MacroScope

European Central Bank chief Mario Draghi and Germany’s Angela Merkel – the two most important people in the euro zone debt crisis response – take to the stage today, the former giving lengthy testimony in the European Parliament, the latter holding a news conference with foreign journalists.

With Greece sorted out for now, Spain and Italy fully funded for the year and markets simmering down, the crisis is in abeyance, in no small part thanks to these two. Draghi provided the game changer with the ECB’s bond-buying plan late in the summer but Merkel has shifted profoundly too during the course of the year – most crucially from considering a Greek euro exit might be a good thing “pour encourager les autres” to realizing it would be a disaster and acting to rule it out and also in backing Draghi’s bold move and ignoring a large measure of German disquiet.

Germany continues to go-slow on future steps, at least in part largely for domestic political reasons, but look where we are now – with an ECB prepared to act in a way that horrifies the Bundesbank, a permanent euro zone rescue fund, a banking union in progress and multiple bailouts agreed and help for Spain likely to come soon – and it’s remarkable to see how far Berlin has moved.

There’s big stuff to come. At least some in the ECB are itching to use their new weaponry – which will require Spain to seek help from the euro zone rescue fund first – and it’s likely they will have to intervene in the bond market to keep speculative attacks on the euro zone’s weak links at bay for an extended period.

Italian elections in February will be unpredictable to say the least and there is still a profound debate to be had on how to build the euro zone’s future structures to knit it together more closely. The euro zone has form in relaxing one the most intense pressure is off it. But for the run-in to the new year at least it’s hard to see any fireworks.

Credit where credit’s due, the EU has surprised on the upside over the last 24 hours or so, not only signing off on a revised Greek bailout plan to keep that show on the road and agreeing that the ECB will supervise 150 or more of the bloc’s biggest banks, but then pledging to set up a mechanism to wind down problem banks.

Now, there is many a slip twixt the cup and the lip as they say – not much more is going to be cemented until next autumn’s German elections are out of the way, the ECB only has direct oversight of 5 percent or so of euro zone banks (when we know from the financial crisis that smaller banks can be almost as lethal as the big boys) and there is no indication of how a bank resolution scheme would be funded (perhaps via a financial transaction tax although only 10 or so countries have so far committed to that). Also, direct recapitalization of banks by the ESM rescue fund, to take the burden of indebted states, is unlikely to happen before 2014.

Nonetheless, we shouldn’t be churlish. EU leaders are clearly using the window of calm created by the European Central Bank’s pledge to buy euro zone government bonds in whatever size is needed to shore up the currency area in order to press on with the permanent structures which will ensure the bloc’s future. So while Finnish Foreign Minister Alex Stubb’s assertion that the EU is in its best shape for years may be pushing it a little, his follow-up line that if you’d offered them this state of play at the start of the year they’d have snatched your hand off is hard to argue with.

The Greek bond buyback has fallen a little short, leaving Athens and its lenders to plug a 450 million euro hole. The euro zone and IMF had given Greece 10 billion euros to buy back enough debt at a sharp discount so that it could retire 20 billion euros worth of bonds and knock that amount off its debt pile. Without that, the deal to start bailout loans flowing to Athens again would fall through.

Due to the discount working out slightly more generously than expected, Greece fell slightly short but it’s impossible to believe the currency bloc will throw itself back into turmoil over a few hundred million euros. Athens will confirm the state of play this morning. One source said German “bad banks” had not tendered most of their holdings and could be tapped again. A solution will be found and probably in time for the EU leaders’ summit on Thursday and Friday. IMF chief Christine Lagarde came close to saying as much last night, welcoming the bond buyback and leaving the loose ends to the Europeans.

More preparatory work for the summit gets underway today with EU finance ministers meeting to try and bridge a gap over plans to regulate euro zone banks cross-border – part one of building a banking union. The European Central Bank is set to be the overarching regulator but Germany wants its scope severely constrained, while others want it to be able to intervene in any euro zone bank, at least in theory. This does not have the power of Greece or Italy to move markets but an inability to agree on the least contentious part of a banking union would not send a good signal.

Italy’s borrowing costs over ten years drew closer to five percent after a decision by Prime Minister Mario Monti to step down early left the country’s political future unclear, hurting riskier euro zone debt.

Monti said on Saturday he would resign once the 2013 budget was approved, raising questions over who will take the reins of the euro zone’s third largest economy at a time when it remains a focus of the region’s three-year debt crisis.

His announcement, potentially bringing forward an election due early next year, came after former prime minister Silvio Berlusconi’s party withdrew its support for the government — and Berlusconi himself said he would run to become premier for a fifth time.

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.

