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Italian Prime Minister Mario Monti.John Thys/AFP/Getty Images

It's déjà vu all over again for Europe. Markets were temporarily besotted by yet another bailout plan, but the glossy veneer has begun to flake off, revealing flimsy details and an underwhelming size. Yet another country – Italy – has been sucked into the gravitational pull of the crisis, and the question is whether it has passed the threshold of no return.

Italy's borrowing costs have soared – its 10-year government bonds still yield about 7 per cent, despite Wednesday's rally – reflecting concern that it could be the next country to topple. This is no trivial matter, given that Italy has the third-largest economy in Europe and the third-largest government debt program in the world.

There are equal doses of truth and misconceptions about Italy. It is true that Italy has a very high government debt-to-GDP ratio, about 120 per cent. This is the main criticism against it, and it is a big one. Similarly, its growth rate is abysmal. Italy is the worst economic performer of the euro zone over the past decade, managing just 0.1 per cent real GDP growth per year.

Until recently, Italy lacked the political will to enact economic austerity and reforms. The good news is that it is now under the stewardship of a technocratic government tasked with precisely that, and the International Monetary Fund has begun monitoring its progress. Political will is crucial; remember that both Argentina and Venezuela defaulted in the past 15 years with debt burdens that were less pressing than Italy's.

Misconceptions about Italy deserve equal ink, however. Its debt-to-GDP ratio of 120 per cent may actually be sustainable for a number of reasons. It has a smaller budget deficit than its troubled neighbours, and already enjoys a slight surplus when interest payments are excluded. This means less hard work is needed to reach firm land.

Italian debt is disproportionately held domestically, rendering it less susceptible to speculative forces. Its debt also has an unusually long average duration of seven years, meaning that the bulk will remain sheltered from rising borrowing costs for some time. Italy also holds about €100-billion in gold reserves.

In contrast to their spendthrift government, Italians and Italian businesses have relatively little debt. Italy is hardly a poster child for prudent budget management, but neither is it on the scale of Greece or Portugal.

Despite these factors, there is still a sense in the market that Italy is verging on insolvency. The main argument is that it has breached the 7-per-cent threshold for 10-year bonds that necessitated bailouts for Greece, Ireland and Portugal. But according to our calculations, Italy is probably different, and very likely still solvent.

By virtue of its small deficit, less-austere economic outlook and long bond duration, Italy's debt load is surprisingly manageable compared with other countries. Under a realistic scenario incorporating a 6.5-per-cent, 10-year bond yield; a moderate recession; and realistic austerity, Italy's debt-to-GDP ratio would decline handily over the next decade. Not drastically, but cleanly and steadily downward. Even a more pessimistic scenario of a 10-per-cent yield and a lengthy recession would translate into a fairly steady debt-to-GDP ratio over the coming decade.

Framed differently, the cost of servicing Italian government debt is currently only 4.6 per cent of output. This is the ultimate test of debt sustainability, and the figure is both unusually light for Italy and nowhere near the danger zone of 10 per cent. Even our pessimistic scenario leaves Italian debt servicing costs well shy of trouble.

This would seem to confirm that Italy remains solvent. The country's big risk, then, is not whether a 7-per-cent borrowing cost is fundamentally sustainable. It is – at least for several years. The question is whether markets believe this. Debt dynamics are exceedingly sensitive, with seemingly small shifts in sentiment having outsized consequences. Irrational fears can very quickly become rational if borrowing costs are pushed high enough. This is the risk.

Italy should remain solvent, but it could certainly use more support to remain that way from the European Central Bank, the IMF and wealthier neighbours.

Italy's other challenge is to regain its competitiveness after years of excessive wage growth. This will be a gradual process, involving a regulatory reform to modernize its business sector and labour market. Italy has at least a fighting chance of righting itself, unlike Greece. But it must do so quickly. To delay is to allow Europe's gangrene to spread even further.

Eric Lascelles is chief economist of RBC Global Asset Management.

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