In terms of ability to rattle markets this week, it is the situation in Italy that investors will be watching most closely. After all, the election of conservative leader Nicos Anastasiades as president of Cyprus was widely expected following his decisive first round lead. The Italian election, in contrast, is taking place after a two-week opinion poll blackout, amid mounting investor anxiety that former Prime Minister Silvio Berlusconi and maverick outsider Beppe Grillo, leader of the Five Star Movement, may make a strong showing. The market has set its heart on a coalition involving centre-left leader Pier Luigi Bersani and current Prime Minister Mario Monti, which it considers most likely to stick to the reform programme embarked on by the current technocratic government. Anything short of this outcome—which the majority of pundits regard as most likely—would be a shock that would unsettle investors...
The risk must be that whatever government emerges will only prove an interlude before a fresh crisis, in which external pressure once again is required to force Rome to confront the Italian economy's structural shortcomings, perhaps in return for a deal with the European Central Bank to support the government bond market under its Outright Market Transactions programme.
But these are problems for another day. Even if the market's focus is on Italy, the attention of eurozone policy-makers will be entirely focused on Cyprus, whose debt crisis has the potential to blow apart everything the eurozone has achieved since June.
The new president will have just weeks to negotiate a bailout to avoid a disastrous default. But the situation is, if anything, even more complicated than that of Greece last year: Cypriot banks alone face a £10 billion ($15.2 billion) capital hole. The government can't afford to borrow that money, equivalent to 50 per cent of Cyprus's GDP, since its debt is already approaching 100 per cent of GDP and so would become unsustainable—raising the spectre of a second eurozone sovereign default that the eurozone has insisted was unthinkable.
But Germany has categorically ruled out direct recapitalisations by the European Stability Mechanism, reneging on the solution apparently agreed by eurozone leaders last June. That leaves the possibility of imposing losses on the providers of capital to the Cyprus banking system. But there is not enough equity and subordinated debt to absorb the losses, so depositors would somehow have to be bailed in too. That might be politically appealing given concerns that Cyprus's banks are flush with Russian money deposited there to take advantage of the country's weak anti-money laundering rules. But it also risks triggering depositor panic across Europe's weaker banking systems, something the eurozone spent most of 2012 trying to avoid...
The long-term future of the eurozone may be decided in Italy. But only if the euro can find a solution to Cyprus first.
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