By LIZ ALDERMAN
Published: December 1, 2010
Throughout Europe’s financial crisis, Italy and Belgium have managed to avoid being one of the countries that keep people awake at night.
But even as concern mounts that Portugal and possibly Spain may seek financial aid after Greece and Ireland requested bailouts, investors have started asking whether those two economies may be the next weak links in Europe’s monetary union, the euro.
Italy and Belgium have a lot in common: both are less dependent on foreign creditors than Greece or Ireland. But each is plagued by severe political dysfunction, which has raised questions about whether they can ever repay a mountain of debt, respectively the second- and third-heaviest loads in the European monetary union after Greece.
Both countries have long histories of debt and political problems that contributed to economic downturns in the past. But no one seemed to pay attention during the current crisis until this week, when investors, transfixed by debt fears in other countries, drove borrowing costs in Italy and Belgium to near record highs.
Investors eased some of that pressure Wednesday after the European Central Bank signaled that it could take new steps to prevent the market contagion by buying more bonds of crisis-stricken countries. Stocks in Europe rose about 2 percent. And yields on government bonds fell after rising sharply in the past couple of weeks amid worries about the growing risk of repayment, although yields are still near their recent highs.
While few currently think these two countries have a high risk of defaulting, the spotlight could turn back to Belgium and glare harshest on Italy, the third-largest euro zone economy after Germany and France, if neither can muster the political cohesion needed to assure financial markets that they can reduce their debt.
“The simple lesson of the last few days is that if you have a very high level of debt, you are not safe if contagion spreads,” said Marco Annunziata, chief economist for Unicredit.
Italy has done a better job than Greece in keeping its fiscal house in order during the debt crisis. The Italian finance minister, Giulio Tremonti, prudently cut government spending and overhauled its expensive pensions system with the blessing of Prime Minister Silvio Berlusconi’s government.
The nation’s current-account balance is modest, and it enjoys high household and corporate savings. Government-issued debt is split almost evenly between foreign investors and Italians, who snap up the offerings to augment their savings. Italian banks, unlike Ireland’s, are relatively sound and did not need a bailout.
But Italy has traditionally depended on state borrowing, even as its efforts through the years to improve growth have stumbled. That raised new concerns after the global financial crisis hit industrial production, a pillar of the Italian economy, and employers failed to improve competitiveness by limiting wages or improving productivity. Having joined the euro zone, Italy, like Belgium, is no longer free to devalue its currency to revive growth.
While Italy’s debt did not balloon overnight, it stands at about 118 percent of economic output, second only to Greece in the euro zone. And despite modest growth during the crisis, the Italian economy is not expanding quickly enough to cover its costs, including those of caring for the pensions and health care of an aging population.
Investors jumped on that dynamic this week in a way they had not since the financial crisis began, driving Italy’s borrowing costs to near-record highs.
“Italy has become a concern because the economy is not growing fast enough to keep up with the public debt,” said Giacomo Vaciago, professor of political economy at the Catholic University of Milan. “With a deficit of 5 percent of G.D.P., and growth of 1 percent, the fear is that you will never reverse your budget balance, and therefore the common judgment is that sooner or later Italy could default.”
The worries are compounded by a continuing political crisis that will come to a head in a few weeks for Mr. Berlusconi, whose staying power may be tested following a series of sex scandals and as the economy ebbs. He faces a confidence vote this month that could lead to the collapse of his conservative government.
Fractured politics has also undermined the tiny nation of Belgium, where decades-long efforts to break the country into separate French and Flemish-speaking nations gained new vigor after elections this summer.
Nearly six months later, the country has not put together a federal government. While investors brushed off such problems in the past, as in Italy, they seized on the uncertainty this week and drove Belgium’s borrowing costs to a 10-year high.
“Politicians are playing with fire,” said Steven Vanneste, an economic adviser at BNP Paribas Fortis. “They can only blame themselves because they voiced the option of breaking up the country.”
Faced with the prospect of market contagion, however, politicians may quickly become pragmatic and form a new government within a month, he said.
A month might be rapid in political terms, but it can be an eternity for fast-moving financial markets. The lingering power vacuum increases uncertainty about how Belgium’s debt load — nearly 100 percent of gross domestic product — would be divided between the French and Flemish populations and repaid to investors. As long as the uncertainty persists, Belgium’s borrowing costs could rise again.
Panic about Belgium’s finances would seem illogical, since the country has the wherewithal to repay debt: It has kept a current-account surplus for the last 25 years and has a healthy private sector, a high savings rate and a wealthy population. It enjoys a close trade relationship with Germany, helping to fuel exports, and employment is rising. Growth is expected to be 2.1 percent this year before and 1.7 percent in 2011, above the euro zone average.
Belgium also has a large banking sector that was bailed out by the government in 2008 amid a crisis, and whose assets represent about 340 percent of G.D.P. Banks like Dexia and KBC are the biggest holders in the Benelux countries of debt in Portugal, Italy, Ireland, Greece and Spain, but they have taken steps to reduce their exposure.
Still, “the market is looking at every country, and the moment there is some weakness, they’re attacking it,” Mr. Vanneste said.
In the end, analysts said, Italy’s problems are probably bigger than Belgium’s — and so are the stakes should markets decide those problems are unsolvable.
“Italy cannot fail — that would be the end of the euro zone,” said Daniel Gros, the head of the Center for European Policy Studies in Brussels. “Everything and anything that would be needed to save Italy would be done.”
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