Markets seem to be optimistic about the euro crisis (at least until today). Indeed, there is some reason for that. There is good news, but things are far from resolved.
The good news: The ECB and Italy
The two "Super Marios" have done their job better, much better than could have been expected. Mario Draghi, the ECB president, has made quite a mark with the unprecedented 3 year loan program to banks. This has been absolutely crucial, not only to keep the banking system afloat, but also to steer some of that money back to the sovereign debt market of plagued nations.
But he could not have pulled off that stunt (to be repeated next month) without the other Mario, Mario Monti, the new Italian Prime Minister. If the European Union would ever deal out knighthoods (or even sainthoods), Monti is a prime candidate. He has achieved more in a couple of months than several Italian governments in decades. He has trimmed budgets where they needed to be trimmed, reformed an overly generous pension system.
Most important of all, he's embarking on structural reforms taking on vested interests in taxi drivers, pharmacies and other professions, opening them up, introducing labor market and welfare reforms.
Let the Italian people share in the glory, and use their sacrifice as leverage on the European stage, where he has quietly pleaded for a less one-sided approach that presses for relentless austerity that bears the risk of being self-defeating.
Italy hasn't got a large budget deficit (although it does have a large public debt, at 120% of GDP), so plugging that can stabilize the debt/GDP ratio and increase confidence, which leads to lower interest rates and further easing of the debt burden in a sort of virtuous cycle. This seems to be happening as we write, with Italian yields already down quite significantly from their peak.
If Italy holds, that's three-quarters of the euro saved. The main danger from Italy is that if the economy would worsen sufficiently, it could negate the above virtuous cycle to take hold as negative growth reduces tax income and could very well keep the deficit from narrowing. This is, after all, happening in many of the other countries, more especially Greece, Portugal, and Spain. Politics could be another Italian risk, but for the moment, Monti is walking on water even in his own country, despite many measures that are going to hurt.
Markets tired of betting on implosion
Another positive is that markets simply seem tired of betting on some kind of catharsis that is pushed ever further every time it seems imminent. The euro crisis has been with us for the best part of two years. Maintaining short positions isn't free, and other instruments (derivatives) have limited life and considerable losses can be incurred on them if the market doesn't sufficiently move in the desired direction.
Things are not moving according to plan in Portugal. It has managed to stay out of the limelight because Greece is in a far worse shape, but ever since the S&P downgrade, interest rates (and CDSs) have ratcheted up. The outstanding public debt is already at Italian levels (112% of GDP) although relatively small in monetary terms (129B euros). Yields on 10 year debt have breached 15%.
While the new government has been praised for its austerity efforts, we're not so sure this is warranted. It seems to backfire:
Jurgen Michels, Europe economist at Citigroup, said Portugal's economy will contract by a further 5.8pc this year and by 3.7pc in 2013, a far sharper decline than official forecasts. The peak-to-trough collapse would be 13pc, a full-fledged depression.
Private debt, at some 250% of GDP, is considerably higher than in Greece though and the combination of this and the weakness of the economy, banks are in trouble. Despite the terrible state of the economy, Portugal still has a large trade deficit, testifying to the lack of competitiveness.
The saving grace is that this year, only 17B of debt has to be refinanced. We fear that it won't be long before Portugal faces a similar situation to Greece, and private-sector debt holders will face a second default.
There now seems to be progress on the private sector involvement deal with Greek debt holders. Apparently, they're going to swap their present bonds for half new ones with a 30 year time to maturity and a 3.6% interest, according to Bloomberg TV Sunday night. That's some progress, and it means a loss greater than 70%, although the real figure is a lot lower as much of Greek debt (40%) is in official hands (the ECB, IMF).
but here is not where the real problem lies. The real problem is implementation of reforms on the ground. Yes, the Greeks have cut public spending, and wages and have hiked taxes, but tax hikes mean little if they can't be collected. As we've been saying for quite some time, there has been too much emphasis on austerity and not enough on structural reforms. The austerity might very well have been counterproductive, sinking the economy further and reducing the tax base.
The Greeks should take a leaf out of Mario Monti's book, but this is now starting to sink in:
The next several days will shape Greece for the next decade, Venizelos said. In addition to the debt swap, "We have labor, structural reforms and pension issues to resolve," he told reporters in Athens late yesterday after meeting with troika officials. "There must be a national pact forged with unions and employers," he said.
But whether this talk boils over into action remains very much to be seen. Confidence that Greece can deliver is so low that apparently the Germans seem to push for more European powers with regard to the Greek budget, giving EU officials implementation powers on the ground. This is quite unprecedented, and it could possibly even backfire. The Greek are a proud nation which already feels rather humiliated, even if they brought most of it on their own shoulders.
Although the frustration with the lack of Greek progress is understandable, and the alternative (a Greek default and leaving the euro) probably even more unpalatable. But this is a dangerous step in itself that could politicize the situation quite significantly and provoke forces that once unleashed, one could rather do without.
How this finishes is still anybody's guess. It's possible that the markets accept the PSI deal that now seems on the table, but the official creditors won't disburse the 130B euro (there is already talk this isn't enough and it has to increase to 145B euro) of the new rescue package anyway, because of lack of progress on the ground.
Although Spain also enjoyed a reduction in yields, the situation on the ground has not improved; quite the contrary. The budget deficit is still around 8%, a long way off from what it was supposed to be this year (4.4%). And since the economy is already shrinking again, that 4.4% target seems very far off. Spain did have very low public debt at the start of the crisis, but with deficits this large, negative growth, and rising interest rates, that increasing at a rather alarming rate (now at 63% of GDP, but needless to say, this will increase rather rapidly still).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.