Europe’s small step on a long road

The EU summit ended late last week with a better than expected outcome, but as usual the devil is in the details. The summit statement (available below) was as loosely worded as these things come and many decisions are still left to interpretation and future actions.

Going into the summit my major concern wasn’t so much economic, but political, because the chicken and egg issue of debt sharing and national sovereignty appeared a bridge too far. I therefore think that the major success from Friday’s summit was that it showed that when push comes to shove the Eurocrats will move in order to break an existential debt-lock. That in itself is a big step forward and the banking union, although again very vague at this moment, appears to be a move towards debt-sharing.

Most of the southern European news agencies appear to have taken the line that this was a huge win by their leaders and a massive capitulation from Germany. The truth, however, maybe a little less clear. Spain and Italy did play hard ball on the “Growth pact” forcing Angela Merkel to agree to concession on direct bank re-capitalisation and the use of the ESM as she required it to get the ESM/fiscal pact vote through her own parliament. Markets have rightly welcomed the news and celebrated the disconnection of banks from sovereigns but this by no means removes conditionality.

The EU summit statement itself makes this clear:

We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding.

And just as important is the ESM treaty itself which states:

It is acknowledged and agreed that the granting of financial assistance in the framework of new programmes under the ESM will be conditional, as of 1 March 2013, on the ratification of the TSCG by the ESM Member concerned and, upon expiration of the transposition period referred to in Article 3(2) TSCG on compliance with the requirements of that article.

Or, in other words, if you don’t ratify the fiscal compact and implement a balanced budget rule as specified in that treaty within the agreed timeline (one year after entry into force) you don’t get the ESM. The ESM and the fiscal compact are intertwined and Merkel well understands that point.

The other issue with the plan is the vague wording in the summit statement:

“When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly”

So when something that hasn’t happened yet happens, then there could, if we decide to, be the possibility of something happening. Not exactly actionable is it.

Firstly, the EC, together with the ECB, needs to work out exactly what this mechanism is and build a proposal for it. This proposal would then have to be agreed to by the same heads of nations that were at Friday’s summit. Angela Merkel has already claimed that the German government would have right of veto over any mechanism and any action made by it.

The other questions are exactly what powers this supervisory mechanism would be granted and what conditions would be placed on ESM bailouts. Ultimately a supervisor needs to have the power to halt trading, bail-in bond and equity holders and, if required, close banks down. Finding agreement on these powers and bailout parameters from Spain to Finland through Germany obviously won’t be trivial and I would expect schedule blow-outs on implementation.

In short this isn’t something that will be implemented quickly and without it the status quo holds. I’m not sure markets fully understood that point.

The summit also didn’t discuss any changes to the size of the EFSF/ESM. These facilities are slowly filling up with obligations and given the state of the European economy there are very likely to be more. This could become a problem in the future depending on the schedule of other supra-European policy adjustments and the speed of economic deterioration.

So all up, the summit beat my expectations with movement on the existential political debt-lock. There are, however, large technical issues outstanding on what has been agreed.  The summit statement did not mention any progress on a Europe-wide deposit insurance scheme or supra-European debt, but we did witness some limited, yet conditional, step forward towards a tighter union which certainly was a positive.

Do I somehow think that this summit means that Europe is fixed? No. The problems of Greece, Spain, Italy, Portugal, Cyprus and Ireland exist today as they did on Thursday. The outcome of this summit has further solidified the implementation of the fiscal compact which is guaranteed to slow the economy of Europe further and, although the steps towards a banking union are a start, there is still a very long way to go in a transition towards a true fiscal union.

EU Summit Statement

Comments

  1. “Markets have rightly welcomed the news and celebrated the disconnection of banks from sovereigns but this by no means removes conditionality.
    The EU summit statement itself makes this clear:”

    But the section of the statement which you then reproduced applies to the use of EFSF/ESM to buy sovereign bonds, not to the use of the ESM to bail out banks. The section which covers the use of the ESM to bail out banks does mention “appropriate conditionally” though, so your point is still valid.

    There may also be a significant unresolved issue regarding who is ultimately responsible for the repayment of the “loans”, as I mentioned in a comment over the weekend.

    http://www.macrobusiness.com.au/2012/06/weekend-links-yeh-nah-yeh/#comment-160147

  2. StanGoodvibesMEMBER

    Just a couple of points the “market” seems to have missed…

    The ESM doesn’t exist yet. Only 4 out of 17 countries have ratified it, and they have until July 9 to do so. Good luck with that.

    The ESFS doesn’t have any money in it and neither does the (non-existent) ESM. There isn’t 500 billion Euros sitting in there. No-one is interested in buying the Euro debt, which is why the ESFS was such a fizzer. The only way the ESM is going to get funds is by contributions from it’s Eurozone members. Spain and Italy between them will have to contribute 30% of the money!

    Farcial much?

    • Yep, and then some.

      The terminal patient has recieved their latest dose of morphine, that’s all. Allowing the banks to be re-capitalised without putting the sovereign on the hook for it – and we’ve yet to see if this will actually occur and if so, to what extent – simply stops that particular situation from being made worse, it doesn’t make the existing situation any better.

      The whole Euro situation looks like going down as the starkest ever example of the market being able to remain irrational for a lot longer than you and I can stay solvent.

      • StanGoodvibesMEMBER

        I think my favorite bit is everyone getting excited about the lack of subordination of private bondholders bonds.

        So Spain defaults and you are left holding the baby with a loss of most or all of your money, but hey, at least you lost all yours before the ESM did.

        WIN!

  3. “When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly”

    I’m going to show my ignorance here, but it’s often the quickest way to learn. 🙂

    Here are two quotes from current articles on a couple of websites. Which one of them is wrong?

    “Of course, since we’re talking about capital – the first buffer against losses – the bailout funds could not simply be lent to the banks, since debt is not capital.”

    http://www.hussmanfunds.com/wmc/wmc120702.htm

    “The purpose of capital, whether it’s raised by debt or equity, is to seek a return.”

    http://macrofugue.com/the-real-cult-of-equity

  4. Isn’t this all really just a long winded way of establishing a Federal Reserve equivalent in Europe with a mandate to purchase both private and sovereign debt?

    Add to that a centralised authority armed with powers of fiscal intervention.

    The United States of Europe.