The Fifth Member of the Bailoutstreet Boys: Italy?

Greece, Ireland, Portugal, Spain… You’d think that after bailing out FOUR countries, Europe’s problems would finally be put to rest. But apparently, that isn’t the case! Introducing the potential fifth member of the Bailoutstreet Boys: Italy.

Italy, the third largest economy in the euro zone, could end up defaulting on its sovereign debt within the next 12 months if it doesn’t get bailed out. Though Italy’s economy is in a better state than Spain’s, debt contagion from Spain could pull Italy back into the deep end of the European debt crisis.

Recently, Italian bond yields have been on the rise, and it appears as though Italy’s strong ties with Spain are to blame. Spanish and Italian bond yields have always had a strong correlation, but in recent months, it has increased to between 0.7 and 0.9. This suggests that Spain’s high borrowing costs may be spilling over into Italy!

Just a few days ago, I discussed how Spanish 10-year bond yields rose to a new euro-era high of 7.29% just as Italian 10-year bond yields hit a new 5-month high at 6.34%. If this continues, it could lead to higher interest payments for Italy, making it that much harder for the country to make a dent in its huge accumulation of debt.

Fortunately, European finance officials have been working overtime to keep contagion from spreading. A couple of days ago, it was reported that German Chancellor Angela Merkel was open to using bailout funds to buy bonds of debt-stricken nations.

The plan, which was conveniently proposed by Italy, would give the EFSF and ESM the ability to buy up Italian bonds and bring down borrowing costs.

The European Financial Stability Facility (EFSF) has a lending power of approximately 350 billion EUR while the European Stability Mechanism (ESM) has a firepower of around 500 billion EUR. Strictly speaking, the new plan isn’t a bailout, as money isn’t given to them outright.

In any case, the purpose of the plan is simple: it allows Italy to have a reliable source of funds to stabilize borrowing costs in case it needs it.

Implications on the euro

German Chancellor Angela Merkel had long been against using the euro zone’s rescue funds to lend directly to troubled countries. She, along with her colleagues, is scared that Germany will end up paying for everything and that rescued countries will not adhere to lending conditions.

However, it seems that Merkel is starting to realize that letting a euro zone country fail has too many negative effects not only to Germany and euro zone but for the rest of the world as well. The 180-degree turn of Merkel’s stance seems to suggest that if worse comes to worst, the more stable and richer countries in the euro zone will stand behind the weaker ones. In some twisted way, this is a good thing for the euro bulls.

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