ECB bond-buying.
As a result, investors are worried that Rome has missed the boat. On Friday, Italy’s benchmark 10-year bond yields inched up to 5.89 per cent, getting dangerously close to the 6 per cent level which investors consider is unsustainable for the country.
Ominously for Italy, the giant US investment bank Goldman Sachs – where Draghi and Monti both previously held senior positions – has recently disclosed that it slashed its exposure to 92 per cent in the second quarter of the year.
Goldman Sachs said its market exposure to Italian government bonds plummeted to $191 million at the end of June from $2.51 billion at the end of March. At the same time, Goldman also beefed up its exposure to Italian credit derivatives, which pushed its total market exposure to both Italian government and non-government bonds to a negative $977 million in June from a positive $2.4 billion in March.
Meanwhile, Monti’s efforts to win broad-based support for a new round of ECB bond-buying appears to have largely failed, with Belgian central bank boss, Luc Coene, telling Belgian newspapers that ECB bond buying would not solve Italy’s debt problem, but it would undermine the ECB.
"It makes no sense for the ECB to start financing those countries,” he told the Belgian newspapers, De Tijd and L’Echo, "It would only lead to the ECB taking on the whole public debt of Spain and Italy onto its balance sheet.” He added that this "would in turn weaken the ECB and do nothing to resolve the underlying problems."
Rome’s inertia is making investors increasingly nervous. They know that Europe simply lacks the resources to launch a full-scale bailout of Italy. Unless Rome takes some urgent steps to get its debt problem under control, the entire eurozone could find itself at risk.