MacroScope

Some key positions were staked out on Greece over the weekend – ECB power-behind-the throne Joerg Asmussen became the first euro policymaker to say on the record that euro zone finance ministers meeting on Tuesday would be intent only on finding a deal to tide Greece over the next two years. But IMF chief Christine Lagarde told us in an interview that she would push for a permanent solution to Greece’s debts to avoid prolonged uncertainty and further damage to the Greek economy.
  
Sounds like those two positions could be mutually exclusive. However, it may be that something like a behind-the-scenes pledge from the German government that it will act decisively after next year’s election will keep the IMF on board.

Eurogroup chief Jean-Claude Juncker said at the weekend that intensive work was being done on a compromise with the IMF and progress was being made, after the euro zone sherpas put their heads together on Friday. And even hardline German Finance Minister Wolfgang Schaeuble said a deal had to be struck on Tuesday and would be. Juncker and Lagarde clashed last week over his suggestion that Greece should be given an extra two years, to 2022, to get its debt/GDP ratio down to 120 percent, the level the IMF has decreed is the maximum sustainable. Lagarde looked surprised and firmly rejected the idea.

IMF officials have argued that some writedown for euro zone governments is necessary to make Greece solvent but Germany has repeatedly rejected the idea of taking a loss on holdings of Greek debt, saying it would be illegal. 
Among ideas under consideration to plug the funding gap are further reducing the interest rate and extending the maturity of euro zone loans to Greece, a possible interest payment holiday and bringing forward loan tranches due at the end of the programme, according to euro zone sources.

Asmussen said loans alone did not help as they raised the long-term debt and that a solution had to be found that did not raise Greece’s debt level. It sounds increasingly like the ECB, which could forego profits it has made on its Greek bondholdings worth 12 billion euros or more and allow that to be thrown into the Greek pot (or should I say urn), is prepared for euro zone governments to take a loss on their  bondholdings. But it can’t countenance doing the same itself.

Even hardline Bundesbank chief Jens Weidmann said late last week that a new haircut of Greece’s debt could come as a reward for Athens implementing the reforms it has signed up to. Klaus Regling, the head of the euro zone’s rescue fund, also left more wiggle room than the German government has, saying a haircut could only happen in “exceptional circumstances”.

So said Winston Churchill of Russia. The Greek debt saga isn’t quite that unfathomable but the economic necessities continue to clash with the political realities.

Eurogroup Working Group – the expert finance officials from 17 euro zone nations who do the clever preparatory work before their finance ministers meet – will convene to today try and get the Greek debt process back on track after a ministerial meeting got nowhere on Monday and in fact ended up in an unusually public spat between its chair, Jean-Claude Juncker, and IMF Managing Director Christine Lagarde.

The Eurogroup plus Lagarde will meet again next Tuesday and there are big gaps to bridge although we intercepted the IMF chief in Manila this morning, insisting that a deal was possible, or at least that’s one way of reading her “it’s not over until the fat lady sings” quote.

Italy is expected to pay slightly more than it did a month ago to borrow for three years at today’s auction of up to 6 billion euros of a range of bonds. Yields edged up at a sale of 11 billion euros of short-term paper on Wednesday but there is no immediate cause for alarm. Three year-yields have dropped from 5.3 percent to around 3.3 since the ECB declared its readiness to buy the bonds of troubled euro zone sovereigns and Italy has shifted about 80 percent of its debt requirements this year, so is on track in that regard.

The fact that it now seems possible that Mario Monti could continue as prime minister after spring elections can’t do any harm either although yesterday’s surprise cut in income tax muddies the waters a little.

The main problem for Italy is that Spain is in no rush to seek a bailout, a move that would alleviate pressure on Rome too. The IMF kept up the drumbeat of pressure for action in Tokyo, demanding “courageous and cooperative action”, having yesterday said the euro area was still threatened by a “downward spiral of capital flight, breakup fears and economic decline”.  German Finance Minister Wolfgang Schaeuble retorted that Europe was solving its problems and had done far more than appeared to outside observers.

The ying.
Sources told us last night that Spain may recapitalize stricken Bankia with government bonds in return for shares in the bank. That would presumably involve an up-front hit for Spain’s public finances (it is already striving to lop about 6 percentage points off its budget deficit in two years) which might be recouped at some point if the shares don’t disappear through the floor.
The ECB’s view of this will be crucial since the plan seems to involve the bank depositing the new bonds with the ECB as collateral in return for cash. If it cries foul, where would that leave Madrid?

Spain’s main advantage up to now – that it had issued well over half the debt it needs to this year – may already have evaporated after the government revealed that the publicly stated figure for maturing debt of the autonomous regions of 8 billion euros for this year is in fact more like 36 billion. Catalonia said late last week that it needed central government help to refinance its debt.  If more bonds are required to cover some or all of Bankia’s 19 billion euros bailout, Spain’s funding challenge in the second half of the year starts to look very daunting indeed.

