Italy Is Now The Main Battlefield

Over the past week, the European debt crisis has increasingly turned into a two-front war for euro area policymakers. They are still attempting to contain the fallout from Greece while probably also increasingly acknowledging that the decisive battle will eventually have to be fought in Italy. The big question is whether euro area policymakers at the current juncture have the firepower to prevail if it turns out that Italy will not be able to get funding in the market at „reasonable‟ interest rates.

On a positive note, there are signs of improvement outside Europe. In the US, data still suggests that the economy is improving slightly, while in China inflation now appears to be declining fast and freeing the hands of China to turn to a more growth supportive economic policy. Hence, the euro area is now the weakest spot in the global economy. We revised our growth forecast for the euro area markedly in the past week and now expect it to slide into recession.

This week the main focus has been on political developments in Greece and Italy. Both countries have had a turbulent week with lots of political drama. In Italy, a vote on budget matters revealed that Prime Minister Berlusconi has lost his majority in the parliament and it was announced that he will step down once new austerity measures have been approved. This is expected to happen on Sunday. Once Berlusconi has stepped down, the most likely scenario is a new unity government led by former EU commissioner Mario Monti. However, a general election cannot be ruled out. As a consequence of the political instability in Italy and a higher margin requirement on the London Clearing House (LCH), 10-year government yields went as high as 7.5% this week. However, by the end of the week, they were back below 7% again.

Following Papandreou‟s announcement of his departure, the discussion on who should lead the interim unity government continued. The main opposition party, the New Democracy, caused difficulties in the negotiations because it was not interested in getting too involved in the new government coalition due to the election in 2012. At the end of the week, it was announced that former ECB Vice President Lucas Papademos will lead the new unity government. The election of Papademos is viewed positively by the market. The first act of the new unity government will be to implement the EU/IMF package in order to pave the way for disbursement of the sixth tranche.