Sleeping, not dead
The euro zone has gone from crisis to catharsis in three months. Markets used to panic over what would happen when Italian yields topped 7 percent. After breaching that level in November last year, Italian 10-year yields have fallen below 5 percent. Spanish yields, which never quite got to 7 percent, have also sunk below that symbolically round number.
The European Central Bank’s willingness to provide ultra-cheap funds to banks – now over one trillion euros – has been just one facet of a grand bargain that has changed the game. In Italy, regime change has enabled a coalition government to push though reform that would have been impossible under Silvio Berlusconi. In Spain, a new conservative government is enacting tough labour reforms. Meanwhile, a commitment by governments to fiscal discipline across the euro zone has enabled the ECB to give banks ultra-cheap funds.
But the contagion demon is dozing, not dead. Greece and Portugal could both still rattle markets with disorderly defaults. Spanish banks may need more capital as recession bites, while its miscreant regions may resist the government’s new controls. In Italy, labour reform is needed, and may prove more controversial than liberalisations enacted so far. Even the grand bargain between governments and the ECB could turn nasty. The central bank will be reluctant to provide more cheap funds if governments drag their heels on reform, or fail to boost the bailout funds as promised. Lastly, citizens in peripheral countries will have to tolerate fiscal austerity and structural reforms at a time when unemployment is high and rising and when there’s no clear light at the end of the tunnel.
The ride may get rocky again. But one side-effect of the ECB’s liquidity operation is that banks won’t need to raise money from investors when they repay hundreds of billions of euros of debt that matures this year. That, in turn, means investors will have lots of cash that they need to redeploy into other risky assets. The feel-good factor looks likely to last for quite some time.