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 American people have spoken but for the markets the votes of 300 Greeks could be of even more importance in the short-term. German Bund futures have opened flat, not really reacting to Obama’s victory, while European stocks have eked out some early gains.
       
We await a knife-edge parliamentary vote in Athens on labour reforms to cut wages and severance payments, which the EU and IMF insist are a key part of a new bailout deal, but which the smallest party in the coalition government has pledged to vote against. That leaves the two larger parties – New Democracy and PASOK – with a working majority of just nine lawmakers and on a less contentious vote on privatizations, a number of PASOK deputies rebelled. Ratcheting up the pressure is a second day of a general strike which will see thousands take to the streets.

We know that the troika has advised that another 30 billion euros needs to be found to keep Greece afloat. We also know that the IMF has been pressing for the ECB and euro zone governments to take a writedown on Greek bonds they hold, which Germany refuses to do so (which means it won’t happen, for now at least). The Eurogroup is awaiting the troika’s final report and it’s looking less likely that a definitive plan will be signed off at next Monday’s meeting of euro zone finance ministers.

Nonetheless, it’s in no one’s interests to let Greece crash at this point so the presumption is a deal will be done, probably featuring Greece getting two extra years to make the cuts demanded of it, extending maturities on its loans and cutting the interest rates. Talk of the ECB foregoing profits on the Greek bonds it holds (rather than taking a loss, since it bought them at a steep discount) continues to do the rounds. A further German condition is for a ring-fenced escrow account to hold some Greek tax revenues to ensure that it services its loans. Greece will probably also be allowed to issue more t-bills to tide it over though that requires the ECB’s acquiescence since Greek banks are entirely dependent on central bank liquidity and have been offering those t-bills up as collateral. Mario Draghi is speaking today.

Following Silvio Berlusconi’s threat to demolish Mario Monti’s government, Italy will try to sell up to four billion euros of five- and 10-year bonds at auction today. It will get away but investors could be forgiven for being nervous. Monti was in Madrid yesterday and issued a veiled plea for Spain to seek help from the euro zone rescue fund, which would trigger ECB bond-buying, in the hope that would drive down Italian borrowing costs too. But Spain, with nearly all of its 2012 funding done, is in no hurry.

Monti continues to insist Italy doesn’t need to seek help itself but said the ECB needed to be seen in action, rather than just offer speculators the threat that it could intervene, in order to keep the euro zone shored up. One suspects that is true.

Also last night, Sicilian election results showed the centre-left Democratic Party and anti-establishment 5-Star movement cleaned up at the expense of Berlusconi’s party. Perhaps the most worrying figure was the record low turnout by an electorate disillusioned by constant austerity. The possibility of Monti retaining the premiership after spring 2013 elections has helped keep market attacks at bay. In reality, that looks unlikely although he could take over the presidency to retain some voice and influence. The fractured nature of Italian politics raises the threat of no solid government emerging from the general election. Fitch cut Sicily’s rating to BBB late yesterday and warned of more to come.

With Spain content to sit on its hands for now (European Central Bank policymaker Nowotny highlighted the status quo on Sunday, saying Madrid is fully financed for the rest of the year), Greece and Italy will hold the euro zone spotlight for the next few days.

Yesterday, we reported that the EU and IMF have refused to offer any further concessions on the labour reforms they are demanding and which one party in Greece’s ruling coalition refuses to countenance. The government could just about carry a vote in parliament without the support of the Democratic Left but it would only take a handful of rebels within the New Democracy and PASOK parties to turn the tables. So we’ve got another standoff. The bill is due to go to parliament next week.

With the debt numbers clearly not adding up, more money – up to 30 billion euros –  is going to be needed, be that via lower interest rates and longer maturities on loans and/or a writedown on Greek bonds held by the ECB and euro zone governments. Athens looks set to get the extra two years it requested to make the cuts demanded of it.

The day before an EU summit that probably won’t come up with anything decisive in crisis management. If that sounds rather underwhelming beware. There’s an awful lot of jockeying for position over when Spain will seek sovereign help, the Greek troika talks continue to look messy with time running very short and the leaders would be very well advised to demonstrate that their longer-term plans for closer integration are not running out of puff – item one on that agenda is getting plans for step one of a banking union back on track.

We could get a decent crack at this today with a number of EU leaders, including Angela Merkel, Spain’s Mariano Rajoy and Greek premier Antonis Samaras, gathering in Bucharest for a centre-right political congress.

On the jockeying front, German Finance Minister Wolfgang Schaeuble has called for a leap forward in euro integration, particularly in terms of fiscal union with a commissioner given power over members’ budgets. That’s going to prompt some heated debate in Brussels on Thursday/Friday with France, in particular, likely to be aghast.