Italy will continue to cast a long shadow and has clearly opened a chink in the euro zone’s armour. It looks like the best investors can expect is populist Beppe Grillo supporting some measures put forward by a minority, centre-left government but refusing any sort of formal alliance. That sounds like a recipe for the sort of instability that could have investors running a mile. The markets’ best case was for outgoing technocrat prime minister Monti to support the centre-left in coalition, thereby guaranteeing continuation of economic reforms. But he just didn’t get enough votes. Fresh elections are probably the nightmare scenario given the unpredictability of what could result.
The story of the last five months has been the bond-buying safety net cast by the European Central Bank which took the sting out of the currency bloc’s debt crisis. But now it has an Achilles’ Heel. The ECB has stated it will only buy the bonds of a country on certain policy conditions. An unwilling or unstable Italian government may be unable to meet those conditions so in theory the ECB should stand back. But what if the euro zone’s third biggest economy comes under serious market attack? Without ECB support the whole bloc would be thrown back into crisis and yet if it does intervene, some ECB policymakers and German lawmakers will throw their hands up in horror, potentially calling the whole programme in to question.
In other words, until or unless a durable government is formed in Italy which can credibly say and do the right things, the euro zone crisis is back although not yet in the way it was a year ago when break-up looked possible.
Because of all this, Thursday’s ECB policy meeting looms very large, not because a shift in policy is expected but because journalists will get an hour to quiz Mario Draghi on the Italy conundrum. The Bank of England meets the same day. Policy stasis will probably be the order of the day again but it’s a much closer call after Governor Mervyn King was outvoted in calling for more money printing last month. Our poll puts a 40 percent chance on it happening this time. When King has been outvoted in the past, he has more often than not got his way some time later. It’s a big central bank week with Japan, Canada and Australia also holding interest rate meetings, so there may be something broader to be done.
The other big setpiece of the week is the monthly meeting of euro zone finance ministers today. They will discuss how to construct a bailout for Cyprus. Progress will be made, our sources say, with an end-March deal the aim. The big question is whether to hit Cypriot bank depositors as part of the deal. That could spark a bank run and set a nerve-jangling precedent for investors but the euro zone is determined taxpayers cannot forever be on the hook for this stuff. There appears to be a split on that question. ‘Twas ever thus. Italy of course will exercise the ministers although it’s hard to see what they can do with no government in prospect for a while.