MacroScope

So we’ve got the fresh Greek elections we expected and markets, despite the inevitability that we would get here, have reacted with some alarm. European stocks have shed  around 1 percent, and the harbour of German Bunds is pushing their futures price up in early trade. The Greeks will try to form a caretaker government today to see them through to elections expected on June 17.

The key question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position (no to bailout, yes to the euro) and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that. SYRIZA remains ahead in the polls.
To be able to pull it off, PASOK and New Democracy will need some help from Europe. There have already been hints from Brussels that if a pro-bailout government is formed, Athens could be given some leeway on its debt-cutting terms. But equally other voices are saying there is no more room for manoeuvre.

France’s Francois Hollande used his presidential debut to frame help for Greece within his push for a European growth strategy last night, saying he hoped that could also foster a return to prosperity there. He and Germany’s Angela Merkel are due in the United States for a G8 summit at the end of the week where doubtless they will come under heavy pressure to make sure Greece doesn’t bomb out of the euro zone or, if it does, that the effect is contained. Easier said than done. Given a Greek euro exit would probably require rapid concerted reaction from the EU, IMF (to shore up Spain?) and the world’s big central banks (remember the global monetary policy response after the collapse of Lehmans?), planning for that could well be bubbling below the surface at the G8.

IMF chief Christine Lagarde said last night that it was important to be technically prepared for the possibility of Greece leaving the euro zone while Finland’s prime minister said Greek euro exit would not cause the financial mayhem seen in 2008.

As we’ve said before, Greece has some leverage. The IMF, ECB and euro zone governments are holding a lot of Greek debt so have an incentive to keep the  show on the road or face heavy losses if there is a hard default. Of Greece’s 250 billion-plus euros of debt, nearly 200 billion is now held by those public bodies, most of it by the ECB, which could need recapitalizing after that sort of hit, something that would fall back on euro zone governments. It is also hard to see how Europe could avoid propping Greece up even if it did leave the currency club. The calculation for euro zone leaders is whether pouring good money after bad is more or less palatable than taking a big loss on their Greek debt holdings.

Greece is stumbling inexorably towards fresh elections which polls suggest will give the anti-bailout far left a stronger grip on power. Last ditch talks aimed at creating a unity government will continue under the aegis of the president today but the leader of the radical leftist SYRIZA has said he will not turn up. Alexis Tsipras says he wants Greece to stay in the euro but will rip up the bailout agreement. Go figure.
This morning the more moderate left party has said it won’t take part in a government lacking SYRIZA.

A big question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that.

Two ECB policymakers –  Honohan and Coene – were out over the weekend talking about the possibility of a Greek euro exit: there goes another taboo. Policymakers must be running through the hard default and exit scenarios now. We need to be asking.

It was Bill Clinton who, after the 2000 U.S. election was thrown into turmoil by Florida’s hanging chads, said the American people had spoken but it was going to take a little time to work out what they had said.
No such dilemma in Greece. A plague on both your houses was the message for the traditional ruling parties PASOK and New Democracy, a result that makes a stable government look a remote possibility and puts a very real question mark over its bailout programme.

Today, the largest party New Democracy will try to form a coalition. Given what they’ve said, the left-wing Left Coalition which leapfrogged PASOK into second place cannot be part of a government committed to the bailout terms so it looks like the two traditionally dominant parties — two seats short of an overall majority between them — must seek support from elsewhere or face fresh elections which could well give an even more fractured result. One thing worth noting is that even the resurgent anti-bailout parties mostly say they want to stay in the euro zone so maybe there’s soom room for negotiation.

The euro has dived to a three-month low, Bund futures have posted yet another record high and European shares are down so we’re right back in fear mode.

After a May Day holiday lull, the euro zone roars back into life with Spain facing a game of chicken with the bond market as it auctions three- and five-year bonds and the ECB holding its monthly policy meeting in Barcelona, which lends it a certain poignancy.

Spanish yields will rise sharply compared with the previous equivalent sale and the auction is the first since S&P’s two-notch downgrade of Spain’s credit rating last week. Spanish banks, flush with three-year cash despite their horrendous bad loans problem, continued to load up on Spanish government debt in March while international investors backed off. Whether they will continue to do so is a very open question.

Three- and five-year yields on the secondary market are more than a percentage point higher than when this maturity was last sold earlier in the year. But 2.5 billion euros is a modest amount to shift and Spain has already sold half its debt issuance target for the year in the first four months.

A week where every facet of the euro zone debt saga will come from all angles.

The major events are the French presidential run-off and Greek general elections on Sunday, May 6.
 
