Who will be the next Eurozone domino to fall?

By Kathleen Brooks, Research Director

Forex.com

This time a year ago no one thought that the third largest economy in the Eurozone would come under the same pressure as profligate Greece, but 12 months later and we are in a situation where bond investors are showing no mercy to Rome.

Italy isn't even insolvent. It is expected to have a primary budget balance this year and next, which means that it will bring in more tax revenue than it spends on public services. This is impressive; the UK has had a primary budget deficit each quarter since 2001.

So why has Italy been sucked into the crisis? Mostly because its overall debt burden is huge: nearly EUR2 trillion and 120% of GDP. As Rome's bond yields surge this pushes up its interest bill, which will weigh on its primary budget surplus. So, a lack of confidence in the bond market can be a self-fulfilling prophecy: rising bond yields make public sector finances even worse, causing even more selling pressure on the bond market.

The problem with the Eurozone is that there is no mechanism to "fix" things. In the US there is the Federal Reserve - at the peak of the financial crisis it came in and bailed out the housing and banking sectors and the UK has the Bank of England to pump the economy with money when things go pear-shaped. The Eurozone doesn't have this support - or lender of last resort - and so the crisis continues to spread.

Could Spain be next under the spotlight?

The market has an amazing ability to only concentrate on one economy at a time, last week it was Greece, this week it is Italy. But could it be Spain next week? Spain's position is considered less severe than Italy's, and accordingly its bond yields have lagged behind Rome's. If 7% is considered the threshold, then Spain has some breathing room since 10-year yields are still below 6%.

In recent days a lot of people have noticed that the gap between 10-year Italian bond yields and 2-year yields had started to narrow. At one point it even went negative as short-term yields rose above longer -term yields. This is a key barometer of market confidence in a country's ability to pay back its debts.

Madrid can breathe a sigh of relief, the spread between its 10-year and 2-year yields is 1.3%, however this gap has narrowed since the summer, so Spain isn't out of the woods yet. Added to that, its growth dynamics are fairly poor. Unemployment has remained above 20% since the last quarter of 2010, consumption is weak, and the housing sector remains in the doldrums. Demand for mortgages has been falling pretty much consistently since 2007 apart from a brief pick-up in mid-2010.

The housing market is the centre of problems for Spain and its collapse has weighed heavily on the banking sector. According to the Spanish central bank, financial institutions are linked to EUR176bn worth of exposure to the beleaguered Spanish property market. The stubbornly high unemployment rate combined with the collapse in consumption is likely to increase the rate of bad debts, even Spain's biggest bank Santander said that it expects bad loans to continue to grow.

The bank also predicted that bad loans as a percentage of total lending could hit 5.8% in the second half of next year. Other banks in the region are in similar positions and Spanish banks represented a quarter of the EUR 106bn capital shortfall for European banks estimated by the European Banking Authority.

If the banks can't boost their capital buffers and get together enough cash in case bad debts rise even more, then Madrid may well have to fill the financing gap. Since governments tend to support banking sectors when they get into crisis an increase in bad loans on Santander's books increases the potential liabilities the government may have to cover, thus further exacerbating Spain's stretched public finances.

So it's easy to see how Spain could come under attack in the near future, and it is extremely doubtful that the EU could support both Spain and Italy if they were in trouble. Now that problems have spread to the core of Europe, this crisis has become a lot more difficult and expensive to sort out, but the pace of collapse in Italy's bond market leaves Spain extremely vulnerable.