Italy gives new bite to euro zone crisis

December 10, 2012

Don’t start putting out the tinsel yet. Just when we thought we had a smooth glide path into Christmas the euro zone has bitten back.

Over the weekend, Italy’s Mario Monti called Silvio Berlusconi’s bluff and said he was pulling the government down which will mean early elections in February. The budget bill will be passed and then the country will be in a potentially precarious state of limbo as parliament is dissolved. Italian bond futures have opened more than a point lower, which denotes a reasonable measure of alarm, although the safe haven Bund future has only edged up so we’re far from panic mode.

The big question is whether a government results that will stick to Monti’s agenda and whether he himself will have a prominent role to play in the administration. There are constitutional difficulties to keeping Monti as prime minister since he has said he would not stand at the election, though he has also said he would be prepared to step in again if no stable government is formed. Most likely, presuming a government is elected that supports his reforms, is that he will play a key role but not take the top job.

That would not be possible if Berlusconi’s bloc won – the result that would really spooks markets – but on the basis of the old adage that the assassin never wears the crown, this should not be good for Berlusconi. Well behind in the polls, he now has less time to turn things around and could be blamed by the public for withdrawing support for Monti’s technocratic government. Centre-left leader Bersani looks to be in pole position and is signed up for much of Monti’s reform agenda. But if we get a messy, fractured result in February, bond market pressure could seriously escalate again. In a country that must be wearying of its economic plight and deep recession, nothing is certain.

If markets do react nervously, the backwash will lap at Spain’s shores and, if it persists, could possibly tilt the balance in favour of Madrid seeking help from the euro zone rescue fund and the ECB. But we’re a long way from that yet. Much of this may be up for discussion in Oslo today where EU leaders are heading to pick up the Nobel Peace Prize. With an EU summit due at the end of the week it would seem too good an opportunity for meangingful talks to turn up.

Most important to watch on that  front will be Angela Merkel and Francois Hollande who have yet to find sufficient common ground on plans for a banking union to allow the process to proceed, one part of a wider Franco-German froideur that has developed. Even the first step – cross-border banking supervision under the ECB – has hit a roadblock over a disagreement about how much scope the ECB should have. Ministerial talks are due this week to try and cue something up for the leaders’ summit.

The other big rolling saga is the Greek bond buyback which must attract enough private investors to hand their paper back at 30-40 percent of  face value in order to wipe 20 billion euros of the country’s debt pile. Fall short and the new deal struck with the EU and IMF could start to fray. The offer, which was supposed to close on Friday, will now run until Tuesday, suggesting Athens has not hit its target yet. But it is probably only a few billion short so it’s hard to believe things are going to fall apart over that and the likelihood is that the euro zone will agree to start bailout loans flowing again before the week is out.

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