By Ryan DeCaro, Associate Investment Strategist

December 2, 2011

The problems in Italy have been well documented over the past few months. The debt-laden country is facing its highest borrowing costs in its history amid the recent panic. This has forced the country to make some very tough decisions to restore fiscal responsibility. It has passed a number of austerity measures and has ousted the government leaders that allowed the lax policies to grow to such unsustainable levels. Italy has acknowledged that they need to reign in some of the fiscal policies that contribute to their high debt/GDP level and are making strides to accomplish this goal. As the Eurozone’s third largest GDP producer, it is necessary that they lead by action and curb this contagion before it further affects the world economy.

Italy has been at the center of the European debt crisis for the past two years and has become the prominent news story since Greece received its financial support from the Eurozone and European Central Bank last month. Italy’s problems are not as bad as those in Greece, but the fact that they are such a large contributor to global GDP has many investors nervous. Investors have seemingly forgotten that Italy has historically run its government with a debt/GDP level over 100% and have instead turned their focus to a myriad of “what-if” scenarios. This premature reaction has caused mass selling within the Italian bond market and has driven interest rates on ten-year notes above 7%. In an effort to appease investors, Italy has taken a number of proactive steps to reel in its growing debt. Some of these measures were necessary; like increasing the age in which public employees receive their pension. Others were merely window dressing to convince investors that it was serious about fixing its debt problems. These actions grew increasing necessary as Italy came closer to needing to refinance its debt. Over the next year, Italy will be faced with maturing debt of $723 billion. It would cause tremendous strain on the country if they had to refinance this debt at current interest rates. If they were forced to refinance at the current rates it could cause a 1-2% drag on its overall GDP. Luckily, the ECB has realized that it needs to buy bonds in countries where the general public is unwilling to do so. Italy is currently one of those countries.

The Italian government has a history of great indecision when it comes to government action. The overall attitude of the country is quite relaxed and it usually takes them a lot of time to make a decision. Italy has never been faced with a situation quite like this and was not prepared to act as quickly as the markets would have liked. They have since realized that indecision will only lead to more problems and have made some significant changes to its government and fiscal policies. Interest rates are still running at very high levels as investor wait to see what kind of effect these policy actions will have on the Italian economy.

As mentioned before, from a fundamental standpoint the problems in Italy are not that bad. The country is used to running its operations with high levels of debt and has historically been an important contributor to global GDP. The recent economic crisis has really exacerbated the fiscal issues here and has investors very cautious of every investment they make. While we do not believe the problems are dire, if the markets continue to force interest rates in Italy higher, it could have an effect on firms outside of Europe (i.e. US banks). The direct exposure that U.S. banks have to Italian debt is $47 billion. This is greater than its investment in Greece, Spain, and Ireland combined. Additionally, U.S. banks have indirect exposure in the form of credit default swaps of more than $180 billion. While this is a very large figure, it only amounts to 2% of all assets on the U.S. banks books. Still, any hit that these institutions take is negative.

Moving forward, the European Central Bank will need to increase its level of purchases in Italy to help drive down interest rates and make borrowing costs more palatable. Additionally, it is likely that we will see a flood of foreign investment in European sovereign debt which should further help reduce borrowing costs. The past few years have been a great time for many countries to reflect on its fiscal policies. Many of these countries have realized that it is not sound to run such high deficits and are making the tough decisions to fix these problems. As we move forward, it is likely that we will see more short-term disruptions, but these disruptions are necessary to solidify long-term prosperity.