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And so the contagion spreads

Italy has become the latest country to have its sovereign debt rating cut. Standard and Poor’s (S&P), the debt rating agency, has reduced Italy’s rating down one level from A+ to A. The debt rating is meant to give a signal as to how reliable the country will be in repaying its debt.

There is a real prospect of a domino effect bringing the eurozone down.

Italy has a debt to GDP ratio of 120% and has recently passed an austerity budget. However, S&P is worried that this will not give Italy the savings the government is looking for, especially after the company downgraded its forecast for Italian growth to 0.7% between 2011 and 2014.

S&P said: “We believe the reduced pace of Italy’s economic activity to date will make the government’s revised fiscal targets difficult to achieve. Furthermore, what we view as the Italian government’s tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy’s economic challenges.”

Already this year, Spain, the Republic of Ireland, Greece, Portugal and Cyprus have had their credit ratings downgraded. But why has this action had such repercussions on the eurozone?

The main reason is fear of contagion. Already Greece is seen as being a ‘basket case’ and if continued, concerted, massive help is not given, it is likely Greece will have to pull out of the euro and default on its loans. This will have a major impact on many European banks, especially in France and Germany, which are holding Greek debt.

Italy has the second-largest debt level in Europe and so any fears that it may not be able to service this debt causes more panic in the markets. The initial response to S&P’s rating downgrade was that the cost of Italy’s borrowing – its yield on bonds – rose from 5.57% to 5.7%.

This is a vicious circle. The more concern there is that a country will default, the higher the market pushes up the borrowing costs for that country’s debt, and the more difficult it becomes for that country to be able to afford to meet its debt, and the more likely it is that it will default without concerted European help.

Could the eurozone collapse? Marc Lansonneur, of Societe General Private Banking was quoted by the BBC as saying: “If there is no trust in the system, then anything is possible. The less trust you have the more expensive the money is to borrow for European countries and the worse the crisis is. It then starts fuelling itself.”

Is it now time to start thinking the unthinkable?

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Posted in European Union, eurozone

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