Redwood: Why the bears are focusing on Italy

A week of near farce in Greek politics ended recently with a government of national unity accepting the previously arranged deal.

Markets see that as progress, and will be temporarily relieved. After all, they argue, a referendum has been prevented, which could have delayed the deal and might even have seen it voted down. The Greek people have looked over the precipice and for the time being seem to have decided to stay with the euro. The opposition politicians have come round to supporting the deal, and will be locked into a national unity government to try to implement it. That is what passes for improvement. It's business as usual.

Unfortunately, the underlying problem remains. The Greek people may not yet want to get out of the euro in sufficient numbers to make exit inevitable, but there is no evidence they like the austerity measures any more this week than last. The new government may have consent from the people for a bit as it settles in. For all the efforts of the outgoing government, the deficit has been getting bigger, not smaller. The EU/IMF programme is not yet showing any signs of working. The Greek economy is still contracting, and with it tax revenues are disappointing.

The same is happening in a more orderly and less dramatic fashion in Portugal. The Troika visitors are there this week to see how well Portugal is doing. It too is behind in curbing the deficit, despite implementing the agreed measures. It too has a problem with growth rates and tax revenues.

Bears in the market will direct more of their attention this week to Italy. The cost of borrowing for ten years has risen to around 6.6%. Some say this is already too high for Italy to be able to sustain its borrowing. Given the size of Italy's historic debts, as they fall due for refinancing at the higher rate so they place strain on state finances, requiring bigger interest charges. Others say if the rate hits 7% it will force Italy into an IMF/EU package and subsidised borrowing. The G20 got agreement to IMF surveillance of the Italian budget as the first step on this dangerous road.

Most of the measures being taken point to slower growth or recession. Weak banks are being told to raise money or restrict lending. In the short term they will do the latter. Public spending is being cut, leading to job losses. The euro has not fallen much, so exporting is still not easy for the less competitive southern Euroland states.

We remain negative on European assets. They still have a long way to go to sort out weak banks and weak sovereign credits. There is a danger of a vicious circle, with weak banks restricting growth leading to weak states short of tax revenues. The states themselves undermine their own finances by propping up weak banks with state money, and by taking actions to cure their deficits which in the short term make the deficits worse.

The issue is not just can the states gain democratic support for the tough measures the EU and IMF expect. The issue is also can those tough measures do the job, cut the deficits, and allow some growth at the same time? The ECB we learn is actively debating how much more Italian state debt it can buy. Its purchases have prevented an Italian disaster in recent weeks. The Germans are against more purchases. It could prove an interesting time in the Italian debt market.

John Redwood is chairman of Evercore Pan Asset's Investment Committee