Italy's Woes Weigh on Europe

Prime Minister Resists Calls for New Measures, Anxiety Spreads Across Continent

By STACY MEICHTRY, CHARLES FORELLE and DAVID ENRICH

ROME—Italian Prime Minister Silvio Berlusconi resisted calls for a swift economic overhaul, heightening worries that the world's eighth-largest economy is sliding into the sort of debt distress that has laid low its smaller European neighbors.

Instead, Mr. Berlusconi blamed global market turbulence for the current spotlight on Italy. Meanwhile, José Manuel Barroso, the president of the European Commission, the European Union's executive arm, released a blistering statement calling the weakening bond prices of Spain and Italy "a cause of deep concern" and urging governments to signal "resolve to address the sovereign debt crisis with the means commensurate with the gravity of the situation."

Meanwhile, Japan and Switzerland took action to hold down the rise of their currencies, where investors for months have been seeking refuge from financial-market turmoil. Tokyo intervened Thursday morning in markets to stem the rise of the yen against the dollar, hoping to preserve modest economic growth that is threatened by a soaring currency undermining exporters. On Wednesday, the Swiss National Bank cut interest rates to nearly zero and pledged to pump billions of newly minted francs into markets, calling its currency "massively overvalued."

Just two weeks after Europe's leaders agreed to a long-awaited second bailout for Greece—considered the Continent's sick man for more than a year—investors are now turning their attention to Italy, the euro-zone's third-largest economy. Italy's debt as a proportion of economic output is second only to Greece's in Europe, and has been plagued by slow growth for more than a decade.

By the end of trading on Wednesday, the yield on 10-year Italian bonds stood at 6.07%. That makes it more expensive for Italy to borrow money, with investors demanding a premium of 3.66 percentage points over benchmark German bonds. Borrowing costs in Spain—long considered the next most vulnerable euro-zone economy after Greece, Portugal and Ireland, which have already received official bailouts—also continued to rise, with the yield on 10-year Spanish bonds closing at 6.23%.

Making things worse are signs that even Europe's stronger economies—Germany, France and the Netherlands—might be headed for a bout of weakness. After expanding at an annualized pace of more than 3% in the first quarter, the euro zone is estimated to have grown at less than half that in the second. Purchasing-manager reports for July suggest euro-area manufacturing was broadly flat to start the third quarter.

Even Germany's manufacturing purchasing managers' index fell to a two-year low last month. That is far from double-dip territory, but it means Europe's largest economy will have to grow well above historic norms to keep the euro bloc chugging along.

Lower growth makes it harder for heavily indebted economies to escape their debt burdens.

Hints that the weakness is starting to affect the euro zone's hitherto stronger economies will heighten the dilemma facing the European Central Bank, which holds a regular meeting Thursday and has begun tightening policy to make sure it keeps inflation in check.

Many had hoped Mr. Berlusconi would show more resolve on Wednesday in his speech to Parliament. Economists and investors have called on the Italian government to show new efforts to revive growth, which is hampered by tight labor laws, high taxes and crippling bureaucracy.

Over the past few days, Italian business leaders had called for a further strengthening of a €40 billion ($57 billion) deficit-busting plan that Parliament approved two weeks ago. Taking a strong stand, some said, would also appease market concerns over the cohesion of the Italian government, which has been put into doubt over reports that Finance Minister Giulio Tremonti might resign—something he has so far denied.

"We have a huge problem of credibility in the country. We need leadership capable of restoring cohesion," Sergio Marchionne, chief executive of Fiat SpA and Chrysler LLC, said in an interview with Italian news agency ANSA before the premier's speech.

Mr. Berlusconi said the rise in Italy's borrowing costs was due to market tensions related to the drawn-out debt talks in Washington, and said markets were failing to consider the high level of savings among Italian families and the strength of local banks, which he said had weathered the financial crisis better than their European peers.

"As often happens in a crisis of confidence, the markets are not correctly valuing the merit of our credit," Mr. Berlusconi said. "Our economy is healthy. The country is economically and financially solid."

The address "did not contain anything specific to turn market sentiment decisively," said Fabio Fois, an analyst with Barclay's Capital. "The government should reopen the reform agenda, as markets have been increasingly focused on the prospects of the real economy."

One reason Italy, which for months had been shielded from the debt crisis, has taken center stage is that it is generally considered too large for the rest of Europe to bail out.

Already, the means for future bailouts are in doubt. The euro zone has for months planned to expand its main rescue fund to €440 billion in lending capacity from around €250 billion, but that measure requires ratification by national parliaments—unlikely before fall. An agreement in July by national leaders to imbue the fund with new powers to intervene and to lend to countries not at the brink of bankruptcy hasn't been put into action either.

At €250 billion—and already committed to bailouts of Greece, Ireland and Portugal—the fund isn't big enough to handle a bailout of Spain for any significant length of time. Even at €440 billion, it isn't enough for both Italy and Spain.

That has led some euro-zone governments to begin discussing a new strategy, according to a senior euro-zone official: Instead of phasing out the current bailout fund in mid-2013 and replacing it with a new fund, as has been planned, keep both funds in place.

The new bailout fund is slated to have a capacity of €500 billion, so the two together would total nearly €1 trillion. Subtracting about €200 billion committed to Greece, Portugal and Ireland would leave more than €700 billion should Italy and Spain need help.

The idea is still in preliminary discussions among just a few governments, and it is far from clear whether crucial players like Germany and the Netherlands would agree. Both have resisted committing more money to the emergency funds.

Concerns about public finances are rubbing off on the Continent's banks. Italian lenders, for example, have been among the most prolific buyers of the country's sovereign debt in recent years.

While Italy's largest banks have major international operations, their fortunes are deeply entwined with those of their home country. At the end of last year, for example, the five biggest Italian banks were holding a combined €1.3 trillion of loans and securities tied to Italian individuals and institutions, according to stress-test data.

Signs of a cash crunch in some corners of the European bank market have increased in recent months. One sign: Banks and corporations in Europe have shortened the terms over which they can borrow, bankers and analysts said.

At the same time, leading Italian banks have seen their shares plunge, while the cost of buying insurance to protect against them defaulting on their debts has soared to record levels over the past month. That is likely to make it more expensive for the banks to borrow funds via the capital markets, as investors demand higher yields in exchange for taking on what appear to be greater risks.

The higher borrowing costs for banks are already having an impact. UniCredit executives said Wednesday that if those costs remain at their current elevated levels, the bank will start charging customers higher interest rates on loans.

By restricting the availability of credit, such moves have the potential to further dent the already fragile economy.

While the attention Wednesday was on Italy, tensions in Spain aren't abating. Prime Minister José Luis Rodríguez Zapatero interrupted his scheduled vacation for a second day, calling political leaders and meeting government ministers to analyze the "latest movements in financial markets," his office said. The government also said it planned to hold two cabinet meetings later this month to approve further economic changes.

—Matthew Dalton

and Jonathan House

contributed to this article.

Write to Stacy Meichtry at stacy.meichtry@wsj.com and Christopher Emsden atchris.emsden@dowjones.com