A day to reckon with

July 4, 2013

This could be a perfect storm of a day for the euro zone.

Portugal’s prime minister will attempt to shore up his government after the resignation of his finance and foreign ministers in successive days. The latter is threatening to pull his party out of the coalition but has decided to talk to the premier, Pedro Passos Coelho, to try and keep the show on the road.

If the government falls and snap elections are called, the country’s bailout programme really will be thrown up into the air. Lisbon plans to get out of it and back to financing itself on the markets next year. Its EU and IMF lenders are due back in less than two weeks and have already said the country’s debt position is extremely fragile.

Given the root of this is profound austerity fatigue in a country still deep in recession a further bailout is increasingly likely. Portuguese 10-year bond yields shooting above eight percent only add to the pressure; the country could not afford to borrow at anything like those levels. President Anibal Cavaco Silva’s will continue talks with the political parties today.

Greece has until the end of the week to put together a detailed programme of public sector reforms to convince the EU and IMF to pay out an 8.1 billion euros loan tranche from its second bailout. That will go to euro zone finance ministers to peruse on Monday.

Without the money, hefty bond repayments due in August look a bit dicey though there are suggestions that the money could be handed out in dribs and drabs to focus minds.

Officials in Athens have already said they won’t meet targets on loosening up public sector hiring and firing but will attempt to address all other concerns. However, Prime Minister Antonis Samaras has ruled out a fresh round of cuts, his government is seeking to lower its privatization revenue target after failing to sell its natural gas operation and there is a 1 billion euros black hole in the state-run health insurer. So its lenders may demand measures to fill that.

With German elections looming in September and no one wanting a fresh disaster, the odds are that the money will flow but whether the IMF can stomach that indefinitely remains to be seen. Longer-term, the smart money is on a further debt restructuring being required and with Greek bonds now overwhelmingly held by euro zone governments, that will mean a hit for Europe’s taxpayers.

Italy is also back in the firing line. Prime Minister Enrico Letta has summoned his fractious coalition partners for a meeting in order to try and forge agreement on economic reforms after the leader of the centrist Civic Choice group, Mario Monti, warned he could withdraw from the coalition.

Civic Choice has too few seats in parliament to bring down the government but former technocrat premier Monti is a voice to be reckoned with. The centre-left PD and centre-right PDL are already at odds over the latter’s insistence on scrapping a housing tax introduced by Monti, which will require cuts or tax rises elsewhere to keep within EU borrowing limits.
Economy Minister Fabrizio Saccomanni holds a news conference with a visiting IMF delegation.

It’s also ECB day, which on any normal day would be the headline. No shift is expected although borrowing costs in the euro zone’s periphery are firmly on the rise again after the Fed said it could have shut down its money-printing presses by mid-2014.

That brought to an end a 10-month trend of cheaper borrowing following the ECB’s pledge to buy government bonds in potentially unlimited amounts to shore up the single currency. The travails of Portugal and Greece have only exacerbated the pressure on borrowing costs – which represents an implicit monetary tightening — while the latest data show bank lending in the euro zone continues to contract.

As usual, Mario Draghi’s press conference will be minutely parsed but it’s not clear what the ECB can do on either score.

Bond-buying can only be triggered if a country requests help from the euro zone’s rescue fund and is borrowing on the market. That rules out everyone at the moment. There has been talk of cutting the deposit rate – which banks get for storing their money at the ECB – into negative territory to try and boost lending. But that rate is already at zero and has not prompted banks to lend. If deflation loomed, the ECB’s mandate would allow it to print money but again that looks unlikely.
Another option would be an offer of cheap, three-year liquidity to banks similar to the more than 1 trillion euros handed over last year. That is probably the most likely crisis response but there has been no hint of the ground being prepared for it so far.

Given all that, don’t rule out another cut in interest rates to a new low of 0.25 percent later in the year. The fact that policymakers are talking up “forward guidance” – giving a steer that policy will stay loose for a long time – shows how bare their toolbox is.

Mark Carney makes his debut appearance at the Bank of England’s monthly policy meeting. The Bank is not expected to add to the 375 billion pounds it has created. Our poll of economists gave a median 40 percent chance that more pounds will be printed before the year-end and that was before startlingly strong manufacturing and services PMI readings this week.

It could quickly become apparent that the man brought into achieve economic “escape velocity” may instead need to look at an economy in recovery with inflation still well above target.
With the era of falling sovereign borrowing costs well and truly over for now, Spain returns to the market as does France. Madrid is a long way through its 2013 funding programme so to that extent the pressure is off. But this is not an auspicious time to be selling up to four billion euros of three different bonds.

France also bears close watching. Its economy is flatlining, the government is railing against exhortations from Berlin and Brussels to raise the pace of structural reform and yet it has been borrowing for 10 years at not much more than two percent. It will sell up to 8 billion euros of long-term debt.

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