Global markets remain spooked as fears over the potential inability of Italy to finance its debt and the failure of major Italian banks causes panic throughout the eurozone and the world.

Italy, Europe’s third largest economy, is facing serious economic difficulties and could seek a large bailout. Multiple media sources say European officials will hold a secret meeting today to discuss the crisis. Italy’s two largest banks, Intesa Sanpaolo SpA and UniCredit SpA, lost nearly 30% of their market value over the past three months. Standard & Poor’s says it will review its credit rating of Italy which now has one of the largest public debts in the world, amounting to 120% of GDP or 1.6 trillion Euros.

The country is under pressure to privatize state assets, but so far has been reluctant to sell. Last week, the government sold 4.97 billion euros ($7.1 billion) of long-term debt in an effort to calm the situation, but that move was undercut by the Italian treasury’s decision to limit the overall size of the auction to ensure strong demand. In early trading today, most major European stock markets were down sharply. Italy’s 10-year yield bonds leaped 12 basis points, and the euro fell 0.6 percent in reaction to the crisis.

Analysis:

Italy must act quickly to contain the economic hemorrhage. Prime Minister Silvio Berlusconi has called for “sacrifices” to help reduce the nation’s debt, but will have to implement concrete steps, including austerity measures, to get the economy back on track. Failure to take strong measures will cause the Italian debt crisis to worsen and lead rating agencies to decrease Italy’s credit ratings, making it more costly for the nation to borrow and even harder to pay back outstanding loans.

An insolvent Italy unable to meet debt obligations would be a body blow to EU finances which is already burdened by the Greek situation. The size of a bailout for Italy would vastly eclipse the combined amount of cash needed to save Greece, Portugal and Ireland. The European Financial Stabilization Facility, set up to deal with the failing European economies, has total lending capacity just over 300 billion Euros. Italy needs nearly double that amount over the next two years to stay afloat.

An Italian default would have wide impact. “If Italy really gets hit by contagion because of political mismanagement, it would be a threat not only to the eurozone, but to the global economy,” said Carnegie Endowment international economic program senior associate Moises Naim. Germany and France, the only two nations in the eurozone capable of bailing out Italy, have nearly 700 billion euros worth of exposure to Italian government and corporate debt. An Italian default would significantly impact both countries and jeopardize the European Central Bank.

Analysis:

The world can ill-afford to allow Italy to fail, but another eurozone bailout will cause resentment among the wealthy countries. Despite their exposure, France and Germany are likely to balk at providing direct assistance to Italy if the European Financial Stabilization Facility is unable to fund the rescue. Germany already is fiercely divided over its role in the helping nations suffering from the financial crisis, and an added bailout request would fuel internal dissent and possibly lead to a refusal to provide additional funds. However, without some form of EU support, the Italian economy could collapse which would cause collateral damage to even the strongest EU countries.

The economic crisis is further threatening Berlusconi’s already embattled government. On Thursday, the Italian Senate passed the four-year 40 billion euro ($56.6 billion) austerity plan, and the lower house is expected to pass the program on Friday. Fitch Ratings approved the program, saying that if the government meets the fiscal targets, it would stabilize the country’s credit profile and maintain its credit rating at AA-minus. However, Berlusconi may not survive the implementation of the package. The center-left opposition has been stepping up calls for Berlusconi to resign after the vote and floating the idea of a transitional government followed by early elections, currently scheduled for 2013. The Prime Minister also is facing hearings on charges of bribery and paying for sex with a 17-year-old girl.

Analysis:

The government will have to undertake a delicate balancing act, implementing enough reform to help make the nation solvent without stifling economic growth. It also will attempt to avoid a public backlash and possible violent demonstrations against reforms. An ongoing vitriolic fight between Prime Minister Berlusconi and Finance Minister Giulio Tremonti is exacerbating tensions in the government and could impact its ability to maintain economic reforms. If Italy moves to a pre-electoral phase, parties may lobby to soften austerity programs to win votes which could derail economic recovery efforts.

[Lisa M. Ruth is a former CIA analyst and officer. She is currently Managing Partner of C2 Research, a boutique research and analysis firm in West Palm Beach, Florida and is Vice President at CTC International Group, Inc., a private intelligence firm.]