Worries Mount Over Italy and Spain

The Wall Street Journal

By STACY MEICHTRY in Rome, JONATHAN HOUSE in Madrid and CHARLES FORELLE in Brussels

Government bonds and financial markets in Italy and Spain continued their relentless downward march Tuesday, heightening concern about the potential spread of the euro zone's debt crisis into two of the region's most vulnerable countries.

In Italy, the government shifted into emergency mode on Tuesday, as government-bond yields climbed and the share prices of the Italian banks that hold many of them slid precipitously.

Economy Minister Giulio Tremonti convened a meeting of top Italian officials, who later released a statement noting that Italy has been hit by "tensions stemming from international uncertainty." It added, "The Italian finance and banking system is solid."

Prime Minister Silvio Berlusconi is planning to address Parliament on the economy Wednesday amid calls for more budget cuts, and Mr. Tremonti will be dispatched to Luxembourg for talks with Jean-Claude Juncker, the head of the group of 17 nations that use the euro.

Spanish Prime Minister José Luis Rodríguez Zapatero on Tuesday briefly delayed his departure for a planned vacation to a coastal park in southern Spain "to more closely follow" the country's "economic indicators," his office said. He eventually left.

They didn't appear good. Earlier Tuesday, investors were demanding a premium of four percentage points over benchmark German bonds to lend to Spain for 10 years. The spread for Italy late Tuesday stood above 3½ percentage points—more than double where it was a month ago.

The Spanish spread later receded slightly, but the moves in Spain and Italy make plain that worsening economic indicators in both the U.S. and Europe, as well as the debt crisis, leave little appetite for the bonds of risky countries in the euro zone's south.

That has the potential to cause serious disruption. Both Italy and Spain are running budget deficits, and they need consistent access to fresh financing to cover those gaps and to repay maturing loans. The shutting out of either or both of those countries is a doomsday scenario that European policy makers are loath to contemplate.

A bid by European leaders at a July 21 summit to cordon off Greece, Ireland and Portugal has had little effect. The leaders publicly promised new measures to aid vulnerable countries, but they have taken little concrete action—and some politicians have begun to backtrack on the commitments.

Among the concerns is the heft of the euro zone's bailout fund: Even with promised changes that will increase its ambit and lending capacity, it is far from sufficient to provide support to Italy. And the changes—which would give it more firepower to help Spain—haven't yet materialized.

What's more, many European governments are entering their languid summer hiatus. Gianfranco Fini, speaker of Italy's lower house, recently told a group of reporters he expects Parliament to vote on further "adjustments" to Italy's public spending in the fall.

It isn't clear how long Italy and Spain can sustain borrowing at long-term rates of around 6%, which is roughly where both now stand. Prospects for long-term growth remain well below that level, and investors are unlikely to lend now if they think there is a chance they won't be paid back in the future.

That has raised the urgency of austerity. In Italy, the government only last month approved €40 billion ($57 billion) in budget-cutting measures aimed at calming investor nerves. It didn't work: The bulk of the cuts contained in the measures would take effect in 2013 and 2014—after national elections that could give a new government power to undo them.

Business leaders, unions and investors are now calling on Rome to tee up a new round of measures aimed at addressing the deep structural weaknesses—from a rigid labor market to heavy taxes—that have caused Italy's economy to stagnate for the past decade.

The government has little room to maneuver. Italy's public debt, which is equivalent to 120% of gross domestic product, is among the heaviest in the world.

Analysts are also concerned that Italy could see its access to funding strained in September, when the country is scheduled to auction €61.7 billion in sovereign bonds, more than double the amount of bonds Italy usually auctions in a month—though still only a small fraction of its more than €1.8 trillion in debt.

"Waiting until September is a strategy of suicide," wrote economist Francesco Giavazzi in a front-page editorial Tuesday in Italy's biggest daily, Corriere della Sera.

Italy and Spain's prospects aren't helped by gloomy economic news.

German retail giant Metro AG on Tuesday blamed fragile demand across Western Europe for its disappointing second-quarter profits and a loss at its Media-Saturn consumer electronics unit, echoing the sober outlook of Philips Electronics NV, Hennes & Mauritz AB and other European consumer-goods makers and retailers in recent days.

Siemens AG, BASF AG and other European industrial heavyweights also have warned over the past week of signs that Continent's economic momentum is waning—even in Germany, which has powered much of the euro zone's economic recovery to date.

In an interview with German newspaper Süddeutsche Zeitung, Lars Feld, one of the five "wise men" who advise Germany's government on economic policy, predicted market jitters over the euro zone's debt crisis would return to fever pitch by September. "What started as the debt crisis of individual countries has grown into a serious threat to the currency system," he told the newspaper.

—Vanessa Fuhrmans in Berlin and Santiago Perez in Madrid contributed to this article