Italy crisis rocks markets. Here's why investors are worried

Why these Italians moved to London
Why these Italians moved to London

A political crisis in Italy is causing global investors to freak out.

Stock markets around the world plunged on Tuesday and investors demanded higher yields in return for taking on Italian government debt.

The main stock index in Italy extended its losses for the week, dropping another 3%. The country's banks were hardest hit, with some stocks falling by over 5%.

Investors are worried that political turmoil in Italy could cause pain beyond the country's borders. The yields on Spanish, Portuguese and Greek debt surged, and US stocks opened lower.

Italy is heading for new elections after populist politicians failed to form a government. Radical parties could gain even more ground, and investors are worried that the vote will turn into a de-facto referendum on the euro.

Some market observers worry Italy may ultimately crash out of the European Union -- a scenario they've dubbed "Italexit" or "Quitaly."

Contagion threat

The big risk is that Italian politicians will stop following the rules of the euro or perhaps even seek to ditch the currency. The euro dropped 1% against the US dollar on Tuesday, a reflection of investor concerns.

"A genuine euro crisis is the worst case scenario," said Florian Hense, an economist at Berenberg Bank.

Italy has the third largest economy in the eurozone, accounting for 15% of the region's GDP. That's much bigger than Greece, the source of the last eurozone crisis.

"In the unlikely case of a messy Italexit, eurozone growth outside Italy may stall for a couple of quarters while the authorities deploy their tools to contain contagion risks and shore up the most affected banks," said Holger Schmieding, chief economist at Berenberg Bank.

It's not clear what platform populists will run on in the new elections. But analysts say it's unlikely that Italy would stop using the euro.

Still, increased spending by a new Italian government could ratchet up market tension.

Years of stagnation and a lack of reform have pushed Italy's government debt above €2 trillion euros ($2.3 trillion), equivalent to more than 130% of annual economic output. That's the third highest level of indebtedness in the world after Japan and Greece.

Ratings agency Moody's warned Friday it could cut Italy's credit rating -- already just two notches above "junk" status -- because the populists' spending plans risked weakening its fiscal position and stalling efforts to reform the economy.

A majority of Italy's government debt is owned by Italians, but the European Central Bank also owns a big chunk, along with banks and investors in France, Luxembourg, Germany and Spain.

Uncertain future

Italian populists may back down from talk of holding a referendum on the euro or leaving the European Union.

"Many voters, even if they are very unhappy with the status quo ... do not really want to leave the euro," said Schmieding. "They do not like the thought ... that part of their savings may go down the drain in an exit from the euro."

Still, many investors are worried about a region that has been repeatedly battered by debt crises.

Some bank stocks were down by about 6% in Spain, which has its own political problems. Prime Minister Mariano Rajoy faces a confidence vote in parliament on Friday.

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