You're reading: Italy increasing worry as euro crisis rages on

FRANKFURT, Germany (AP) — Italy's borrowing costs rose above Spain's on Friday for the first time in more than a year, pushing European leaders to interrupt their vacations and look for a response to deepening fears about the health of the eurozone's third-largest economy.

At the start of Europe’s debt crisis 21 months ago, Italy was rarely grouped with the weaker members of the single currency zone, such as Greece, Ireland and Portugal. Many in the markets thought Spain, with its 20 percent unemployment rate, was vulnerable.

But the emergence of Italy as a potential victim over the past few weeks has highlighted just how vulnerable the eurozone is and how insufficient its anti-crisis measures are.

The yield on Italy’s ten-year bond stands at 6.09 percent, ahead of Spain’s equivalent of 6.04 percent — though both are lower than the euro-era highs earlier in the week and markedly below where they were at the start of the day, they’re still not far from the levels that forced Greece, Ireland and Portugal to seek international financial help.

Worries that Italy and Spain maybe next in line led German Chancellor Angela Merkel, vacationing in the Italian Alps, and French President Nicholas Sarkozy, on the French Riviera, to take time from their summer holidays for a phone conference on the eurozone crisis. Spain’s Prime Minister Jose Luis Rodriguez Zapatero is also set to have talks with Sarkozy.

Their options to what a leading EU policymaker described as "incomprehensible" movements in the markets appear limited.

Even a better than expected U.S. jobs report Friday failed to ease the pessimism that has gripped investors over the past few weeks.

It’s only been two weeks since eurozone leaders agreed to expand the powers of its €440 billion ($623 billion) rescue fund that helped bail out Greece, Ireland and Portugal. The fund will be able to buy governments bonds and bail out banks, but the new powers will not be in place until parliaments approve the changes in September.

Analysts also warn that the fund is currently not big enough to rescue Italy, whose debt amounts to 120 percent of economic output, around double that of Spain. Only Greece has a bigger proportion to service in the eurozone.

Markets have put increasing pressure on Italy because of its chronically weak growth and a general lack of confidence in Prime Minister Silvio Berlusconi’s ability or willingness to push through politically difficult measures to make the economy more productive.

Analysts at Rabobank International called the current fund "hugely inadequate" to cover Italy and Spain, not least because it would lose the pro-rated contributions those countries make if they needed to be bailed out with loans.

They calculated the fund would need €665 billion ($941 billion) to cover Italy’s funding needs for three years.

The EU’s Monetary Affairs Commissioner Olli Rehn returned to Brussels in an attempt to shore up investor confidence following the recent spike up in the two countries’ borrowing costs.

"Such dramatic changes in the markets are incomprehensible," Rehn said. "It is not as if the fundamentals of the Italian or Spanish economies have changed overnight."

He reiterated previous calls to increase the capacity of the bailout fund and said recently agreed changes to the fund’s powers should be ratified by all governments by early September.

That delay leaves the currency union without a clear defense against the current turmoil, since the European Central Bank appears reluctant to take on a big role.

Leaders rejected an increase in the bailout fund’s size, due to resistance from Germany and other rich euro countries to having their taxpayers on the hook for overspending by others.

A longer-term option would be a eurobond whereby the 17 members of the currency union borrow jointly. That has also been rejected by Germany and others with strong finances that let them tap bond markets cheaply, and who would see borrowing costs go up.

The European Central Bank can buy government bonds under emergency powers but has only done so reluctantly because it does not want to be seen as supporting shaky government finances.

On Thursday, the ECB restarted its bond-buying program by making purchases of Portuguese and Irish bonds, but not those of Italy and Spain.

Luc Coene, the head of Belgian’s central bank and a member of the ECB, said the bank was reluctant to buy the bonds of either Italy or Spain until they have taken additional steps to cut deficits.

Otherwise, "it’s like pouring water into a bucket with a hole," Coene said.

Commerzbank economists said that for now the ECB appeared the only line of defense against a nightmare ending.

If Spain and Italy cannot borrow after the summer break, they said, their governments will have to slash spending because they can no longer finance deficits. That could cause a profound recession.

"The foundations of economic activity would be undermined and euro area GDP would collapse, possibly on the same scale as in the winter of 2008-2009 following the Lehman bankruptcy," they said.

"If… finance ministers failed to act in time, the ECB might bridge the gap via massive bond purchases even if this were tantamount to financing government spending with fresh money," they said in a report.

Currently, the central bank drains money from the financial system when it buys bonds to ensure that its purchases do not contribute to inflation.