Political thorns in a rosier Europe

Political crises swirling around Spain, Italy and European Central Bank Governor Mario Draghi appear to threaten a decent run of economic activity in the eurozone.

The eurozone is grabbing a lot of headline economic and political news at the moment. Some of it is good, some bad. It is a see-saw between strength in Germany and generally favourable market moves versus ongoing weakness in most other countries overlaid with political poison that threatens to undermine confidence.

First the good news. Germany’s service Purchasing Managers Index rose a thumping 4.1 points in January to be at 54.4 points, the highest reading since June 2011. The strong person of Europe is getting stronger. In Spain, the PMI reached a 19-month high of 47 points, which means that the speed of contraction is slowing. It would be great to see Spain registering decent economic growth again, not least to help create jobs for the 26 per cent of the workforce currently unemployed. While not in the eurozone, of course, the UK services PMI registered a decent lift to 51.5 points suggesting the triple dip recession may be ending with a move to recovery during the first part of 2013.

Now the bad news. In France, the services PMI fell to a near four-year low of 43.6 points while in Italy it slumped to 43.9 points. Both France and Italy are slipping backwards when Germany is strong and even Spain is improving, albeit from a low base.

Remember, a reading of 50 points is meant to represent the break even between expansion (above 50) and contraction (below 50).

Overall, the services PMI for the eurozone as a whole was a decent 48.6 points in January while the composite index, which aggregates services with manufacturing, rose to a 10-month high of 48.6 points. Both readings are favourable relative to expectations of a deeper and more protracted slump.

But just as the good news was building on the eurozone climbing out of the doldrums and when its sovereign bond markets were calming down and even starting to normalise, a range of political problems emerged to again highlight many of the problems within Europe.

Spain’s Prime Minister Mariano Rajoy has been implicated in a scandal that involves his People’s Party manipulating its financial details in a deliberate effort to circumvent the political party funding rules. This is threatening to create a fresh round of political turmoil at a time when Spain was moving to fix its fiscal imbalances and have, as noted in the PMI data above, more to repair the economy. Policy stability is threatened if Rajoy is forced to stand aside and a new government is formed.

In Italy, there is the Monte Paschi banking regulation ructions which involve the bank gaining access to €3.9 billion in bailout assistance, even though it was involved in fraudulent activity that was designed to cover up the true state of the bank’s accounts as the financial crisis was unfolding. While this is creating its own level of controversy, more importantly it is dragging the European Central Bank governor, Mario Draghi, into the mix given he was governor of the Bank of Italy from 2006 to 2011, when Monte Paschi executives were devising ways to massage their books. There are questions, at least, over Draghi’s oversight of the bank when this fraud was taking place. The affair is likely to play out for many months, but if the findings include evidence of wrongdoing from Draghi, confidence in the eurozone would be further eroded.

In Italy, there is also the upcoming election where the issues are getting muddied by the Monte Paschi scandal. According to recent polls, there is almost certainly going to be a complex coalition government formed which will make decisions on economic reform difficult to deliver. This throws up the possibility of Italy only muddling through and the threat of unstable policy hindering much needed reform. A fresh election is a distinct possibility within the next year.

Overnight, European markets were calm after the weakness of Monday. Share prices bounced back, generally rising by 1 per cent, bond markets saw yields falling back in Spain and Italy, but rising in Germany. This is a sign of market confidence.

The next meeting of the ECB is Thursday and while no change in interest rates or the bond buying program are expected, Governor Draghi’s press conference afterwards will be important not only for issues relating to his knowledge of Monte Paschi issues, but also to gauge his interpretation of the run of better economic news domestically, and also around the world.