Greece lightning

Financial markets

The prime minister’s botched referendum plan has left the debt deal in trouble

“JUST when I thought I was out, they pull me back in.” Investors must be tempted to echo the words of Al Pacino in “The Godfather: Part III”. Markets rally every time euro-zone leaders announce a plan to solve their debt crisis, as they did again on October 27th. But within a few days, it becomes apparent that each package has not solved the underlying problems, and investors are pulled back into the mayhem.
On October 31st the unheralded announcement by George Papandreou, the Greek prime minister, that he would call a referendum on the debt deal turned market sentiment drastically. It prompted intense pressure from Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president, that any such referendum be held as soon as possible and become a vote on staying in the euro. By November 3rd, as The Economist went to press, the prospect of a vote that could pave the way for an exit from the euro, and a disorderly default, had pushed the Greek government to the brink of collapse.


A Greek default would alarm investors in other indebted nations, such as Portugal and Italy, and might trigger the very financial meltdown the authorities have been striving to avoid. European bank shares, which rallied on initial news of the deal, slumped again on the referendum news (see left-hand chart). There is also the risk that depositors will shift their funds from banks in weak countries to safer havens. David Owen, an economist at Jefferies International, notes that Portuguese and Irish banks have pushed up deposit rates in recent months in an attempt to dissuade savers from withdrawing their money.

If Mr Papandreou is ousted or his government falls, a referendum becomes much less likely. But uncertainty about Greece’s ability to stay the painful course and remain in the euro will persist.
Doubts about the deal had emerged even before the Greek thunderbolts. It was not clear that the euro-zone leaders had done enough to bolster their rescue fund, the European Financial Stability Facility (EFSF), so that it could plausibly stand behind the debts of Italy and Spain. Ten-year Italian bond yields rose back above 6%, with the spread over German Bunds reaching a record euro-era high.
European leaders hoped that emerging economies, particularly China, might put money into a special purpose investment vehicle (unhappily, SPIV) capitalised by the EFSF. That would help bolster the EFSF’s remaining firepower to €1 trillion ($1.4 trillion). But the early signs were that such countries would be willing to invest only small amounts, and then on terms that would leave European governments bearing even more of the risks. A €3 billion bond issue by the EFSF was postponed on November 2nd because of the uncertainty.
Nor was it clear whether the requirement for banks to raise €106.5 billion of capital would be enough to reassure investors, or if it would instead force banks to shrink their balance-sheets, thereby shrinking the supply of credit to industry.
Investors were also unnerved by signs that the European economy seems to be slipping closer to recession. The euro-zone purchasing managers’ index for the manufacturing sector fell to 47.1 in October, the third month it has been below the crucial 50 level, signifying a decline in activity. Unemployment in the region rose to 16.2m in September, the highest since the launch of the euro. The OECD cut its forecast for euro-zone growth in 2012 from 2% to 0.3%.
European stockmarkets fell heavily on November 1st, with Greek and Italian indices falling by 7%. The euro also dropped to $1.37, having been as high as $1.42 in the wake of the debt deal. It made for a very uncomfortable first day at work for Mario Draghi, the new head of the European Central Bank. The ECB was reportedly buying Italian bonds this week but it has not made the kind of unlimited commitment to purchase bonds desired by many commentators (see Economics focus). Many have their eyes on the huge amount of bond redemptions Italy faces next spring (see right-hand chart).
Global markets took their cue from Europe, with the Dow Jones Industrial Average falling by 573 points over the course of October 31st and November 1st. In October stocks on Wall Street enjoyed their best monthly gain since 1974 on the back of economic data that soothed fears of a double-dip recession and robust third-quarter earnings reports from S&P 500 firms. But a European collapse would still be very bad news for American banks and exporters.
Investors rushed for the safety of Treasury bonds, where the ten-year yield dropped back below 2%. Worries about the euro also prompted traders to flee to the perceived safety of the yen, prompting the Japanese authorities to attempt to weaken their currency. All of which meant yet another crisis-strewn agenda for the G20 leaders meeting in Cannes as The Economist went to press. If only summits created economic wealth, the world’s problems would all have long been solved.