The plunge in Italian markets overshadowed policy makers'efforts to fix Greek finances as the euro-region's debt crisisinfected Europe's largest borrower.

Italian bonds fell for a seventh day and the nation's borrowingcosts jumped by more than half at an auction of 6.75 billion euros($9.4 billion) of bills today. Stocks pared declines after fallingto a two-year low. Warnings by Moody's Investors Service andStandard & Poor's over Italy's ability to trim debt, coupledwith infighting in Silvio Berlusconi's government over abudget-cutting plan, fueled the sell-off.

“Italy coming under severe market pressure, being thethird-largest economy and a founding member of the EU, signals thatthe sovereign and banking crisis has reached a deeply systemicphase,” Vladimir Pillonca, an economist at Societe Generale SA inLondon, wrote in a note to investors today.

The rout in Italy underscored Europe's inability to contain thecrisis that began in Greece in October 2009 and led to bailouts inIreland and Portugal. Finance ministers last night failed to agreeon how to share with creditors the cost of a second bailout forGreece to be financed primarily by its European Union allies,including Italy.

The policy makers pledged to complete “soon” the Greek aidblueprint, without giving more details. The meeting in Brusselsdidn't discuss Italy, though the ministers were aware the countryis now the “focus” of financial markets, Luxembourg's Jean-ClaudeJuncker said at a press conference late yesterday.

Acknowledging Contagion
“Europe needs torecognize it's no longer a crisis of small sovereigns in the euroarea,” Jacques Cailloux, chief European economist at Royal Bank ofScotland Plc said in an interview yesterday with Maryam Nemazee onBloomberg Television's “The Pulse” “It is becoming a euro-area widecrisis and European policy makers have struggled to accept that forsome time.”

The yield on 10-year Italian bonds rose 7 basis points to 5.76percent, after reaching 5.96 percent earlier, the highest since1997. The yield premium investors demand to hold the debt overGerman bunds to a euro-era reached a euro-era record 348 basispoints, before narrowing to 311.

Bill Auction
The jump in bond yieldstranslated into a surge in the country's borrowing costs today,when Italy priced 6.75 billion euros of 1-year bills to yield 3.67percent, compared with 2.147 percent at the previous sale a monthago. The Treasury is due to sell 5 billion euros of bonds on July14.

Italy's bonds have suffered more than debt of Spain, consideredthe euro-region's next-weakest link after the three bailed-outcountries. The premium to hold Spanish debt over Italian bondsnarrowing to as low as 30 basis points, the least since November2010.

Trading in shares of UniCredit SpA, Italy's biggest bank, had tobe suspended limit down after the stock plunged more than 7percent, pushing the benchmark FTSE MIB index down as much as 4.8percent. UniCredit, one of the biggest holders of Italian bonds,pared losses and advanced 4.5 percent to 1.206 euros as of 11:40a.m. in Milan. Even with the rebound, UniCredit has fallen by 22percent this month, shedding about 9 billion euros in marketvalue.

Tremonti Leaves
Italian Finance MinisterGiulio Tremonti left the Brussels meeting early to return to Rometo prepare to present his 40 billion-euro budget-adjustment packageto Parliament. The plan seeks to eliminate the deficit in 2014.Neither he nor Berlusconi has commented publicly on the Italiansell-off.

The bulk of the measures won't be taken until 2013, when generalelections are due. Market turmoil has been stoked by investorconcern about the plan's implementation and tensions over the cutsbetween Berlusconi and Tremonti, including speculation that theminister may resign.

“The recently announced fiscal adjustment profile is heavilyback-loaded to 2013-2014, by which point the plan may be diluted.Besides, the general elections are scheduled for 2013, furtherthreatening the plan's credibility,” Pillonca said. “The politicalsituation remains fragile. The rift between Finance MinisterTremonti and Berlusconi reinforces the political uncertainty.”

The market sell-off spurred opposition leaders to offer quickpassage of the plan, vowing to present few amendments that wouldslow a vote. Italy's Senate may approve the plan on July 14 withthe Chamber of Deputies voting three days later, Anna Finocchiaro,head of the Senate delegation of the main opposition DemocraticParty, told news agency Radiocor today.

'Disaster'
Italian bond yields are nearing“disaster,” according to Gary Jenkins, head of fixed-income atEvolution Securities Ltd. Greece, Ireland and Portugal all soughtinternational assistance after their 10-year yields rose past 7percent.

Italy has more than 500 billion euros of bonds maturing in thenext three years. That's about twice as much as the 256 billioneuros extended to Greece, Ireland and Portugal in their three-yearaid programs.

At almost 120 percent of gross domestic product, Italy's debt isthe EU's second largest by that measure after Greece. Its 1.8trillion euros of borrowing in nominal terms is more than thecombined debt of Greece, Spain, Portugal and Ireland.

Borrowing Costs
The surge in Italy's bondyields, if sustained, will increase financing cost, which thegovernment estimates will total about 75 billion euros this year,or almost 5 percent of GDP. That figure is expected to rise to 85billion euros by 2014.

Jefferies International Ltd. estimates that if the averageinterest rate on the debt rises to 6 percent over that periodrather than the 5 percent forecast, financing costs will jump byanother 35 billion euros.

Average financing costs of 5.5 percent means Italy would need aprimary surplus of at least 3 percent to stabilize debt at around120 percent of GDP, a level Italy won't reach until 2015, Pilloncaestimates.

Until this month, Italy had avoided the worst of the debt crisisfallout. Tremonti's fiscal rigor helped trim the budget deficit to4.6 percent of GDP last year, less than half the shortfalls inGreece, Spain and Ireland. The country dodged the real-estatebubble that devastated the Irish and Spanish economies. More thanhalf its bonds are held domestically, which with the low level ofhousehold debt, was seen as underpinning demand and shielding Italyfrom some of the turbulence in international markets.

'Better Shape'
“Italy is still in bettershape,” Michael Spence, a Nobel-winning economist, told Ken Prewittand Tom Keene on Bloomberg Radio's “Bloomberg Surveillance”yesterday. “It has a high amount of debt, but it has a high savingsin the private sector, and frankly I think it can manage its waythrough this unless there is a huge attack on the euro and risksspreads go way up.”

Confidence in Italy has eroded after both Moody's and S&P inthe past month said they were reviewing their ratings. Thecountry's anemic growth will make it difficult to tame the debteven if the government achieves its goal of balancing the budget in2014, they said. Moody's last cut Italy's rating in 1993. S&Phas an A+ rating and last cut in October 2006.

Italy's economy expanded an average 0.2 percent annually from2001 to 2010, compared with 1.1 percent in the euro area. Growthwas 0.1 percent in the first quarter, a fraction of the 0.8 percentfor the euro region.

Bloomberg News

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