Italy's benchmark 10-year bond yield has fallen about 20 bp since the Fed's decision not to taper and it has moved back below comparable Spanish yields, but its problems have not diminished. Rumors of a downgrade that circulated in the European afternoon reflect ongoing concerns.
S&P had cut Italy's sovereign rating to BBB in July, matching the comparable Moody rating. That leaves Fitch, with its BBB+ rating, as the outlier. If Italy is to be downgraded then, Fitch would be the most likely suspect. This would be a catch-up move and may not be disruptive for investors.
While much attention has been focused on the Senate debate over enforcing the ban from public office on Berlusconi, who was found guilty of tax evasion, that is only one flash point in the growing tensions in the unprecedented center-right/center-left government led by Prime Minister Letta.
The more immediate issue is about the VAT tax. It is scheduled to be hiked by 1 percentage point the beginning of next month. After abolishing the controversial property tax earlier this year, and the slippage of the fiscal target, the EC is pressing Letta to enact the VAT hike. Finance Minister Saccomanni reportedly threatened to resign if the government bowed to pressure from the center-right to abolish the tax entirely. In fact, some from the center-right have argued that reversing Monti's planned VAT hike was a precondition of the coalition government in the first place.
The center-left itself is divided. Prime Minister Letta faces a leadership challenge from Renzi on December 8. If he had his druthers, Letta would seem to prefer avoiding alienating supporters by hiking the VAT. Local press accounts suggest Letta is looking at alternatives, which are thought to include a new kind of real estate tax, some increased levies and additional spending cuts.
It is thought to cover the cancellation of the IMU property tax, jobless benefits and refinancing missions abroad, the government needs to find something on the magnitude of 5 bln euros. And this is before turning toward next year's budget.
That said, Italy's problem is not really its deficit, which was supposed to be 2.9% of GDP this year, but may be a bit higher, slightly above 3%, the envy of the periphery and even some core countries. Rather Italy's problem is the large debt burden, accumulated from past deficits amid a still contracting economy, and rising bad loans at the banks. The competitive problems Italy faces are not simply the result of adopting the euro and the inability to devalue. It involves enforcing contracts, getting credit and securing basic services like electricity and telephone. The World Bank's "Doing Business 2012" ranks Italy 30th among the 31 high income countries.
Prime Minister Letta is in the US trying to encourage foreign direct investment flows in a campaign dubbed "Destination Italy." OECD figures show Italy having drawn about a third of the direct investment flows as Spain over the past five years.