Monday, December 12, 2011

A European “fiscal compact”

Important progress was made at the latest European Summit at the weekend. As was signalled pre-Summit by the French and German leaders, the important outcome was a “fiscal compact” amongst the members of the Euro Zone. The show of political unity at the Europe-wide level is a welcome development, although the UK has already opted out (this is likely to cause tension in the UK coalition government).

The agreement will require each member to introduce new rules on public finances into their constitutions which will have to be ratified by individual parliaments. There will be penalties for countries that then break these rules. However, political risks remain high as domestic politics in some countries may still get in the way of a fully-implemented outcome.

Other outcomes from the weekend include European central banks providing the IMF with €200 billion to use in Europe with the expectation (hope?) that other countries will contribute. The start date for the European Stability Mechanism (ESM), the permanent mechanism that will eventually replace the EFSF, has been brought forward to July next year. This will provide a further €500 billion of capital. Finally, demands that investors share in the costs of future bailouts have been dropped. This will go some way towards restoring investor confidence in European sovereign bonds.

The “fiscal compact” provides for a stronger fiscal framework in Europe. It should have been part of the original setup of the common currency, but that’s history. Alongside further measures from the ECB last week to provide liquidity to the European banking system, some progress has been made.

However the increase in the bailout funds will most likely be insufficient to relieve stress in sovereign debt markets. For that we are still looking for a stronger commitment from the ECB to step-up its purchases of bonds. Without that, the pathway to lower bond yields in Italy and Spain will be ever more austere budget initiatives. That will be counter-productive in terms of ensuring an appropriate balance between fiscal consolidation and supporting economic growth.

As we have warned after each of the previous “solutions” to the European debt crisis, there is still a lot of water to flow under the bridge. The critical factor in the period ahead is how the ECB see’s its role in alleviating pressures in sovereign debt markets. Watch this space.