Italy on the brink

For global markets, and the global economy, there is a tug of war going on - between fears that the eurozone may yet implode, and hopes that China and the US are to an extent decoupled from the woes of Europe's currency union.

What's been striking is that on mainstream equity markets at least, the hopes have been in the ascendant. Shares across the world have risen well over 10% in general over the past four or five weeks - and are significantly higher even on European markets.

It may be wrong to read too much into this bounce. I am told trading has been relatively thin.

But there has been some good news, drowned out in a news sense perhaps by the confusing cacophony emanating from the eurozone. For example, recent statistics show that the US is further from recession than was widely feared it would be, when the government of the world's biggest economy lost its AAA rating over the summer - although growth is sluggish and unemployment intractably high.

As for China, the economy is slowing, but is some distance from hitting the buffers. That great China fan, Jim O'Neill of Goldman Sachs, wrote over the weekend that if Chinese CPI inflation drops to 5.5/5.6% or so, that would be "comforting to those expecting a 'soft landing'" - although I should point out that China's critics see abundant evidence of an incipient Chinese property crash and banking crisis.

So that's the glass-half-full view of the world - which can even be topped up a bit by this weekend's damping-down of Greece's political conflagration, such that the probability has receded a bit of a messy default on unsustainably huge debts and an explosive Greek exit from the euro

But for investors - and indeed for leaders of the world's most powerful economies - it is the risk of financial crisis in Italy, the eurozone's third largest economy, that is their greatest anxiety.

This morning the cost for the Italian government of borrowing for 10 years has risen to a new euro high of 6.6%, around 4.8 percentage points above what Germany pays.

That is dangerously close to an unaffordable interest rate for a public sector that has debt equivalent to 120% of GDP, well above what economists see as healthy, and which will have to borrow 300bn euros next year alone.

The Italian prime minister, Silvio Berlusconi - who faces an important parliamentary vote on the 2010 budget report tomorrow - insists markets are making the wrong decision about his country's finances.

But when investors demand a certain level of payment for the risks of lending to a country like Italy, history shows it is incredibly difficult to persuade them to accept a lower rate of interest. And here is what matters: Portugal, Ireland and Greece were forced to seek emergency rescues after investors insisted they pay interest rates not much greater than what they're demanding of Italy.

If you want to see Italy on the road to ruin, there's no shortage of signposts - not least of which was the failure by eurozone leaders to increase the firepower of its bailout fund to a size big enough to persuade investors that there is no risk at all of an Italian default, that there's enough money in the kitty to cover whatever Italy may need.

That said, it may well be the behaviour of the European Central Bank that is most unsettling.

On the one hand, the rhetoric of Mr Berlusconi and indeed of most eurozone leaders and officials is that Italy's problem is one of liquidity - the growing challenge of borrowing from nervous investors - not one of fundamental solvency.

Or to put it another way, the official view is that Italy is intrinsically capable of repaying all it owes, that it is capable of recalibrating the balance between public sector and private sector in a way that over time will allow the burden of debt to fall.

But if that were so obviously so, there would surely be far greater purchases of Italian government debt by the European Central Bank, even if it is reluctant (as it is) to play the role of lender of last resort to eurozone governments - because forcing down the interest rates paid by Italy when the eurozone is teetering on the brink of recession and inflation seems to be falling would (on the face of it) be consistent with the ECB's monetary policy mandate.

Or to put it another way, if the ECB and eurozone countries - especially Germany - are not prepared to stand foursquare behind the Italian government, is it any wonder that investors are increasingly reluctant to lend to Italy?

Update 09:58: For one-year loans, the gap between what Italy and Germany pay to borrow is now extraordinarily wide. The implicit interest rate for Italy when borrowing for a year is now 6.3%, 605 basis points (6.05%) over what Germany pays.

Update 12:21: Italy may be raining on Spain: there seems to have been contagion to the Spanish government's borrowing costs, from the surge in what investors are demanding that the Italian government should pay.

To borrow for a year, Spain would have to pay 4.7%, 4.46 percentage points more than Germany, which is another high for the euro era (that's "era" not "area"). Or at least that's the implication of the latest yield on Spain's one-year treasury bills (or loans).

That said, the implicit interest rate for Spain when borrowing for 10 years - the yield on 10-year bonds - hasn't budged much, and is around 5.6%, which is high but still a decent margin less than Italy.

So the European Central Bank may be having more luck propping up the price of Spain's 10-year bonds than it has been having with Italy's (for those who've forgotten, when the price of a bond falls, the yield or implicit interest rate rises).