What Lies Ahead for the Euro?

Would Italy be where it is today had Berlusconi planned its public finances as well as he planned his private events?

ECB building in Frankfurt, Germany. (Photo: AP) ECB building in Frankfurt, Germany. (Photo: AP)

Masked behind the sweeping hills of Tuscany and Rome’s romantic Via Veneto is a debt crisis that Italy can’t seem to shake.

Adding to Italy’s plight of over indebtedness are rising borrowing costs. The yield on 10-year Italian bonds now hovers around 7%, which is the same level that pushed Greece, Portugal, and Ireland to seek financial bailouts.

In November, the yield on 10-year Italian bonds spiked to a record of 7.48%, despite the European Central Bank's plan to backstop Italian bonds.

What’s going on? Simply put, the credit market is penalizing Italy with higher borrowing costs to compensate for rising credit risk.

How will this impact the euro and where will the next big move be?

An Important Component

Unlike Greece or Portugal, Italy plays a key role in the euro’s survival or demise. Italy has the third largest economy but it also has the dubious title of the second most indebted eurozone country, after Greece. Around 53 billion euros in Italian debt must be repaid in the first quarter of 2012. 

The plan to dig Italy out of its 1.9 trillion euro sinkhole has angered its citizens. Reductions in pension benefits and tax increases are seen as the solution by politicians. But unfortunately, upset citizens aren’t a good formula for economic productivity.

The Italian government projects 0.6% economic growth in 2011 and a 0.4% pullback in 2012. Tax hikes and pension reform are pushing Italy deeper into recession.

One Politician Later

For most of the year, Silvio Berlusconi ran the show in Italy. He kept promising his eurozone comrades that Italy’s debt spiral was not out of control.

Although none of that was true, he became Italy’s longest serving post-war prime minister, serving for 17 years. And with a net worth in the vicinity of $6.2 billion, he is one of Italy’s richest men.

The public spotlight isn’t the only place Berlusconi made a name for himself.

A British investigation linked more than 100,000 wiretaps of detailed conversations between Berlusconi and a businessman by the name of Giampaolo Tarantini. The taps showed how Tarantini paid for and arranged plane tickets for women to attend “parties” hosted by Berlusconi at his homes in Rome, Milan, and Sardinia.

Would Italy be where it is today had Berlusconi planned its public finances as well as he planned his private events? We can only wonder.

As it runs out, bond investors that bought into Italy’s fairyland stories of happily ever after got suckered. (See MF Global and Jon Corzine.) Berlusconi resigned in November 2011, leaving Italy’s financial mess in the hands of Mario Monti.

Rescue Fund Needs Rescuing

Illustrating Italy’s deep problems along with the rest of Europe, is a bailout rescue fund that itself may need a bailout. The European Financial Stability Facility’s (EFSF) was established to give countries that run into liquidity problems, emergency cash. Yet, the ability of the EFSF to help troubled countries like Italy is being undermined because the emergency fund’s very backers have been swept into the crisis.

France’s credit outlook was just lowered by Fitch Ratings last week. The country is among the six EFSF sponsors with a top credit rating that is at risk of being cut. Both Moody’s Investor Service and S&P have issued similar warnings, saying that eurozone governments face possible credit downgrades.

A credit downgrade for the backers of EFSF would mean a downgrade for the EFSF itself. As of today, the EFSF has guarantees of 726 billion euros from eurozone governments.

Conclusion

In the middle of the year, here’s what ETFguide’s ETF Picks said about the eurozone region:

“Europe’s crisis is the same story it’s always been – financial contagion. Clear evidence is Germany’s disappointing second quarter GDP figures of just 0.1%, which badly missed expectations of 0.5% growth.

As the Union’s strongest economic member, Germany is experiencing decelerating growth because of the region’s crisis. Also, its association with weak members is making itself weak.

Here’s an analogy that drives home the point: Putting clean clothes into a pile of dirty laundry doesn’t make the rest of the clothing suddenly clean. The myth of "there's power in numbers" never looked so wrong.”

The January 2012 ETF Profit Strategy Newsletter highlights a short list of mega investment themes, which include the euro and the ETF trades to make the most of the opportunity at hand.

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