Italy and Belgium face crisis

But even as concern mounts that Portugal and possibly Spain may seek financial aid after Greece and Ireland requested bailouts, investors have started asking whether those two economies may be the next weak links in Europe’s monetary union, the euro.

Italy and Belgium have a lot in common: both are less dependent on foreign creditors than Greece or Ireland. But each is plagued by severe political dysfunction, which has raised questions about whether they can ever repay a mountain of debt, respectively the second- and third-heaviest loads in the European monetary union after Greece. Both countries have long histories of debt and political problems that contributed to economic downturns in the past. But no one seemed to pay attention during the current crisis until this week, when investors, transfixed by debt fears in other countries, drove borrowing costs in Italy and Belgium to near record highs.

While few currently think these two countries have a high risk of defaulting, the spotlight could turn back to Belgium and glare harshest on Italy, the third-largest euro zone economy after Germany and France, if neither can muster the political cohesion needed to assure financial markets that they can reduce their debt.

Italy has done a better job than Greece in keeping its fiscal house in order during the debt crisis. The Italian finance minister, Giulio Tremonti, prudently cut government spending and overhauled its expensive pensions system with the blessing of Prime Minister Silvio Berlusconi’s government. The nation’s current-account balance is modest, and it enjoys high household and corporate savings.

Government-issued debt is split almost evenly between foreign investors and Italians, who snap up the offerings to augment their savings. Italian banks, unlike Ireland’s, are relatively sound and did not need a bailout.

But Italy has traditionally depended on state borrowing, even as its efforts through the years to improve growth have stumbled.  Having joined the euro zone, Italy, like Belgium, is no longer free to devalue its currency to revive growth.

While Italy’s debt did not balloon overnight, it stands at about 118 per cent of economic output, second only to Greece in the euro zone. And despite modest growth during the crisis, the Italian economy is not expanding quickly enough to cover its costs, including those of caring for the pensions and health care of an aging population. Said Milan’s Catholic University political economy professor Giacomo Vaciago, “With a deficit of 5 per cent of GDP, and growth of 1 per cent, the fear is that you will never reverse your budget balance, and therefore the common judgment is that sooner or later Italy could default.”

The worries are compounded by a continuing political crisis that will come to a head in a few weeks for Berlusconi, whose staying power may be tested following a series of sex scandals. Fractured politics has also undermined the tiny nation of Belgium, where decades-long efforts to break the country into separate French and Flemish-speaking nations gained new vigor after elections this summer.  Investors seized on the uncertainty this week and drove Belgium’s borrowing costs to a 10-year high.
A month might be rapid in political terms, but it can be an eternity for fast-moving financial markets. The lingering power vacuum increases uncertainty about how Belgium’s debt load — nearly 100 per cent of gross domestic product — would be divided between the French and Flemish populations and repaid to investors. As long as the uncertainty persists, Belgium’s borrowing costs could rise again.

Panic about Belgium’s finances would seem illogical, since the country has the wherewithal to repay debt: It has kept a current-account surplus for the last 25 years and has a healthy private sector, a high savings rate and a wealthy population. It enjoys a close trade relationship with Germany, helping to fuel exports, and employment is rising. Growth is expected to be 2.1 per cent this year before and 1.7 per cent in 2011, above the euro zone average.

Belgium also has a large banking sector that was bailed out by the government in 2008 amid a crisis, and whose assets represent about 340 per cent of GDP.
In the end, analysts said, Italy’s problems are probably bigger than Belgium’s — and so are the stakes should markets decide those problems are unsolvable.

“Italy cannot fail — that would be the end of the euro zone,” said Brussels-based Centre for European Policy Studies head Daniel Gros. “Everything and anything that would be needed to save Italy would be done.”