Fear Italy could be the next to falter

The relief in Rome was short-lived.

Italian bonds rallied early on June 11, the first trading day after European finance ministers' weekend agreement on a US$125 billion ($160 billion) bailout for Spanish banks.

But within hours, Italian borrowing costs were creeping back up again, reflecting persistent market fears that the continent's third-largest economy could be the next to falter.

"Contagion into Italy and other countries is a reality," said Joachim Fels, chief global economist at Morgan Stanley in London.

There seems to be little Italy can do to inoculate itself.

Prime Minister Mario Monti, appointed last November to succeed Silvio Berlusconi, has moved decisively to get Government finances in order, overhaul the pension system, and implement regulatory reforms.

The country is on track to bring its budget deficit within 3 per cent of GDP this year. Italian banks are relatively healthy, and unemployment is less than half the 24 per cent in Spain.

"Spain's fundamentals are a lot direr than Italy's," says Nicholas Spiro, managing director at Spiro Sovereign Strategy in London.

Italy's situation is hardly rosy.

Its debt burden - 120 per cent of GDP - is the highest of any European country except Greece.

Its economy slid into recession during the fourth quarter of 2011 and is expected to contract 1.7 per cent this year.

"Monti's reform agenda is stalling, unemployment at 10.2 per cent is the highest in a decade, and consumer confidence is the lowest in 15 years," said Marc Chandler, head of currency strategy at Brown Brothers Harriman.

"Italy is positioned to be the next lightning rod in the euro area."

Monti, speaking on Public Radio ARD yesterday, called on the markets and financial observers "not to be governed by cliches or prejudices".

"I understand that Italy could have been associated with the idea of an undisciplined country in the past," but "now it is more disciplined than many other European countries," he was quoted as saying.

"Our country pays through its financial contribution ... to support Greece, Portugal, Ireland and now Spain. And now it also pays through extremely high interest rates because of tensions on the markets."

Earlier yesterday Monti slammed as "totally inappropriate" a suggestion by Austrian Finance Minister Maria Fekter that Italy may be forced to follow stricken Spain into begging for a financial rescue because of its high borrowing costs.

For now, yields on Italian debt are at 5.84 per cent, less than they were when Monti took over last year and well below the maximum 8 per cent that officials have said the country can afford.

Maria Cannata, the head of Italy's debt agency, said last week that fewer foreign investors had been participating in debt auctions in recent months.

That means the Italian Treasury is more dependent on local banks, which have been among the heaviest borrowers from the European Central Bank in the past three years.

"If Italy has a problem with accessing the markets because investors lose confidence in the Italian ability to do the right thing, the ECB will be drawn into the fire," says Thomas Mayer, an economic adviser to Deutsche Bank.

Although the focus is now on Italy, it could soon shift to France.

President Francois Hollande campaigned on an anti-austerity platform, and his Socialist Party and its allies took 46.9 per cent of the popular vote in the first round of parliamentary voting on June 10. But Hollande won't know until the June 17 second round if he'll have an absolute majority.

If he doesn't, he'll have to form a coalition with far-left parties, some of which are demanding big increases in government spending that would undercut Hollande's promise to reduce France's budget deficit.

Investors will be watching closely, Chandler says. "Hollande's honeymoon may last through the final round of the Parliament elections. But then things will become more difficult."

- Agencies

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