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Hiding under the shadow of Greece’s infamous debt situation is another contender set to pull the rug from beneath the euro zone. Italy, the fourth largest heavyweight in the region, came under the spotlight yesterday when Nobel Prize winner Robert Mundell, a.k.a. Godfather of the euro, warned that the heavily indebted nation poses a larger risk to the euro zone.

Let’s look at Greece’s and Italy’s stats, shall we? Currently, Italy owes an eye-popping €1.8 trillion (that’s with a capital T!) in debt, more than SIX times as much as Greece’s €270 billion deficit. The IMF, which estimated that Greece’s debt will swell to 108% of its GDP this year, also forecast that Italy’s debt will balloon to almost 120% of its GDP.

Furthermore, Italy’s shaky fundamental economic background leaves a little to be desired. For one, unlike Germany and France, Italy’s economy has fallen back in the red. The most recent GDP report revealed that Italy’s economy shrank 0.2% during the final quarter of 2009, causing investor confidence to falter. In 2009, Italy’s economy is estimated to have contracted by 4.8%.

The industrial production report for December sang the same dismal tone. For the fourth straight month, the report failed to meet expectations and showed a 0.7% fall. The sharp drop mainly came from a softer energy and equipment production. What happened to all those Ferraris?

Lastly, Italy’s public budget deficit currently stands at 5.3% of the country’s GDP, well above the limit specified by the Stability and Growth pact made in 2002. According to the pact, no government in the euro zone should have a deficit above 3% of GDP and that the national debt should not exceed 60% of the GDP. Tsk tsk, seems like Italy hasn’t performed up to par…

While growing debt is a concern, some suggest that the short-term outlook for Italy is much brighter than that of Greece. After all, Italian banks have long been strict, even before the start of the financial meltdown. Also, unlike the real estate market of fellow PIIGS member Spain, Italy’s did not pop, leaving it fundamentally stronger. It looks like Italy has some Rocky Balboa left in it!

Still, the prospect of a high debt to GDP ratio could present a huge risk down the line. With government spending still rising, it appears that this ratio could continue to rise. Remember, with Italy’s economy playing a much larger role in the euro zone, its impact on the euro zone is much larger than that of Greece. If Italy’s debt continues to grow, we could see the entire euro zone fall flat on its face onto the canvas.

Yesterday, the heavily traded fiber (EURUSD) started to slip when the news regarding Italy’s debt woes hit the airwaves. And why wouldn’t it? As described earlier, Italy’s debt which currently stands at €1.8 trillion takes up about a fourth of the borrowings of the entire euro zone! The less confidence investors have on Italy’s government to finance their debt, the more difficult it will be for the government to clean their financial obligations.

If Italy isn’t able to clean up its act soon, it probably won’t be long before credit rating agencies dole out their downgrades on the nation. And if this whole financial mess, together with the other issues that are currently plaguing the euro zone, is not contained, we may see the whole bloc implode from within. I admit it is a bit far-fetched but if it does happen, we may see the euro slide back to its historical lows at 0.8232! Heck, we might even see the euro get phased out!