In the former case, a likely socialist Francois Hollande victory could cause some market jitters given his rhetoric about the world of finance. But we’ve looked at this pretty forensically and actually there may not be much to scare the horses. Yes he is making growth a priority (but even the IMF is saying that’s a good idea) yet his only fiscal shift is to aim to balance the budget a year later than Sarkozy would. And, contrary to some reports, he is not intent on ripping up the EU’s new fiscal rules. And of course, the bond market will only allow so much leeway.

If the two main Greek parties – PASOK and New Democracy – fail to win enough votes to govern together, they may have to turn to a fringe anti-bailout party which would put a big question mark over Athens’ ability to stick with the austerity terms demanded by its international lenders.

Even if fears about a hard Greek default or even euro exit result, the threat of contagion looks far smaller. With creditors already having taken a massive haircut, most non-Greek banks completely out or at least having written down anything they hold, a 500 billion euros rescue fund shortly in place and the IMF raising an extra $430 billion of its own, the power Greece has to start a domino effect in the euro zone is very much diminished.

Once again European efforts to contain crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank’s commitment to provide nearly a trillion dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval. Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

ECB policymakers from Mario Draghi down will come at us from all angles today. Expect a united front on the main theme of the moment; calls for it to consider yet more liquidity operations essentially creating money and/or resuming its government bond-buying programme. That call was first heard at the IMF spring meeting over the weekend and the ECB president’s response could hardly have been clearer, saying: “None of the advice of the IMF has been discussed by the Governing Council, in recent times at least”.

Since then a number of his colleagues have followed up. The message: they are looking more to inflation now and banks and governments have to put their own houses in order after the ECB gave them time with its colossal three-year money-creating exercise.
The ECB’s man in Spain, Gonzalez-Paramo, is already out this morning saying Spain will not struggle to meet its debt issuance target this year despite its rising yields.

The ECB will, of course, act if the crisis drives Europe right back to the brink, it’s mandate will pretty much demand it at that stage but we’re not anywhere near there yet – contrary to what many in the markets believe.

It was fun to watch. Nouriel Roubini, NYU economist and crisis personality, was one of just five carefully selected individuals at a large gathering in the International Monetary Fund HQ1 building’s towering atrium who actually got to ask questions of the policymakers on stage.

Roubini was characteristically biting in his critique of conventional orthodoxy, singling out the European Central Bank for not having done enough to stem the euro zone’s two-year financial crisis. He challenged the notion that the ECB is powerless to boost growth further, suggesting — to the clear discomfort of some policymakers in the room — that measures to weaken the currency could provide a badly-needed boost to exports:

I saw that on the panel there are four central bankers and the panel is about fiscal policy and sovereign debt. So the natural question is then to think maybe about what could be the contribution of central banks in resolving sovereign debt issues. Now, one simple answer would be to just monetize very large budget deficits and I understand why a central bank would say that’s a no-no.

An action-packed weekend with both good and bad news for the euro zone, which may — net — leave its prospects little clearer.

Item 1: The IMF came up with $430 billion in new firepower to contain the euro zone-led world economic crisis, although some of the money will only be delivered by the BRICS once they have more sway at the Fund. Nonetheless, the figure at least matches expectations and could give markets pause for thought. The official line is that it is for non-euro countries caught up in the maelstrom but no one really believes that. If a Spain is teetering, IMF funds will be there. Together with the 500 billion euros rescue fund set up by the euro zone, there is still barely enough to ringfence both Italy and Spain if it came to it. But will it come to it?

Item 2: Socialist Francois Hollande came out top in the first round of the French presidential election and is now a warm favourite to win. Some fear that could weaken the Franco-German motor which must be humming smoothly if further crisis-fighting measures are to be convincing. Others say he is essentially a centrist who, either way, will be constrained by the realities of the euro zone situation. Domestically, his focus on tax rises over spending cuts and a slower timetable for cuts could drive up French borrowing costs. Attempts by Hollande and President Nicola Sarkozy to woo the substantial votes that went to the far right and far left could lead to some nerve-jangling campaigning messages for the markets to swallow in the run-up to the May 6 second round.

Central balance sheets across the industrialized world have increased rapidly in response to the financial crisis, as recently noted on this blog. In Europe, the balance sheet of the ECB and the 17 national central banks that share the euro currency has grown to around 3 trillion euros after the ECB injected more than a trillion into the market in 3-year loans and loosened its collateral standards.

At above 30 percent of gross domestic product, the ECB’s balance sheet has overtaken that of the Bank of Japan, which has been grappling with deflation for some two decades and started from a much higher level. It is also bigger than that of the U.S. Federal Reserve, which has aggressively responded to two financial crises in five years by tripling the size of its balance sheet to nearly $3 trillion today.

Historically, a central bank’s job is to maintain price stability and the value of its currency. The ECB’s non-standard measures have aimed to do just that as the euro zone debt crisis threatened the viability of the euro currency. But a growing and deteriorating balance sheet also comes at a price.