Italy turmoil raises questions about ECB backstop
Why has Italy's muddled election result spooked global investors so much? Because it raises unsettling questions about the availability of the financial safety net that has kept Europe from catastrophe for the past six months.
That safety net is a crucial offer from the European Central Bank to buy unlimited quantities of struggling countries' bonds. The one catch was that participating countries had to commit to austerity measures - such as spending cuts and tax increases to lower their deficits.
And if there's any clear message from the Italian elections, it's that voters rejected austerity.
If Italy can't - or won't - agree to cuts and reforms to promote stronger growth, the ECB can't help.
That would leave Italy defenseless if its borrowing costs rise to unmanageable levels and into default territory. And if Italy fails, Europe can't afford to bail it out.
A top European Central Bank official underlined Wednesday that any country that wants to use the crucial backstop will have to meet stiff conditions and agree to take steps to cut its deficit.
Peter Praet, the top ECB official in charge of its economic analysis and forecasts, did not mention Italy in the text of his speech in Frankfurt, Germany. But he warned that the bond-purchase shield "will only be activated in cases where the benefiting country has signed up to strict and effective conditionality," meaning an agreement to take concrete steps to curb its financial problems.
Praet's warning came as Italy saw its borrowing costs rise as it sold (EURO)6.5 billion ($8.5 billion) of 10-year and five-year bonds. The interest yield rose to 4.83 percent from 4.17 percent a month ago for the 10-year and to 3.59 percent from 2.94 percent for the five-year.
So far, Italy's borrowing costs have risen only moderately. But the fear is that continuing turmoil could let them climb toward the heights of late 2011 and early 2012- a hefty 7 percent.
The ECB bond purchase program has been given most of the credit for the easing of the eurozone debt crisis in recent months. Before the ECB offered Sept. 6 to buy unlimited amounts of government bonds issued by a struggling country, Italy and Spain were facing borrowing costs that would have proved crippling in the long term. The fear was that these two big economies - the third- and fourth-largest among the 17 European Union countries that use the euro - would be pushed into defaulting on their debts.
No bonds have been bought under the ECB plan, but the mere offer reassured investors and sent borrowing costs lower for debt-plagued countries such as Italy and Spain.
"Basically investors are taking this on faith," said Simon Tilford, chief economist at the Center for European Reform in London.
The Italian result risks undermining that faith.
"It would be very hard for the ECB to wade into the market and buy substantial quantities of Italian debt if there is political gridlock in Italy and a broad based rebellion against the austerity strategy," Tilford warns.
The two-day election on Sunday and Monday was a clear rejection of the previous government of financial and economic experts led by Mario Monti. That government won support from eurozone leaders by raising taxes, cutting spending, and narrowing the deficit. But the cost to Italians has been high, with the country mired in recession and unemployment on the rise. Austerity opponents argue that cutting government spending lowers growth and makes debt ultimately harder to repay.
Pier Luigi Bersani and his center-left allies appeared on Tuesday to have won a narrow victory in the lower house of parliament, but the Senate looks split with no party in control. Silvio Berlusconi, the former Italian premier whose center-right coalition did better than expected, is a key player since his coalition is now the second-biggest bloc in the upper chamber.
Comic-turned-political leader Beppe Grillo, whose 5 Star Movement capitalized on a wave of voter disgust with the ruling political class, had a surprisingly strong showing. His bloc of seats in Parliament could prove crucial in making any coalition government viable.
More than half the voters supported either Berlusconi's or Grillo's group - both of which campaigned against Monti's austerity measures.
Berlusconi has already ruled out an alliance with Monti, whom he blamed for driving Italy deeper into recession.
And on Wednesday Grillo wrote on his blog that his party would not back a confidence vote on any new government formed by mainstream parties, calling instead for a new election soon.
European leaders pleaded with politicians in Italy to quickly form a government to continue to enact reforms to lower Italy's critically high debt of 127 percent of annual economic output and spare Europe another spike in its four-year financial crisis.
Monti held talks with Jose Manuel Barroso, head of the European Commissions, in Brussels on Wednesday amid worries that the lack of political stability in Italy might reignite the eurozone debt crisis. Afterward, they said in a joint statement that they are "convinced that continued and determined action at European and national levels is needed," including agreed reform and budget consolidation efforts to create growth and jobs. Monti and Barroso said, "The crisis is not yet over and efforts must not be relaxed."
Though Italy's annual borrowing - its budget deficit - is relatively small compared with other euro countries at 3 percent of its annual gross domestic product, its overall debt stands at a colossal (EURO)2 trillion.
Some analysts believe the threat of losing the ECB life preserver might be enough to push Italian politicians into moderating some of their stances so they can form a government and reassure markets.
Holger Schmieding, chief economist at Berenberg Bank in London, said the mere prospect of facing the bond market without the ECB's implied backing could put pressure on politicians to sort out their differences, especially with a nudge from the European Union's executive commission and eurozone heavyweight Germany, the architects of austerity as a strategy for getting Europe out of its financial mess.
"We would expect the ECB, Brussels and Berlin to emphasize that the safety net would be available for an Italy that gets its act together," he said in a research note to investors.
"If tensions escalate, this could help to concentrate minds on the center-right and the center-left in Italy to form some kind of coalition and pursue sensible policies."
McHugh contributed from Frankfurt, Germany, and Juergen Baetz from Brussels.