ROME (Reuters)- A surge in Italy's bond yields over the past week does not doom the country's efforts to keep its sovereign debt under control, but it does increase the risk of a further spiral of yields that could prove disastrous.
Despite a debt mountain second only to that of Greece, Italy has until now managed to stay on the sidelines of the euro zone crisis. The euro zone's third largest economy, its debt costs have been tempered by its relatively modest budget deficit, its conservative banking system and its high level of private savings.
But with the Greek crisis intensifying, yields on Italy's 10 year government bonds hit 5.71 percent on Monday, jumping more than 40 basis points, and the premium investors demand to buy Italian rather than benchmark German bonds reached 300 basis points, its highest level since the launch of the euro more than a decade ago.
"Italy's not Spain, it hasn't got substantial imbalances in the private sector, it's got better longer run debt dynamics than some countries but obviously if the market perceives that it's a problem, then it becomes a very big problem," said David Owen, chief European financial economist at investment bank Jefferies International in London.
Italy has struggled to keep public debt down to some 120 percent of gross domestic product, stuck with one of the world's lowest economic growth rates over the past 10 years.
As 10-year bond yields, which last year averaged 4 percent, move pass 5.5 percent, interest rate costs on the 1.6 trillion euros of outstanding Italian government bonds could rise significantly if maturing debt is refinanced at the higher rate.
With around 176 billion euros of debt redemptions due between now and the end of 2011, less than 10 percent of the total stock, a higher rate would not necessarily have a disastrous immediate impact if the timeframe were limited.
"This level of interest rate is not, in itself, a huge worry," said Owen. "The issue is, do we go from 5.5 percent to 7? Then it becomes more of an issue. You can get a buyer's strike which causes yields to gap up to 8 percent and so on."
Graphic comparing Italy with other 'debt-heavy' euro zone countries: r.reuters.com/cuz52s
Italy debt/deficit comparison: r.reuters.com/baz52s
Jefferies estimates that a market rate of 7 percent could add an extra 73 billion euros (64 billion pounds) to overall debt servicing costs by 2014 or 106 billion if the rate rose to 8 percent.
"If this is transitory, in that it applies to only six months or nine months of refinancing, it's not an issue," said Deutsche Bank economist Gilles Moec. "But the more it applies to a larger amount of refinancing, the more disruptive it is."
Recent warnings by ratings agencies Standard and Poor's and Moody's that they could cut Italy's credit rating if it does not improve growth point to the other big problem facing Italy, its chronically stagnant economy and weak competitiveness.
Recent PMI data, pointing to a slowdown in both services and manufacturing activity suggest weakness ahead with some analysts expecting at least one quarter of contraction this year, while even the government sees growth of no more than 1.1 percent.
A divided government which has struggled to push through reforms of a kind needed to get growth above the average of less than 1 percent seen over the past decade suggests that prospects for the kind of economic revival needed to cut into the debt are slim.
That has raised doubts about the credibility of the budget cutting measures Economy Minister Giulio Tremonti has championed in the face of reluctance and outright resistance from cabinet colleagues worried about voter appetite for yet more austerity.
"What is more worrying from the market point of view is if Italy cannot reach the public finances targets for 2014," said Alessandro Tentori, bond strategist at BNP Paribas in Milan.
"Right now it looks as if even domestic politicians do not believe in it, so why should foreign investors?"
However despite much headline-grabbing scandal and infighting, Prime Minister Silvio Berlusconi's centre-right government has generally been very conscious of the need to convince markets that it is in control of public finances.
Italy runs a primary budget surplus, excluding interest rate costs, and its projected budget deficit of 3.9 percent of GDP is below the EU average of 4.7 percent. Parliament is this week discussing a 40 billion euro consolidation programme aimed at bringing that back to balance by 2014.
"Italy has actually been very good on consolidation, they have good budget figures, the deficits are below European averages, they have had primary surpluses," said Andreas Scheuerle, an economist at Deka Bank in Frankfurt.
The average debt maturity of Italian debt is just over 7 years, one of the longer average maturities in the euro zone, which should also offer some protection against immediate interest rate swings.
A traditionally strong domestic investor base has also helped, with around half of Italian debt held at home, around the middle of a sample of 17 developed economies featured in a recent Deutsche Bank study on public debt.
"I think Italy will continue to place its debt without problems, even if tensions continue," said Cyril Regnat, a bond strategist at Natixis in Paris.
"Bond spreads over Bunds are at a euro zone high, yes, but let's not forget that they were borrowing without any problem at 5.7 pct over 10 years in the early 2000s."
(Additional reporting by Michel Rose, Valentina Za and Silvia Aloisi in Milan; Editing by Ruth Pitchford)