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Economics

Bond holders put the boot into Italy

Italy

Italy is going to have to take drastic and immediate measures to cut spending, as bond yields, or interest rates, rise to unsustainable levels.

I’ll try to keep this as simple as possible. Italian 10 year bond yields rose overnight to record levels, to above 7 per cent, a rate seen as unsustainable. When Portugal and Ireland reached that level, they needed a bailout from the European Union.

When an investor buys a government bond, they’re lending money to a government, for a certain time and interest rate. After that agreed time, the bond matures, and the government pays back the loan amount and the interest owing.

But what’s happened is, that now Italy’s economy is being seen as more risky, the interest rate has surged. There needs to be an incentive for an investor to lend money to someone, or Italy in this case. That incentive is the interest rate, and if it’s perceived as a risky investment, then naturally, the interest rate is generally higher. So for Italy it’s become more expensive for it to borrow money. The problem is, that there’s fewer investors out there willing to take that risk. The way the interest rate, or bond yield, is calculated is a complex one, but that’s the very basics of what you need to know.

What’s concerning is that these yields rose, despite reassurances from Italian Prime Minister, Silvio Berlusconi that he’ll resign after a vote on economic reforms passes the measures. But this latest development either suggests many believe Berlusconi’s word doesn’t mean anything, or, even if he does step down, there’s a lot more that needs to be done.

Italy has more than $2trillion of debt accounting for nearly a quarter of all euro-zone public debt.

The recently expanded European Financial Stability Facility, or bailout fund, isn’t big enough to help Italy out.

So, the country needs to act. It can survive a short-term spike in borrowing costs, but not if bond yields remain above 7 per cent for a protracted period.

Government jobs will need to go, salaries will need to be sliced, and government spending pulled back to sure up its finances. That’ll hopefully reduce the borrowing risk to Italy, keeping both investors and Italy happy.

MEMO

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