Italy’s Political Unrest Puts Markets on Edge

Sources:

NYT: Interest Rates on Italian Bonds Pushed to New Levels
WSJ: Ailing Italy Accepts IMF Monitoring
Spiegel: Italy Becomes Next Euro Battleground
Spiegel: Why Berlusconi's Departure Is Making Markets Nervous

On Tuesday, Italian Prime Minister, Silvio Berlusconi, announced that he would resign from office once the Italian parliament passed a package of austerity measures European Union (EU) leaders demanded to reduce Italy’s vast debt and restore investor confidence in the country. The move came after a humiliating budget vote where parliament approved a plan to increase taxes and raise the retirement age, during which it became clear that the Prime Minister no longer had support from the majority of parliament.

Following the announcement, the interest rate on Italy’s 10-year bonds (which is viewed as a measure of investor anxiety) increased to 7.45%, from 6.63% just the previous day. There are also fears that the higher rates may force clearing houses (the intermediaries between buyers and sellers of bonds) to demand higher collateral payments from traders of Italian bonds to protect the clearinghouses from default, which would push interest rates even higher. Although by some measures the Italian economy is in better shape than the economies of Greece and Portugal, the economy cannot sustain paying such high rates on debt. If the interest rate rises so high that investors stop buying Italian bonds, the country will be unable to raise sufficient money on the bond market to continue paying its current debts and will have to seek a bailout like Greece and Portugal.

The developing crisis in Italy is of particular concern to European Union leaders. The Italian economy is the third-largest in the 27-member bloc and the current Eurozone bailout fund, the European Financial Stability Facility (EFSF), does not have enough money to bail out Italy. Italy’s debt is currently €1.9 trillion and accounts for 25% of all the sovereign debt in the Eurozone.

In an effort to restore market confidence in the country’s economy, the Italian parliament passed another package of austerity measures on Saturday. The austerity package includes an increase in the value-added-tax (a form of sales tax) from 20% to 21%, a freeze on public sector salaries until 2014, and an increase in the retirement age from 60 to 65 by 2026. Also, a new special tax will be imposed on the energy sector along with tougher measures to fight tax evasion. The austerity measures are expected to produce €59.8 billion in savings by the year 2014. Following the passage of such measures, Prime Minister Berlusconi stepped down, as he had promised earlier in the week, and a new Prime Minister, Mario Monti, has been appointed. The new appointment has been welcomed by EU leaders as a signal of the Italian authorities’ determination to overcome the current crisis. However, Italy is still not out of the danger zone as the country will continue to be monitored while it implements the austerity measures.