Five uncommon observations about the European debt crisis

The escalation of the European debt crisis and mounting evidence of new economic contraction has increased the scrutiny on the region. Yet it seems like many observers may be failing to grasp several important points, including the nature of the new governments, the Italian challenge, pressure on the ECB, risks of a euro zone break up and the coming election in Spain.

1. With tough austerity being demanded of Greece and Italy, new governments seem to reflect a greater part of the elites than the previous governments. And in this light, considering it "technocratic" does not do justice to what is happening. Papademos government has 100-day mandate with elections slated for Feb 19th.

   In Italy it is not clear the length of the Monti government mandate. What is most striking about Italy that appears to have gone largely unnoticed or uncommented on is that the fact that what ultimately toppled Berlusconi was not voter moral outrage or even an alternative program by the opposition, but rather the international capital markets and the loss of credibility among European leaders, manifested most clearly in the Merkel/Sarkozy press conference in last October.

2. The German Finance Minister said last week that if Italy needs assistance it should apply to the EFSF. This suggestion cannot be taken at face value. What most observers do not appreciate is that Italy cannot go to the EFSF; or perhaps more accurately stated, if Italy were to go the EFSF it would signal a potentially catastrophic turn of events. To wit, Italy contributes 140 bln euro of guarantees to the EFSF. If it becomes a recipient of the fund, its guarantees are withdrawn from the system, like on a much smaller scale, Greece, Ireland and Portugal. Only about 30 bln or so of Italy’s guarantee has been drawn up, leaving about 110 bln, which almost half of the uncommitted amount of funds at the EFSF, prior to leveraging and that is before Italy is given a single euro. Before going to the EFSF there is much that Italy can do. Note that some people who may be in or close to the new Italian government were responsible for imposing a 0.6% tax on savings accounts previously. This is a simply example of a measure meant to be suggestive of the fact that despite the government’s debt, the private sector wealth is substantial and in the not-too-distant past, the government has seized some.
3. The ECB is under strong pressure to step up its bond sovereign bond purchases and although it appears to have increased its purchases, the sums seem mild and are well shy of the unlimited commitment that some observers argue is necessary. The ECB is strongly resisting. It can act as a lender of last resort to banks. It does not only refuse to play this role for sovereigns, but is limited by its charter.

   There is reason why the hard money camp is worried about losing control of the ECB. It was thought to have been "Germany’s turn" to head the central bank, but Weber took himself out caught Merkel unprepared with an alternative. Little noticed by most observers, four of the six executive board has left this year. Austria’s Trumpel-Gugerell’s term expired, Germany’s Stark is resigning in protest, Trichet’s term expired, and Bini Smaghi resigned under pressure to make room for a French candidate (not that nationalities can be admitted to matter in mixed company).

4. Many observers misunderstand signals from Germany and France that they want to evict some country or countries from the euro zone. Merkel has been explicit: the main goal is to stabilize the existing euro zone. Germany and France wanted Greece to reaffirm its commitment to the euro zone when a referendum looked likely, but that is different than seeking to push it out. It does make sense to consider contingency plans, but this too is prudent not an aggressive act. The CDU party congress is under way and there is a difference between a wish list and CDU policy and German policy and EU policy.

   If one country leaves, it does not diminish, but increase the risks that others will leave. A disintegration of the monetary union would be the ultimate failure of the European elite. The true signal coming from Germany and France is the opposite of disintegration…more integration is being contemplated.

5. Spain has been off the radar of many investors as Italy and Greece has stolen the limelight. That is changing and Spanish 10-year yields moving back above 6% today is the taste of things to come. Spain’s economy stagnated in Q3 and may be contracting in the current quarter.

   The government’s growth forecasts need to be cut, as the EU did last week (the EU forecasts 0.7% this year and next and the 2012 forecast may be on the high side). This means that it is likely to overshoot this year’s deficit target of 6% by a wide margin (10%) and unless substantial more savings are found it, it will overshoot next year’s deficit target by a wider margin.

   Enter the new government. The PP is likely to secure a strong mandate at Nov 20 election. It may win as many as 200 of the 350 seats and it will governs most of the regions. However, its policy will be even more austerity.

   Moreover, according to a recent BBVA study, Spanish banks face more than 60 bln euros of not yet disclosed losses as the economy slips back into recession. Net-net since the end of Oct, Spanish 10-year yield is up 53 bp and Italy’s 10-year yield is 63 bp. While Italy faces 30 bln euro in redemptions in the remainder of the year, Spain has no bond redemptions, but some bills mature. Both sell bonds later this week.