Euro back in Davos focus as first ECB then Greece decides

The euro-area economy is back in the cross-hairs of investors.

It’s a familiar place for the currency bloc, which spent the past five years struggling for growth, the faith of investors and even its very existence. The latest concerns, that failure to break political logjams dumps the region back into recession and crisis, are propelling the continent back up the worry list of investors, executives and policy makers heading to the World Economic Forum’s annual meeting in Davos.

A Greek election in six days may hand a slice of power to a party gunning to renegotiate the austerity on which the nation’s bailout is based, potentially serving as a preview for votes in Portugal and Spain and reviving talk of a euro exit.

Meantime, European Central Bank President Mario Draghi, the man who defused the turmoil in 2012, is trying to craft the cross-border consensus needed for full-blown quantitative easing as the threat of deflation hovers over the region and governments resist overtures to do more.

“The politics of Europe is so much more problematic even though the economics look better,” says Ian Bremmer, founder and president of the New York-based Eurasia Group. “Everywhere you look politically, bottom up, inside out, outside in, Europe is bad this year.”

False Dawn

That’s a reversal of fortune from last year when Draghi was telling Davos delegates that he anticipated signs of a “dramatic” improvement in his economy’s health, and German Finance Minister Wolfgang Schaeuble declared the crisis over.

For a sign of the renewed concern, look no further than the euro, which turned 16 years of age this month and is trading at its lowest in more than a decade against the dollar.

The currency’s downward slide was compounded by the Swiss National Bank’s surprise decision on Jan. 15 to scrap its currency cap on the franc, sparking turmoil in markets. The euro fell more than 3 percent last week, the biggest weekly drop in more than two years.

The first of this year’s election battles will be in Greece, the euro-zone’s original problem child. Voting takes place Jan. 25 with Syriza leading in opinion polls after five years of fiscal austerity and with unemployment still north of 25 percent. The party is pledging to ease the budget squeeze on which international aid depends and seek a writedown on some of the country’s debt.

Collision Course

That would put it on a collision course with the so-called troika of creditors including the ECB, which have kept the country afloat with 240 billion euros ($277 billion) of loans pledged since 2010.

While Syriza leader Alexis Tsipras has committed to keeping Greece in the euro area, the ECB has warned the country could lose financial support if its rescue program collapses. Some in Germany have also expressed a belief that a departure of Greece would now be manageable, although Chancellor Angela Merkel wants it to remain.

There are some reasons for confidence that there won’t be spillover in financial markets if Greece does bail. Aid programs are now in place to defend stressed markets and state finances across the bloc are in better shape, with bond yields declining to records in Italy and Spain even amid Grexit speculation.

Signaling comfort with a smaller currency bloc may still be a bluff nobody wants to call for fear investors would then turn their sights on the likes of Portugal, Ireland, Spain and perhaps even Italy.

The idea that a Greek exit would be manageable “is a dangerous game to play,” said Laura Tyson, a professor at the University of California, Berkeley, and a former adviser to U.S. President Bill Clinton.

Spanish Concerns

Even if Greece stays, the rejection of the traditional political class could still spread. While bailed-out Portugal holds an election in October, it is Spain that’s drawing concern from investors.

Home to the euro region’s second-highest unemployment rate at 24 percent, it votes at year’s end with the Podemos party outpolling rivals on promises to increase public spending and impose losses on the holders of about 1 trillion euros of government debt.

“These elections could show a shift with respect to European integration as the electoral balance between the centre-right and the center-left is abandoned in favour of new ‘protest’ parties,” said Elga Bartsch, chief European economist at Morgan Stanley in London.

While not subject to imminent elections, French President Francois Hollande is already campaigning, having pledged to step down after one term unless unemployment falls from 10.5 percent. He is being squeezed by Marine Le Pen’s National Front with its denunciations of foreigners and the euro.

Presidential Vacancy

Meantime, Italian Prime Minister Matteo Renzi faces pressure to revive an economy set to shrink for a third year in 2014. Renzi, who will meet Merkel this week, must also find a new Italian president, a position whose clout grew during the debt crisis because of the head of state’s role as a mediator in the country’s politics.

For Anne Richards, chief investment officer at Aberdeen Asset Management Plc, electoral anger comes after Europe dodged it on the streets at the height of its debt turmoil.

“It took time for the economic pain to see its way through to the ballot box,” said Richards. “We’re on the cusp of another financial crisis.”

If it wasn’t for the politics, the euro-area economy would stand to be doing better this year, according to Stephanie Flanders, chief market strategist for Europe at JPMorgan Asset Management in London.

The ECB has cut its key interest rate to a record low and started buying private-sector assets, fiscal austerity is easing, the weaker euro may help export competitiveness and oil is extending its 50 percent slump from a June peak. Banks are even extending credit more.

QE Primed

“There are reasons to feel less gloomy about the euro zone than a year ago,” said Flanders. “But the politics isn’t looking calm.”

Politics is also playing a role in the ECB’s decision-making as it appears primed to announce on Jan. 22 that it will buy government bonds for the first time, six years after the U.S. Federal Reserve began doing so. Adding to the urgency, consumer prices fell an annual 0.2 percent in December, the first decline in more than five years.

The reason the ECB hasn’t conducted quantitative easing sooner “must be entirely politics as I cannot imagine an economist thinking this,” said Nobel laureate Christopher Pissarides, a professor at the London School of Economics.

The main obstacle is Germany, where some coalition lawmakers have joined Bundesbank President Jens Weidmann in warning against QE because it risks pushing the ECB into fiscal policy and encouraging governments to foot-drag on revamping their economies or run up fresh debts.

Legal Questions

“There’s a whole row of economic reasons that speak against government-bond purchases, even before you consider the legal question of whether they’re compatible with the ban on monetary financing,” Weidmann said last month.

Keen not to alienate the euro area’s biggest economy and so jeopardize the ECB’s credibility, Draghi has conducted a charm offensive. Rare interviews have been granted to German media to tackle concerns he’s taking unwarranted risks, giving governments a free pass and penalizing savers. He’s made the point himself that the ECB alone can’t revive the region.

At the heart of his case is that the ECB’s sole mandate is to keep inflation just below 2 percent in the medium term and that goal is clearly being missed. He caught a break last week when the bond-buying plan he designed in 2012 to save the euro won a key legal endorsement from a top adviser to the European Court of Justice.

To forge as strong a consensus as he can on the ECB’s Governing Council, Draghi may need to limit the quantity and the quality of bonds purchased and have national central banks accept the risk of losses.

“The ECB’s well aware that to get a really big impact on growth you need structural reforms,” said Anatoli Annenkov, an economist at Societe Generale SA in London. “But that doesn’t exclude them from doing their job as they have a mandate.”