ITALY AT RISK OF CATCHING SPANISH FLU / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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JULY 8, 2011, 8:22 A.M. ET.

Italy at Risk of Catching Spanish Flu .

By RICHARD BARLEY

Which will be the next domino to fall in the euro crisis?


For the last two years, the conventional wisdom has said that Spain is the most vulnerable after Greece, Ireland and Portugal, but investor attention is increasingly focusing on Italy. The gap between Spanish and Italian bond yields has halved this year amid fears that Rome's problems may ultimately prove trickier to address than Madrid's.


The two countries face different challenges. Spain had a high deficit of 9.2% of GDP in 2010 and needs to restructure its savings banks. But its debt-to-GDP ratio is lower than the euro-zone average, and growth has started to recover. Italy, by contrast, has a low deficit of 4.6% and hasn't had to prop up its banks. But it has barely grown for a decade, and its debt-to-GDP ratio of 119% in 2010 was second only to Greece.


For now, markets are more worried about Spain, given uncertainties over its deficit and banking system. Ten-year Spanish government bonds yield 5.64%, or 2.71 percentage points more than German debt, while Italian paper yields 2.36 points more than Germany. The lower yield on Italian debt also partly reflects its greater liquidity: Italy's €1.6 trillion bond market is roughly three times the size of Spain's.


But while Spain has taken decisive action this year, Italy's longer-term challenges have become more apparent. It has a chronic growth problem and debt is expected to remain well above 100% of GDP for years. Italy's interest bill will be more than 10% of government revenue this year, versus 6% for Spain, according to Moody's.


The yield gap between the two could yet narrow further if investors start unwinding long positions. Thanks to rising yields, Italian debt has returned just 0.5% this year, compared with 2.1% for Spain, according to Bank of America-Merrill Lynch data. That is testing investor patience at a time when Italy still has to raise around half its total funding requirement of €222 billion this year; Spain needs to raise only a further €40 billion.


Euro policymakers should take note: Any loss of confidence in Italy would be truly alarming.


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