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What Italy's debt downgrade means for Greece and the eurozone?

(Xinhua)

09:57, September 21, 2011

BRUSSELS, Sept. 20 (Xinhua) -- Europe's sovereign debt woes continue to snowball with Italy suffering a downgrade by a major ratings agency on Tuesday.

Standard and Poor's marked down Italy's creditworthiness from A+ to A with a negative outlook, much to Italian Prime Minister Silvio Berlusconi's discontent. He was quick to slam the move as being influenced by "political considerations" rather than economic reality.

Berlusconi's pointed out that Italy passed painful austerity measures just last week. However, S&P said Italy's new reforms, designed to reign in spending equivalent to 2.8 percent of its GDP, falls well short of market expectations given that its debt to GDP ratio stands at 120 percent.

"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," said S&P's statement.

After an initial dip, global markets registered gains in the wake of the Italian downgrade. Experts said this was because markets already punished the country with record-high bond yields all summer over doubts it had the political will to meet its economic challenges.

"I think the downgrade reflected to a large extent a lack of faith in Berlusconi's government," said Dorothea Schaefer, financial markets research director at DIW Berlin.

Philippe Gijsel, head of Market Strategy at BNP Paribas Fortis, believes that since Italy still has a nice rating, the impact on the market is limited. "The focus was on the Fed meeting (FOMC) today and tomorrow. The hope is that some new measures to stimulate the economy will be announced. This could help stimulating markets."

Italy, the eurozone's third largest economy, has now joined the ranks of countries such as Cyprus, Greece, Ireland, Portugal and Spain that have had their credit ratings cut this year. The biggest fear now is that of contagion.

"Governments across Europe are finding it extremely difficult to bring their profligate spending under control. But until they take the necessary measures, people will continue to doubt their creditworthiness," Tom Clougherty, executive director of the Adam Smith Institute, told Xinhua.

"My fear is that we're sleepwalking towards disaster. Unless spendthrift governments get their acts together quickly, we could end up facing widespread defaults, banking collapses, and even - if governments decide to turn on the printing presses - hyperinflation," he added.

All eyes are now on Greece, which is currently convincing the International Monetary Fund (IMF), European Union (EU) and European Central Bank (ECB) that it has fulfilled all the conditions to receive a tranche from a 110 billion euros bailout fund agreed in May last year.

At the euro summit in Brussels two months ago, EU leaders unveiled another bailout package for Greece and decided to broaden the scope of the European Financial Stability Facility (EFSF). However, delays by member states in ratifying these decisions heightened market fears of a possible Greek default and, even more worryingly, an exit from the eurozone.

Analysts point to two scenarios: Greece either exits the eurozone and returns to a devalued drachma or Europe embraces a historic fiscal union and Greek debt is collectively backed by the EU as a whole.

There are some who believe a Greek default is becoming increasingly likely.

"There have been talks about a possible Greek default since early 2010, so financial markets should be prepared to face this event," said Cinzia Alcidi from the Brussels-based Centre for European Policy Studies, alluding to how some European banks are writing down their exposure to Greek debt.

However, experts warn that continued financing of Greek public debt is the only viable option. Mainly because Greece is a relatively small economy which can be bailed out, political will notwithstanding. Secondly, if Greece is allowed to fail - like the Lehman Brothers were by the U.S. in 2008 - it could trigger a domino effect putting Spain and Italy under pressure, both of which are simply too big to save.

From a Greek perspective, leaving the eurozone would mean its euro-denominated debt would be even higher in a successor currency. "This would cause its banking system to collapse, hyperinflation and have destabilizing political effects," said Iain Begg, professor at the London School of Economics.

The bigger danger, for investors and European leaders alike, is that a Greek departure could trigger a global financial crisis. "The rest of Europe can handle Greece failing, but if Italy, the world's eighth largest economy, was to go under, the economic consequences could be catastrophic," said Clougherty.

So what options does the EU have to solve this crisis? A show of political will and credibility is key, say commentators. "European leaders have to show markets that they are committed to working toward fiscal governance," said Fabian Zuleeg from the European Policy Center.

"Even if eurobonds, comprehensive debt restructuring and enhanced fiscal union takes five years to put into place, leaders have to show that they are politically committed to doing so. This would go a long way in calming markets," Zuleeg stated.

What role can China and other emerging nations play amid the ongoing economic turmoil? Last week, markets were buoyed by speculation that Beijing was looking at purchasing Italian bonds. Can BRIC nations help lift Europe out of its debt crisis?

In a recent interview, World Bank president Robert Zoellick made it clear not to expect any miracles. "The idea you are going to have the Chinese come with a bag of gold and buy everyone out of this problem, I wouldn't hold my breath," he said.

Since China has a big stake in the global stability of financial markets, it can help restore confidence to a certain extent by purchasing bonds of troubled European economies, feels Zuleeg. "But a permanent solution has to come from Europe itself."

"China can contribute, but only Europe can definitively help itself," he said. (Chong Dahai, Oussama Elbaroudi and Liu Xiaoyan in Brussels contributed to this report)

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