Crunch Time for the Euro

The danger with ignoring elephants in the room for a long time is that they may grow to believe they really are invisible. Wrongly believing themselves to be immune from danger, they start to move carelessly until they stumble and make a noise far too loud for the willing ignorant to dismiss. Awoken, financial market operators have been forced to stare and take a good look at the big Italian elephant lurking in the eurozone sovereign debt room. The reaction that has followed has not been pretty.

Italy is of course to blame for putting herself in the market's firing line. An overburdened, sclerotic economy with a directionless government headed by a man whose time is mostly spent fighting all kinds of corruption allegations is never a good presentation card to the world. And yet, the frenzied market reaction of the last few days has probably little to do with Italy per se. Indeed, driven to total despair by eurozone politicians' constant bickering and biblical time scales, the market is upping the stakes to force a credible solution of the still-outstanding Greek debt problem. Adding Italy to the eurozone debt contagion mix is akin to threatening to push the nuclear button; for if most commentators thought that Spain alone was probably too big to bail, Spain and Italy together certainly are.

Let's be clear, neither Spain nor Italy has a solvency problem. However, what the market can easily engineer is a liquidity problem whereby punitively high yields make it financially unwise for both to seek funding in the open market. By contrast, Greece is bankrupt. And despite the rating agencies' attention of late with Portugal, my hunch is that Ireland is the one that could find it more difficult to honor the financial commitments undertaken upon underwriting the country's banking system's total debt. But the most pressing need is that of Greece. And so, what we need is a credible mechanism to deal with her insolvency. Not in months, but now. Otherwise, the market will keep on pushing Spain and Italy until the whole eurozone bursts at the seams.

What to Do With Greece
As obvious as it may sound, the first step is to acknowledge that Athens is bankrupt. Only once this is done can one start devising a credible strategy. Greece needs plenty of time and very cheap funding in order to carry out the comprehensive package of structural reforms needed to rid it of its basket-case status. A silly succession of bailout loans at unaffordable interest rates will not work. Unrestricted access to cheap market funding for Greece can now only come with explicit support from her eurozone partners in the shape of eurozone-backed bonds.

The Greek public debt burden should be brought to a sustainable level from the get-go, and this can only mean agreeing to a substantial haircut on outstanding bonds, both for private investors and also for the European Central Bank. Besides, the ECB would probably have to support the Greek domestic banking sector for a number of years via a special liquidity scheme. All this probably will trigger a selective default by the rating agencies, but this is something that is already priced in. Granted, we might be exposed to very choppy market conditions in the short term as all this is agreed and put into practice, but if the deal on the table is really credible, the market should be expected to let the Greek prey go.

The ball is now firmly on the core eurozone countries' court, and particularly in that of Germany. Chancellor Angela Merkel may be playing hard ball for populist political reasons, but her dealings with the eurozone periphery are not going down too well with key exponents of German industry. These entrepreneurs know only too well how beneficial the euro has been to Germany. Even the CEO of Commerzbank (CRZBY), one of the German banks most exposed to Greek debt, has publicly called for a Greek debt restructuring including a minimum of a 30% haircut, adding that such a plan could also be extended to Portugal and Ireland if needed. A Greek partial default would be painful but, crucially, it would also be bearable and much easier to handle than a messy eurozone breakup pushing all peripheral countries into a long period of economic decline.