No holiday in sight for Club Med debtors


Italy’s debt auction on Friday reminded us that the Eurozone’s third largest economy is still its weakest link. It had to pay the highest price since joining the euro-area to sell 10-year bonds, as investors’ charged a higher risk premium to hold Rome’s debt, 6.06 per cent. So far this year Italy’s average growth rate has slowed from a fairly bleak 1.1 per cent in 2010, to a dismal 0.8 per cent. It is the third largest debtor in the world behind Japan and the US. But both countries have extremely low bond yields: Japan’s 10-year bonds yield 1.04 per cent, while US 10-year yields are 2.34 per cent, and both have higher growth projections than Italy.

Investors no longer tolerate enormous debt. If Rome doesn’t clean up its act and push through growth and public spending reforms there could be more trouble to come. Some good news came from last week’s summit: French and Spanish borrowing costs fell in the aftermath of the deal. However, the fact that Italy remains mired in trouble has the potential to dent investor confidence and could start to weigh on risky assets.

It would be incredibly naive to think that the Eurozone crisis has been solved. We still don’t know much about the methodology behind how the headline solutions will be reached. Make no mistake, European economies are in a dark place, with governments saddled by debt and growth under severe strain by the required austerity plans needed to contain a debt fallout. Eurozone GDP grew at an anaemic 0.2 per cent in the second quarter – its weakest for two years. Tackling the debt storm in the Eurozone is a vital first step towards fiscal strengthening of the Eurozone, but growth will be contingent on many other additional factors.

The uncertainty of how these measures will be achieved saw the stock market surge to a relatively quick end on Friday, as the adrenaline has waned from the relief of the initial deal. If investors fully believe that the plans are credible and, just as importantly, achievable, then this could certainly help provide a fillip for stocks to push higher. But that remains a big if.

The resilience of the single currency presents Europe with a problem that cannot be ignored. For growth to return, Europe needs a weaker currency, not a stronger one. This move higher makes life much more difficult for the southern economies, which need to grow to pay down debt.

The European Central Bank was a spectator at last week’s events and needs to be much proactive, along with European governments, to kick start growth in Europe. All the key indicators from PMIs suggest Europe is heading for recession, if not already there, and Mario Draghi, Jean-Claude Trichet’s successor, needs to take the first steps this week. Reducing borrowing costs by cutting interest rates to pull the euro lower is a first step.

Last week’s higher than expected German CPI numbers could make a possible rate cut more problematic for him at his first meeting, but he needs to be bold. Last week’s agreement will rely on the continued delivery of fiscal goals. It is less than certain that Greece, or Italy for that matter, will be able to grow at the required rate, while at the same time implementing spending cuts and further austerity.

The most important thing for Europe’s economies right now is confidence and last week’s EU summit has at least given a boost to confidence to some degree. Many are arguing that the moves do not go far enough and despite haircuts, recapitalisations and boosts to bailout funds, none of these are going to prevent the eventual default of Greece. What it does do though is buy time and that's what the Eurozone has been crying out for.

Has the can been kicked down the road and when we get to it will it be a bigger and heavier can to kick later? Quite possibly, however it gives heavily indebted nations breathing space to get their houses in order and rid themselves of the debt shackles.
Of course none of this will be possible without growth. The confidence boost that Wednesday’s plans can give to businesses and consumers within the Eurozone could just be the trigger needed in order spark growth again and avoid a double dip recession.

However, the bigger question is whether banks can absorb the huge writedowns on top of having to recapitalise and at the same time keep lending going, the life blood of the economy. If the plans lead to another credit crunch and the bigger nations don’t address their debt problems, when we come to that can two years down the line, then it’ll be too heavy to kick.