Last week was supposed to have been Europe's victory lap. European leaders were going to start fleshing out the details of the hard-fought deal reached the prior week before travelling to Cannes for the G-20 summit.
But nothing is ever that easy.
A series of political stumbles and the hard realities of the situation got in the way. The crisis remains as serious now as it has ever been. Many of the open questions posed with the deal are now even trickier to answer and no clear solutions are at hand. It's going to be a bumpy ride.
The real wrench in the works happened when Greek Prime Minister George Papandreou blindsided the European community by announcing his intention to hold a referendum on whether his country would agree to the terms of the bailout. This referendum morphed into a full-blown plebiscite on whether the country should remain in the eurozone at all. After a few days of wrangling and angry glances from the rest of the EU, Papandreou called off the poll last Thursday after leaders of the main opposition party agreed to vote for the bailout measures in parliament.
But even without the referendum taking place, the mere floating of the idea underscores the fragility of the Greek political system, further exposes the popular unrest surrounding the deals, and likely makes the situation even more precarious.
Friday's confidence vote didn't instil much confidence in the Greek political system, either, particularly since it was followed by Papandreou’s resignation over the weekend. On Monday, Europe woke up to a new plan to create a unity government in Greece, which unfortunately raises more questions that it answers. Will the coalition government have the mandate to actually push through the bailout plan? Will the proposed early elections turn into a de-facto referendum on the plan? The latest political reshuffle in Athens has just added to the murkiness of the situation.
A Greek Departure Is Now More Likely
Up until last week, the official line has been that Greece leaving the eurozone is not an option. Leaders across the spectrum swore up and down there is no situation in which Greece would leave and that no preparations were being made. As Sarkozy and Merkel fumed over the referendum, they started mentioning for the first time that Greece needs to decide if it wants to keep the euro or not.
The mere suggestion that Greece could leave the eurozone makes it more likely to happen. As Greeks get more fearful that their bank deposits are on the verge of being devalued, the run on Greek banks is only going to get worse, compounding the country's woes. And the chatter could also provide political cover for Greek politicians who may want to push for a euro exit as a way to help ease the burden of externally imposed austerity measures.
And an exit is not a trivial matter. The country will have to impose strict capital controls to keep the entire economy from collapsing. Banks will be pushed to the absolute brink and there will be limited resources to keep them standing. There are also a bunch of tricky issues that will be very hard to solve. What will happen with pre-existing cross border euro-denominated contracts? German firms aren't expecting payment in Drachmas. Will the fact that the EU law has essentially no provision for leaving the euro--short of leaving the EU altogether or using some unspecified emergency powers--be any hiccup? What would happen to the agricultural and other transfer payments from the EU that Greece currently relies on?
Greece's exit from the eurozone is not yet a fait accompli. If the Greek people were determined to remain and the rest of Europe was willing to further open its wallet, there are scenarios in which the country can stay. But the recent political dysfunction makes that less likely.
Italy Will Be Threatened
Italy is also having a difficult time. Spreads on Italian bonds versus German bonds continue to rise to new euro-era highs as worries mounte that Italy would need a bailout and that bondholders would be forced to take a large haircut. The wrangling in Greece is forcing investors to take a hard look at what was, until a few months ago, still considered a remote possibility of default.
Even though Italy has a better short-term liquidity profile than Greece, its long-term view isn't much rosier. Large structural reforms are needed to get the country back on track, and that is going to involve complex and competent government action. But Prime Minister Silvio Berlusconi's government can hardly be called competent. This is being seen as an even greater risk after the Greek government's failings have highlighted the political risk inherent in actually implementing austerity packages. As investors lose faith in the Italian government to do much of anything, they will also lose faith in its obligations.
Average Italians could also lose faith. When they see what will happen in Greece if it leaves the euro, they are going to rush to get their money out of the country as quickly as humanly possible. The flood of capital from the country will make the situation that much harder to solve.
And an Italian collapse is a much scarier prospect. Italy is a core part of the eurozone, and its departure or default would likely mean the end of the euro. There just isn't enough money to throw at it to make the problem go away. The economies of Greece (and Ireland and Portugal, for that matter) are small enough that they can be bailed out without bringing down the rest of the continent. But Germany can't save Italy. A full-blown Italian crisis could starve off growth for years and send unknown shockwaves through the financial system.
Cracks in the EFSF?
One of the key parts of the latest eurozone deal was to leverage the funding that the member countries put in to make the European Financial Stability Facility more effective. One way to do that would be to have the fund issue bonds. The only problem with this plan is that it turns out the demand for these bonds is not as strong as was hoped. Even though they have received a AAA rating, no one is exactly treating the EFSF debt as a risk-free asset and a planned sale of bonds had to be pulled this week.
One of the reasons for investors' caution seems to be that the rules of the game are constantly changing. The political situation remains incredibly fluid. And as we saw last week, the recipients of the bailout funds could very well try and change the terms of the agreement at any time.
It is going to be harder and harder to convince investors to hitch their wagons to this star. And if this method of boosting the EFSF fails, then how will the EU raise the money needed to provide emergency liquidity to failing members? It sends the community back to the drawing board once again.
I don't think last week will go down as the eurozone's finest. All is not yet lost, but there have been many steps back from the prior week's step forward.
What do you think? Can last week's deal be saved? Will other political hot spots pop up? Can Italy get its house in order?
This article was originally published on Morningstar.com, a sister site of Morningstar.co.uk, on Sunday, November 6 and has been updated on Monday, November 7.
