Is Italy heading for disaster?

The very narrow election victory by Romano Prodi's centre-left alliance was a "disaster for Italy and is a threat to the future of the euro", says William Rees-Mogg in The Times. Italy is now in the economic condition "that normally preceded devaluation of the lira" in the years before it joined the euro.

So expect international investors to "start taking speculative bets on Italy's euro membership within the lifetime of a Prodi government", says Wolfgang Munchau in the FT. Italian withdrawal from the euro "is equivalent to sovereign default". That ought to mean that Italian bonds yield significantly more than their European counterparts in return for the risk that Italy defaults on repaying them.

Indeed, the spread between German and Italian ten-year bonds has already jumped from 20 to 31 basis points, says Ambrose Evans-Pritchard in The Daily Telegraph. And "there's a risk that the spreads could widen further to at least 40 basis points", Marc Ostwald, an economist at Monument Securities, told Evans-Pritchard.

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The gap is already the highest for over 18 months, but it is still too low, suggesting that "the markets do not currently see a high risk of default", says Munchau. But Rome has "squandered the windfall benefits of joining the euro", and unit labour costs have soared over 40% since 1995, so "Italy is now chronically overvalued against the rest of the eurozone, with no way out", says Evans-Pritchard.

The outlook for Prodi's leadership was not improved when ratings agency Standard & Poor's last week threatened to downgrade Italian government bonds. The treasuries are currently rated at AA- (the lowest in the eurozone; Germany's is Aaa), but S&P said this rating "could be lowered this year" unless the new government took "urgent" measures to tackle Italy's financial crisis: the country's growth is stagnant, and its competitiveness is declining rapidly.

Painting an even darker picture, Bernard Connolly, a strategist at AIG and former head of economic research at the European Commission told Evans-Pritchard that Italy was now in a worse state than Argentina in the late 1990s before it was forced off the dollar peg. Most Italian debt is owned by Italian investors but foreign holders of Italian bonds should be wary: they "would nurse the big losses, since treasury bonds would probably be switched into devalued lire".