EUROPE COMPASS WEEKLY UPDATE DECEMBER 10, 2012

The collapse of Italian Prime Minister Mario Monti's government became inevitable on December 8, when the technocratic leader made it clear to President Giorgio Napolitano that he would not be held hostage by the parties of the centre-right. As a result, Italy will go to the polls early, with national elections looking set to be held sometime in February. This also means that centre-right leader and former Prime Minister Silvio Berlusconi has just over two months to campaign against austerity measures and decry German leadership in European affairs. Monti will still be able to pass his government's budget this December -- the centre-right has committed itself to support it -- but that is about as much stability as Italians can expect. Monti's official resignation will take effect once the budget is passed.

Into the abyss?

It is not unreasonable to ask, therefore: "Is Italy falling into an abyss?" Indeed, this was the first question European Central Bank (ECB) President Mario Draghi received at his press conference on December 6. The answer is important because if the Italian economy heads into crisis, it will likely take the rest of Europe along with it. The strength of the German economy will not be enough to drive the rest of the continent. The Bundesbank announced an expected slowdown as part of its most recent forecasts, which see GDP growth falling from 0.7% this year to 0.4% in 2013 -- a significant climbdown from its June forecast of 1.0% for 2012 and 1.6% for 2013. While the official press release stresses that recovery could be just on the horizon, the longer article-length analysis ends by highlighting the downside risk to Germany from weaker-than-expected performance in other euro-area countries: "Germany cannot prosper on its own; it has a particular interest in the prosperity of its partners."

Italy's debt load

One way to consider the plight of Italy is to compare it to the same period last year. By that measure, the situation is much better. The Italian government enjoys borrowing costs more than 200 basis points lower on 10-year sovereign debt obligations and much less volatility in sovereign debt markets. So, while it is still possible that bond traders could take fright when the markets open today, they will have a long way to go to reach the heights of December 2011. Moreover, the calendar for debt redemptions in the first four months of 2013 is less crowded. The Italian government had to roll over more than 150 billion euros (194 billion dollars) between January and February 2012; it must roll over a little over 116 billion euros in the first four months of next year. While still a big number, this is more manageable.

Wider European environment

Monti will likely prove less effective at the European Council summit on December 13-14 than he would have if his government were not in jeopardy. Nevertheless, the need for his input is much less than it was last year when he assumed his post. Since then the broad outlines for Europe's banking union and other stabilisation measures have become clear: Europe's heads of state and government may argue about the importance of harmonising deposit insurance or the financing for a common banking resolution authority, but they basically agree that these are areas where Europe should take action.   They also agree on the broad outlines for a single supervisory mechanism for the European banking system. The only questions now are how banking supervision could be managed from the ECB and whether it should cover all 6,000 monetary financial institutions in the euro-area. Draghi's response to a question on the subject at the December 6 press conference is revealing: "It is quite obvious that the ECB supervisor will not be able to supervise 6,000 banks, and that, as the size of the bank and as its systemic significance decreases, so the intensity of the supervision that is carried out at the central level will decrease and the intensity of the supervision that is carried out at the national level will increase." This concession will not put an end to the controversy over the structure and reach of ECB supervision, but it does suggest movement in the conversation.

Spain and Greece

In the meantime, the European Stability Mechanism, the 500 billion euro permanent bailout fund, has begun efforts to recapitalise the Spanish banking system, and the Greek government has made progress in its bond repurchasing programme. These are still ongoing developments. It remains to be seen whether and when the Spanish government will accept the conditionality necessary to receive support from the ECB in the form of outright monetary transactions or unlimited purchases in secondary markets of short-term sovereign debt securities. Similarly, the Eurogroup of euro-area finance ministers will determine on Thursday whether the Greek bond repurchase programme has been sufficient to trigger the release of the next tranche of international financing. However, the point remains that the financial crises in both Spain and Greece are now bound up in well-structured European programmes where support can be activated in a predictable manner without having to resort to ad hoc new arrangements.

Encore Monti?

Europe is now less prone to crisis and therefore more able to help Italy from falling into an abyss. By that measure, Monti's period in office should be regarded as a success. He may not have managed to do all the reforms that his European partners wanted or expected, but he did manage to make progress with his domestic agenda and he also succeeded in buying enough time for Europe to get ready for his departure. Monti's government is ending but there is no longer any need to panic. It is unfortunate that he is leaving office early, but it is not a disaster either for Italy or for Europe as a whole. Indeed, it is possible that Monti could return to power with a renewed mandate, should the election produce a 'hung' parliament. He could even decide to run for office, despite his assurances until now to the contrary. Everything depends on how things pan out this week and next, especially with regard toBerlusconi's People of Liberty (PdL) party. If Monti were to run, and the PdL splintered, a credible alternative to Berlusconi could emerge.

I trust you have found this weekly Europe Compass note helpful. The Europe Compass is one element of Oxford Analytica's Europe Practice, which provides analytical insight and advice on the changing political economy of Europe and the implications for corporations, investors and public institutions in all markets and regions. I invite you to contact me or anyone at our Europe Practice with your queries or concerns.