Deepening Italian debt crisis weighs on the FTSE 100

The FTSE 100 lost close to 2% in trading on Wednesday as investors moved to offload risky stocks such as banks and insurers after a sharp rise in Italian borrowing costs threatened to escalate the European sovereign debt crisis.

The Italian debt crisis intensified today after benchmark Italian 10-year bond yields, the effective cost of borrowing, raced to new euro era highs of well over 7% despite Silvio Berlusconi confirming that he will step down by calling new elections early next year after his government has implemented economic reforms.

The 7% level on bond yields is a crucial figure, as it was at this level that Greece, Ireland and Portugal all sought their respective bailouts but crucially this time around, European bailout resources seemingly does not have enough firepower to contain the Italian debt crisis, which is significantly larger than that of Greece, Portugal or Ireland, being that Italy is Europe’s third largest economy.

The mere fact that Mr Berlusconi refuses to leave until his government has implemented the fiscal reforms Europe dictates are vital, is exacerbating the situation. There are fears that considering the weakness of his position, he lacks the necessary political firepower to implement economic reforms efficiently and that the situation could drag on until he has vacated his office.

In the meantime, we have the cost of borrowing for Italy at unsustainable levels and this is threatening to blow the euro crisis out of its current proportions. Investor confidence remains fragile and the stock gains made over the last week have been eaten into by investors avoiding risky asset classes such as heavyweight banking and insurance stocks today, two sectors most exposed to sovereign debt liabilities.

The euro also lost significant ground on the back of the Italian concerns, with the single currency falling 1.7% against the dollar and 0.8% against the pound sterling.

Investors want to see first and foremost political solidarity in Rome, for without such, any effort to implement fiscal reform and contain the country’s debt problems is lacking credibility. It is looking increasingly likely that the sort of solidarity needed may only come about with a quick exit of Silvio Berlusconi.

The FTSE 100 did stage a late rally of 30 points after the Italian President attempted to cool market fears by claiming that a new government would be formed in a short space of time and elections held at the earliest timeframe after the adoption of new financial law.

Moves by the ECB to buy Italian bonds also helped yields to retrace somewhat from record highs but there are doubts that the ECB has the required firepower to contain the sorts of rises in yields witnessed today on any longer term basis. The rises in yields were also exacerbated somewhat by moves from clearing houses to increase margin rates on Italian bond holdings, requiring traders to deposit more to trade them.