European Debt Crisis: Could Italy Be Next?

European leaders are worried a Greek default would ripple throughout the Eurozone.

By + More

This European sovereign-debt crisis is back and bigger than ever. Greece is once again on the ropes, and the members of the European Union are worried that a default on its debt could spread throughout the Eurozone. Last summer, Greece and Ireland were both forced to take bailouts, and for a while it seemed a crisis wasn't imminent. Then, earlier this summer, Portugal was forced to take a bailout. Now European leaders seem to have come to the realization that Greek bond holders will have to accept loss of principal on their investment. And contagion—which could happen if one faltering country causes the crisis to spread—has become the main concern for members of the so-called PIIGS countries, which include Portugal, Ireland, Italy, Greece, and Spain. For the moment, the spotlight is shining brightest on Italy.

"It's all a confidence game," says Michael Mata, comanager of the ING Global Bond Fund (symbol INGBX). "As long as someone is willing to buy your debt, everything is fine. In Italy, two weeks ago, everything was fine. Now, it's not." This week, borrowing costs have risen sharply for the Italian government on fears that it is saddled with too much debt.

[See 50 Best Funds for the Everyday Investor.]

The latest fear in Europe is that the sovereign-debt crisis could spread to two of the largest but weakest economies in the EU. Because Italy is the third-largest economy in Europe, it is attracting most of the attention. "Italy is the worst-case scenario," says Dimitre Genov, manager of the Artio Global Equity Fund (BJGQX). It also has the world's third-largest bond market, behind the United States and Japan. Italy's debt, at about 120 percent of GDP, is second to only Greece among members of the EU. However, most of Italy's debt is held within the country by domestic savers, so there isn't as much pressure from foreign investors who may otherwise sell in huge numbers.

Italy's problem? "They have no growth, and they haven't had any growth for over a decade," Mata says. As interest rates rise on Italy's sovereign debt—or government bonds—it becomes harder to finance. The International Monetary Fund expects the Italian economy to grow by a measly 1 percent this year, and 1.3 percent in 2012.

[See Why Europe's Debt Crisis Will Keep Coming Back.]

Like Italy, Spain hasn't been forced to take bailout money. It, too, has a fairly large economy, the fourth largest in Europe behind Italy. Earlier this week, the yields of Spain's 10-year government bonds rose above 6 percent, a level experts say isn't sustainable over the long term. Anemic growth is expected in Spain as well: 0.8 percent in 2011 and 1.6 percent in 2012, projects the IMF.

Meanwhile, the outlook for the smaller, so-called peripheral countries of Greece, Portugal, and Ireland has also worsened. In recent weeks, these countries have received a litany of downgrades from ratings agencies. Greece now carries the world's worst credit rating, and experts say some type of default or restructuring of the debt is inevitable. Over the past week, Moody's Investors Service has downgraded both Portuguese and Irish debt to junk status, noting that both countries may need a second bailout. Whether the peripheral countries make noticeable progress in trimming their deficits will be important for the future of the Euro and the EU. "The Europeans need to keep the situation contained within the three smaller countries," says Geoffrey Pazzanese, comanager of the Federated InterContinental Fund (RIMAX). "It can't spread to Spain and Italy."

[See Why Small Businesses Aren't Fueling Job Creation in This Recovery.]

For now, Genov says it's important that any type of restructuring or default is handled in a controlled fashion. "Now it's crunch time," Genov says. "Hopefully there are no disorderly defaults like we saw with some investment banks here in the United States."

Twitter: @benbaden