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Enemy at the Gates - the debt crisis and Italy

July 15, 2011
The start of the corporate earnings season was overshadowed by signs that the eurozone's debt crisis is spreading to Italy. Continued weakness in the US jobs market and evidence of runaway inflation in China also helped revive global risk aversion. The pressure is increasing Europe to come up with a credible strategy to resolve its peripheral debt problem.

Global stock market rebound stalls, some markets risk falling to new cyclical lows
Most major stock markets failed to break out to new cyclical highs, falling back to their recent consolidation patterns. The S&P 500 index in the US reversed course on Friday just 0.8% short of the April record close at 1,363 points. Germany’s DAX missed the April peak by exactly the same distance. In Asia, indices such as Hong Kong’s Hang Seng and the Hang Seng China Enterprises, which represents mainland China’s stocks, reversed well before moving close to the most recent highs. They began retreating 7% to 8% short of April’s peak levels. Only Japan’s Nikkei 225 managed to climb to a new interim high – but that’s from the depressed level that resulted from the March disasters. Global stock markets appear to remain stuck in the consolidation phase that began in May, with some Asian markets risking a drop to new cyclical lows. But equity indices have nevertheless remained well within the ranges and trend channels that were carved out in recent months, which means that events of the past few days have probably not initiated the end of the underlying global bull market.

Disappointing data from US and China, and selloff in Italy’s government bonds
The failure of the major stock markets to break out to new highs was triggered by a US labor market report on Friday, which showed that job creation in the world’s largest consumer market was weaker than expected for the second consecutive month. In addition, Chinese data released over the weekend showed consumer prices continued to rise by more than expected, reinforcing concern that China will continue to tighten credit policies. The situation worsened on Monday, when Italian government bonds slumped along with debt securities of Spain and other peripheral euro members. These declines contrasted with rallies in government securities of other big economies such as Germany, France, US, or the UK. The fact that Italy’s bond market diverged so intensely from other Group of Seven economies offered a clear warning that euro area’s peripheral debt crisis has reached the currency union’s third biggest economy. 

Peripheral debt crisis knocks on Italy’s and Belgium’s door
Monday’s debt market volatility and divergence came amid reports that European leaders are still far from agreeing on a strategy to overcome the debt crisis. Some reports suggested that European officials are looking into reviving plans that were previously supported by European Central Bank and the European Commission, but opposed by Germany. While the debate about what Europe should do continues to be discussed in the media and many research reports, the main point is that Europe’s debt crisis may have started to infect major European economies. In fact, on Monday, Belgian yields also moved in synch with Irish and the Mediterranean sovereign yields, for example. If the debt crisis were to further significantly undermine confidence in Italy’s debt market, it could also spread to Belgium. Despite the deteriorating situation, Europe’s political and economic authorities have yet to come up with a credible plan to deal with the debt problem. That is rather unhelpful.

Pressure on Europe to stop biding for time is increasing
But there may be a positive element in Monday’s debt market turmoil. The possible infection of Italy, with Belgium beginning to look shaky as a result as well, increases the pressure on European institutions and political leaders to stop biding for time. The moment may be approaching for Europe's currency union to move toward the inevitable, proceed with an orderly debt restructuring for its weakest members, and introduce a central fiscal institution of some sort. The latter would most likely be an institution that will issue common bonds backed by all eurozone members. The alternative scenario of breaking up the euro area appears highly unlikely. For one thing, it is not clear where exactly Europeans should draw the line between the periphery and the core. The exit of very small economies such as Greece may appear to be more feasible, but would not solve Spain’s or Italy’s challenges. As things stand right now, the single biggest obstacle for any quick resolution of the euro’s problem seems to be German reluctance to approve of anything that could infuriate German taxpayers and voters. As events unfold, however, Germany will most probably accept this course as inevitable, in exchange for maximum possible commitment to stricter common rules and continued fiscal consolidation by all euro zone members.