Will Italy go bust- or get kicked out of the euro?

The European Central Bank looks to be facing a ticking time bomb as the cost of Italian debt shot through the roof yesterday.Will Italy go bust- or get kicked out of the euro?This left markets in free fall with the Dow Jones in particular dropping 3.2% leaving the eurozone facing its biggest economic ‘problem child’ to date.

On paper Italy looks too big to rescue yet is too big to fail.

The Italian’s have nearly €2 trillion in debt and is the third largest country in the eurozone and therefore it cannot be as easily dealt with as Greece.

Italy is required to raise €19 billion every month to meet its budget deficit and bond redemptions and with a continued increase in yields (hitting close to 7.5% for 10 year bonds) borrowing costs are rising sharply and fast becoming unsustainable.

Higher collateral haircuts on Italian debt are adding to the pressure.

Even though Italian PM Silvio Berlusconi has promised to step down following votes on austerity measures this may not lead to a sharp exit as this may not take place for weeks.

Furthermore, Berlusconi may try to re-obtain power after stepping down, which effectively brings us back to square one.

Meanwhile the prospect of Italy becoming the next country to need to a bailout will intensify.

This could lead to liquidity issues with only around €270 billion left in the EFSF bailout fund and the mechanics of how the fund will be leveraged to a planned €1 trillion is still uncertain.

This has lead to press reports that the major power houses of Germany and France have started talks to break up the eurozone due to worries that Italy will be too big to rescue will only add to a downward spiral on this story.

Under the spotlight today will be the 12 month auction of €5 billion in Italy.

Back in October the 12 month auction were sold at an average yield of 3.57% however this time we could see this rise above 6%.

What is most concerning is that it appears that even with the ECB buying Italian debt it has been insufficient to prevent yield rising.

In any case, given the ECB’s lack of enthusiasm to become the last resort lender to European peripherals, any further support from this direction will be limited.

Based on this the single European currency looks highly susceptible to further losses and we could see the EUR/USD drop through 1.35.

Leave a Reply