Italy too big to fail? Odds are it's too big to save.

With an economy seven times bigger than Greece, Italy could cost the eurozone €1.2 trillion if it requires a bailout like Greece's. That's more than Europe's emergency coffers have, even with leverage.

Tony Gentile/Reuters
Italy's Prime Minister Mario Monti talks on the phone during a vote of confidence at the Lower House of Parliament in Rome Nov. 18, 2011. Italy's economy is much bigger's than Greece's – so big that it might prove too big for the eurozone to save.

Markets worldwide are on edge. Investors and politicians are holding their breath over the fate of Italy. Surely European nations will rush to its support. It’s too big to fail, right?

The reality is more alarming: As the eurozone’s third-largest economy, Italy is probably too big to save.

To understand why, look at Greece. Despite the combined efforts of the eurozone nations, the European Union, and the International Monetary Fund and €130 billion ($176 billion) in aid – a sum equal to more than half of Greece’s entire economy last year as measured by gross domestic product (GDP) – Greece still faces the indignity of a partial default.

The best guess is that investors will be forced to accept a 50 percent loss on maturing Greek debt.

What would happen if a similar scenario unfolded in Italy? The market is already pricing in a possible default with each passing day as the yield spread between Italian debt and German benchmark bonds touches new euro-era highs. In a word, Europe’s bailout costs would skyrocket.

Italy’s economy is nearly seven times the size of Greece’s. Applying the same emergency funding-to-GDP ratio that was provided to Greece, it is not unrealistic to expect about €1.2 trillion in outside aid would be needed to prevent a disorderly default in Italy.

Europe’s emergency coffers don’t currently have anywhere near that sum. The European Financial Stability Fund (EFSF), after providing urgent bailouts to Ireland and Portugal, currently has about €290 billion in cash on hand. Further payments are already scheduled for Greece that will further deplete the fund.

In late October, European officials said that more cash would be added to the fund and that the account would also be “leveraged up,” effectively raising the balance of the fund to €1 trillion. In other words, the EFSF would borrow money to top-up the fund. Isn’t this how the Eurozone got into trouble in the first place?

Looking even further downfield, the news only gets worse.

In addition to Italy, it appears that France is heading for its own debt showdown. Last week, the impact of falling German bond yields, together with rising French bond yields, resulted in another euro-era record spread between French and German 10-year notes.

The one positive is that with a debt-to-GDP ratio of 82 percent, France’s, debt is considerably less oppressive than Italy’s 119 percent ratio or Greece’s 145 percent. While the rising yield spread is a worry, France should be able to avoid the same fate as Greece so long as it can continue to attract investors without yields rising to the point of making the cost of borrowing overwhelming.

The same cannot be said for Italy, which may have already passed the tipping point.

 Scott Boyd is a currency analyst with OANDA, a Forex trading company with offices in New York,Toronto, Singapore, and Dubai, and contributes to the company’s MarketPulse FX blog.

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