Despite Latest Greek Farce, Eurozone Remains Becalmed…

The euro zone continues to simmer in the background, but shows no signs of boiling over again. Despite the second rating agency downgrade to France’s AAA rating, the euro zone has dropped to the edge of investor’s concerns in recent months, which looked a good bet back in June. Even an unseemly spat between euro zone officials and the IMF about the level to which Greece’s debt/GDP ratio should fall and exactly when has failed to arouse renewed panic, a dispute that has delayed yet again a new €44bn tranche of funding to much Greek frustration, after the latest raft of deflationary austerity measures were passed in the Athens parliament. The IMF initially calculated that without any further relief, Greek debt will stand at nearly 150% of GDP by 2020, while the EU believes it will be just over 140%; of course, even half that would be a challenge for an economy as chronically uncompetitive as the Greek one. Moving the target to 2022 makes a significant difference to designing the debt relief structure, as it may not require official sector write-downs, which the IMF (and ECB) are keen to avoid.

A ‘voluntary’ extension of Greek debt duration to as long as 30 years is being discussed or secondary repurchases of discounted Greek debt from private holders, but ultimately Greece will have to write off another huge chunk of its sovereign debt, and official lenders will have to take the pain this time, but that was never feasible before the German elections next year. Spain still needs a bailout package, but is loath to ask for one; the IMIE index showed a 12.5% y/y decline in Spanish property prices last month, which brings the cumulative decline since the market peak to 33.2%, still 20 percentage points less than in Ireland for even greater overbuilding. Despite some encouraging signs of a potential return to the markets for funding and local probably levelling out, Ireland badly needs relief from the legacy burden of its bank bailouts to become Chancellor Merkel’s ‘poster child’ for financial self-discipline.

Overall, while European deleveraging (particularly for Italian and Spanish banks) will take years to sort out Japanese style, widespread predictions of EMU’s imminent demise in early summer proved very premature. There is still a common view that austerity will prove self-defeating and will collide with political resistance in the indebted countries, or even regionalism with for instance wealthy Catalonia seceding from Spain. However, the euro zone now has a permanent rescue system and a central bank that will finally act as lender as last resort, albeit with strict conditions. Germany has proved much less rigid in policy terms than most observers expected, and by backing the ECB ‘put’ on peripheral debt has got ahead of the markets for the first time in this saga.

One risk remains a reappraisal of French credit risk next year, as the country loses its ‘safe haven’ premium rating on a gradual normalization of capital flight inflows from the periphery. Near term, so long as a Greek deal is signed in the next couple of weeks, the welcome solvency crisis respite should continue while investors nervously watch the footwork of Washington politicians as they wrestle on a cliff edge. As most senior Republicans seem keener to push each other over a cliff rather than the country in the aftermath of the Romney debacle, and the Tea Party’s economic ‘Taliban’ has been largely sidelined, common sense still looks likely to prevail, but there will be inevitable posturing along the way.