The yang.
Latest Greek opinion polls, five of them, show the pro-bailout New Democracy have regained the lead ahead of June 17 elections although their advantage is a very slender one. If the party manages to hold first place, and secures the 50 parliamentary seat bonus that comes with it, then it looks like it would have the numbers to form a government with socialist PASOK which would keep the bailout programme on the road … for a while.

After last week’s hefty losses, European stock gained yesterday and are up up again this morning, denoting some optimism about the Wednesday supper summit of EU leaders, which might well be unrealistic.

The European growth measures that we know are in the works – boosting the paid-in capital of the European Investment Bank and plans for ‘project bonds’ underwritten by the EU budget to finance infrastructure – might help a little but will fall a long way short of turning the euro zone economy around, so unless we get something more, on either the growth or the building defences fronts, there’s scope for investor disappointment.

Europe’s international partners continue to demand more dramatic crisis action. After the G8 summit, President Obama was out last night with four demands:
- firewalls to protect countries from Greek contagion (are the ESM and IMF funds now viewed as insufficient?),
- recapitalization of banks that need it (Spain to the fore here presumably),
- A growth strategy to run alongside tight fiscal measures (easier said than done),
- easy monetary policy to help the likes of Italy and Spain keep cutting debt (the ECB thinks its 1 percent rate is very loose and is unlikely to cut soon with inflation above target and will only flood the system with more liquidity in utter extremis)

Focus for the euro zone is firmly on Washington with G20 policymakers gathering ahead of the IMF spring meeting. The Fund is seeking an extra $400 billion-plus in crisis-fighting funds which, tallied with the $500 billion euro zone rescue fund about to be established, adds up to a meaningful firewall for the markets to ponder before they consider pushing Spain and Italy to the edge.

But as many sage minds are saying – U.S. Treasury Secretary Timothy Geithner among them – a firewall does not solve the root problems of the euro zone debt crisis. As our very own Alan Wheatley puts it, “It is not obvious why a stronger firewall should encourage anyone to enter a burning house”. Nonetheless, Reuters polling yesterday ascribed only a 25% and 13% chance respectively to Spain and Italy needing an international bailout.

If the IMF falls short, given the jittery mood in financial markets, that could be cue for a further sell-off. The IMF has pledges of $320 billion so far. The Chinese and British have yet to show their hands and the BRICS led by Brazil are demanding more power at the Fund before handing over extra cash. German Finance Minister Wolfgang Schaeuble told us earlier in the week that conflating those two issues was not acceptable so there is potential for a rift. The U.S. and Canada have already said they will provide no more funding. Finance ministers and central bankers from the Group of 20 advanced and emerging economies had dinner on Thursday night, ahead of a longer session on Friday.

Spain’s borrowing costs are likely to soar at an auction of 12- and 18-month T-bills after its 10-year yields were pushed through the totemic 6 percent level on Monday. The history of the euro zone debt crisis shows that once above 6 percent the spiral accelerates and before you know it you’re at 7 percent – the level generally seen as unsustainable for state financing.

Worryingly, Spain is dragging Italy’s yields up in its wake. But in Spain’s case, there are strong reasons for caution about imminent disaster. The government cannily used ECB-created benign market conditions in the first part of the year to shift nearly half its annual debt issuance needs already and the banks – which look like they will need recapitalization at some point – are well funded for now having also loaded up on the European Central Bank’s three-year liquidity splurge.

We also know Europe’s banks, too scared to invest elsewhere, are depositing 700-800 billion euros back at the ECB daily. If Madrid could engender a shift in confidence, some of that money could flow back into its bonds, particularly by Spanish banks.

So the debt crisis is back (did it ever really go away?) but it’s not yet anything like as acute as it was late last year.

Spain is coming under real market pressure, and dragging Italy with it to an extent, but there are good reasons to think it won’t fall over; banks well funded for now and the government’s savvy move to take advantage of benign early year conditions to shift almost half its 2012 debt issuance in three months.

Madrid faces another key test with a Thursday bond auction. Two weeks ago, it suffered its first wobbly debt sale for some months. The turning point is pretty clear – Prime Minister Mariano Rajoy’s decision to rip up Spain’s agreed deficit target for 2012 without consulting his partners. Since then, Spanish borrowing costs have soared though given the amount of debt Madrid has already shifted, that might not be as damaging as it was.

A day for central bankers and maybe the hint of a row brewing within the ECB. After days of jitters, euro zone bond markets were calmed a little this week when ECB policymaker Benoit Coure said the central bank’s government bond-buying programme could be revived if Spain started teetering.

That is decidedly not what the orthodoxists in Frankfurt would have wanted to hear. They are already worried that the creation of more than a trillion euros of three-year money could be stoking future inflation and creating addicted banks and feel that the bond-buying programme crosses a red line — that the ECB should not fund governments.

We know Bundesbank chief Jens Weidmann has been leading the charge to at least talk about an exit strategy from the ECB’s extraordinary policy stance – something the top man, Mario Draghi, slapped down pretty bluntly last week — and Orphanides, the ECB man from Cyprus, was out last night saying individual central bankers should not be making any commitments about bond-buying, a clear swipe at Coure.