If Greece defaults, Italy might not be far behind.
As Greece tumbles into political chaos, investors are fretting about where the next debt domino might fall, and Italy is looking increasingly vulnerable.
Yields on Italy's 10-year bonds have surged well above 6 per cent – the country's highest borrowing costs since the creation of the euro and beyond what it can afford over the long haul.
The prospect that Greek voters might reject a European bailout package in a proposed referendum would make it tougher for embattled Italian Prime Minister Silvio Berlusconi to shield his country from contagion.
Hot money is shifting into German bonds and other perceived safe investment areas amid fears that Italian authorities won't have the political resolve to tackle their debt problems.
Italy's soaring bond yields are "clearly unsustainable for a country whose debt sits at 120 per cent of [gross domestic product]" said BMO Nesbitt Burns senior economist Benjamin Reitzes. The European Central Bank was buying Italian bonds Tuesday to add stability to the market, according to reports.
Italy has roughly €1.8-trillion ($2.5-trillion) of debt, portions of which it must continually refinance at prevailing interest rates.
A hard-fought European plan unveiled last week included a plan to boost a European bailout fund to €1-trillion. But as debt problems pile up, analysts said the fund could be too small, particularly if Italy has trouble rolling over its hefty debts at now-inflated interest rates.
Goldman Sachs economist Francesco Garzarelli argued in a research note that the standoff in Greece is really just a "proxy war" for Italy, where the real debate will take place over how far euro zone countries must go toward harmonizing their fiscal policies.
The Italian government is proposing tough austerity measures, including sharply higher taxes coupled with spending cuts. But there's lingering doubts that Italian politicians will be able to keep a lid on spending over time.
The larger dilemma is that Italy's fiscal problems aren't unique. The debts of many countries are simply too high in an environment where the economy is barely growing and the threat of another recession looms.
However, Mr. Garzarelli said the spread between Italian and German bonds – 4.5 percentage points – is exaggerated given the two country's relative fiscal and economic prospects. Although saddled with huge debts, Italy is on track to post a primary budget surplus – before interest charges – of 1 per cent of GDP this year, and even better in 2012.
He also said there's no reason to think that the European Central bank won't continue to prop up Italy's bond market and its banks.