Italy downgrade: Will this prompt a mass bailout of Europe

5th October 2011

Moody's lowered Italy's rating three levels to A2 from Aa2 – with a ‘negative outlook'. The action comes after Standard & Poor's downgraded Italy on September 20 for the first time in five years, added the Daily Telegraph. Italy was last cut by Moody's in May 1993.

The moves appeared to have little impact on the markets, as European stock markets rose strongly at the start of Wednesday trading. Bank shares led the increase as the main markets in London, Frankfurt and Paris opened well above 2%.

While this news will provoke further fear among investors, in some ways it only catches up with an economic reality. So those looking for an immediate effect may well be disappointed.

What had led to the most recent downgrade?

Mindful Money blogger Shaun Richards explained on his blog that Italy suffers from long-standing problems and that these had not improved as a result of Eurozone membership.

He says on the blog: "If we go back to the inception of the Euro it was Italy that was always expected to be the problem child. This problem was often expressed by describing Italy as a high debt-low (economic) growth economy which if you think about it had the implication that sooner or later the growth would prove insufficient to support the debt. If Italy was a boat it would be one with a high waterline prone to being swamped by waves.

"The debt problem would be kept under control if the Italian economy could maintain a respectable economic growth rate. But unfortunately headwinds have appeared in this area…These numbers highlight two issues the first being the reduction from relatively healthy levels to rather anaemic ones and the second being that such growth levels will see Italy's already high debt burden rise."

He concluded: "As we stand Italy is producing an output level equivalent to that of 2004 whilst her debt level has grown substantially."

So who's next? "A danger for the Euro zone is that the bail out of Dexia leads to Belgium and France being downgraded and as they are considered "core" countries that will raise the stakes another notch," says Shaun.

Does this mean a mass bailout for the banks is on the cards?

A report Financial Times (paywall) says: "European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the regions banks."

Shaun comments: "A co-ordinated bank rescue sounded like the Cavalry charging to the rescue and offset for a moment the fear engendered by the descent of the Franco/Belgian bank Dexia into part nationalisation." However, as ‘the details of the plan are still under discussion', there is an ever more familiar theme – that of politicians putting off making these serious decisions.

BBC economics editor Robert Peston says on his blog: "There are some European regulators and politicians who regard the downgrade of Italy and the woes of the Franco-Belgian bank Dexia as positive events (oh yes) – because they hope that these serious but containable shocks will speed eurozone governments into taking credible, evasive action ahead of more devastating shocks."

Olli Rehn, the European commissioner for economic affairs, told the Financial Times that "capital positions of European banks must be reinforced" and he talked of a "concerted coordinated approach".

Commenters were divided on the correct action to take. John_from_Hendon says: "A mass bail out is the WRONG thing to do, unless the bailed out NEW bank is separated from the existing toxic bank."

hughesz adds: "Question is what can they do? The issue is all about trust .The Greek government did not do, what it agreed to do. If a private company did the same , it would be put into receivership. The solution can only be the partial dismantling of the Euro. I don't believe there is sufficient organisations / countries willing to lend the money."

The problem for Europe, says David Scammell, Head of European & UK Interest Rate Strategies at Schroders, is lack of growth – and it is this that needs to be addressed.

He says: "There doesn't seem to be an end in sight…people say what are the policymakers doing and how will they get us out of this?

"The markets want to know where the answer is coming from…We expect some soothing comments and that they are thinking of making the EFSF (European Financial Stability Fund) larger but in a way that's not going to appease the markets as their concern is lack of growth, and this is killing the answers in Europe."

More from Mindful Money:

Greece: What does a default look like?

How Eurozone Instability affects Global Investors

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