Calm after the storm

December 3, 2012

After months of bickering and struggle, the euro zone and IMF have agreed on a scheme which will notionally cut Greece’s mountainous debt to a level they view as sustainable in the long-term. Athens has now launched a buyback of its debt at a sharp discount from private creditors which should wipe 20 billion euros of its debt pile – a key plank of the plan.

Is the problem solved? Absolutely not. But has Germany achieved its goal of delaying any disasters, or really tough decisions, until after its elections in the Autumn of 2013? Almost certainly. So we could (famous last words) be in for a period of relative calm on the euro zone crisis front.

German Chancellor Angela Merkel and her finance minister have begun quietly hinting that euro zone government and the European Central Bank may eventually have to take a writedown on the Greek bonds they hold to make Athens’ debt controllable. That won’t happen for at least two years but in the meantime, bailout money will flow and Greece will survive.

The threat of its euro exit has pretty much vanished for the next year and the threat of a wider euro zone break-up has been vanquished by the ECB’s pledge to buy as many of the bloc’s government bonds as necessary to keep the currency area afloat. That pledge alone has driven 10-year Spanish borrowing costs down close to 5 percent, from highs around 7.5 earlier this year, while Italy sold 10-year debt last week at the lowest yield for nearly two years.

Having met all its debt financing needs for this year, Spain is already pre-funding 2013 and is in no hurry to seek outside help. But daunting debt figures next year, and the fact that Madrid is likely to miss its budget deficit targets again, mean it is still likely to seek help from the euro zone rescue fund at some point. That need not be too scary, however, since such a request would allow the ECB to intervene for the first time with its own bond-buying programme. We are reliably told that if that moment comes, it will act aggressively in the secondary market, probably driving Spanish borrowing costs lower still, with Italy’s following in their wake.

Ireland and Portugal could emerge slimmed down from their bailout programmes and regain capital market access next year although question marks hang over both. And few believe Greece can ever recover under the yoke of austerity imposed by its lenders – hence the likely need for a further debt writedown though not before 2014.

What could upset the apple cart? Italian elections in the spring could if they delivered a government intent on reneging on the economic reforms Rome has put in place over the last year. But even that seems unlikely given the imperative for whoever is in power to prevent Italy going over a cliff.
What the euro zone does face is a long period of grim economic inertia, while government debt is cut. So the other wild card is if public opinion can take no more and flares up into social unrest or delivers unpredictable votes at future elections. France can borrow at record low costs for now but faces a tough 2013 of cuts and has perhaps the most consistent history in Europe of popular protest overturning government policy.

And there is always the danger, as demonstrated before with this crisis, that policymakers will take the their foot off the pedal once the sense of impending disaster recedes. Brussels has set out ambitious proposals for closer economic, fiscal and banking union, including a common euro zone fund to reward structural reforms, but again big changes will be on hold until after the German election. In the meantime, only modest progress is likely on creating a single European banking supervisor, the first step towards a euro zone banking union, but without a joint deposit guarantee to deter capital flight and bank runs. That remains years away.


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