Tuesday, June 26, 2012

What do we expect from the Summit?

The upcoming EU summit (June 28 and 29) presents the latest last chance for Europe to get its act together.  We expect nothing more than further incremental progress on some issues, but others will remain in the “too hard” basket. 

The most interesting aspect of the summit will be the impact of the shifting sands of political alliances.  Let’s remember the euro is a political construct and it is politics that will determine its fate.  The Merkel/Sarkozy alliance is broken and Mr Hollande seems to be striking up a strong rapport with Mr Monti.  Fascinating.

There have been a couple of positive (or at least non-negative) developments in the lead up to the Summit.  The second Greek election was pro-bailout so we can park the issue of Greece exiting the euro, at least in the near term.  Some renegotiation of the bailout terms will still be sought.  That may well be delayed until the health of Prime Minister Samaras improves and a new finance minister is appointed, following the resignation of the current finance minister for health reasons.

The audit of the Spanish banking system has revealed the recapitalisation will require €62b, less than the €100b that was made available.  The detail of the recapitalisation is still yet to be determined.  Most important of those details is whether the funds will be channelled through the Government or made directly available to the banks, breaking the negative feedback loop between bank recapitalisation and sovereign debt.  That issue will be part of a broader Summit discussion around the role of the European Stability Mechanism (ESM).

Fiscal union is the ultimate end-game, but we are not expecting any significant progress on that front.  Fiscal union ultimately requires some form of debt mutualisation.  Germany has refused to countenance the concept of eurobonds, however some alternatives have been flagged recently such as the issuance of euro treasury bills and the establishment of a redemption fund.  

We still think eurobonds are inevitable, but it’s too early for individual Governments to endorse such a concept.  The loss of economic sovereignty at a time of heightened financial stress is too big a bridge to cross.  Debt mutualisation can only occur from a starting point of some degree of fiscal co-ordination, and we are a long way from that now.  Such a concept may be part of the longer-term roadmap for the survival of the euro currently being prepared by officials.

With fiscal union off the immediate agenda, we may see some progress on the only slightly less challenging issue of the formation of a eurozone banking or financial union.  That would still require a central agency to act as banking supervisor (the existing European Banking Authority or possibly the European Central Bank itself). 

We like the concept of the ESM being available for common bank recapitalisation funds, reducing the negative feedback loop between bank recapitalisation and sovereign debt as we have recently seen in Spain.  Some form of deposit guarantee to prevent runs on banks could be part of such a plan.  Both the International Monetary Fund and Bank for International Settlements have come out in support of a banking union in recent days.

The other issue we would like to see some progress on is an improved balance between fiscal austerity and economic growth.  Ideas to boost growth have been floated such as boosting the capital of the European Investment Bank, but the fundamental problem is front-loaded fiscal austerity.  A relaxation of agreed deficit reduction targets is the best action that can be taken now to support growth and reduce the risk of a popular backlash.  Greece, Portugal and Spain would all benefit from such a move and in so doing, cement in attainable medium-term targets from both an economic and social perspective.  The key challenge would be the credibility of those medium-term targets. 

A more immediate issue is the recent increase in Spanish and Italian bond yields.  In that last few days there has been some suggestion that the European Financial Stability Facility (EFSF) could be used to purchase Spanish and Italian bonds.  We are in favour of action being taken to bring those yields down to more sustainable levels, whether that be through purchases by the EFSF or by a resurrection of the ECB’s Securities Markets Program.  As we said last week, we believe bond purchases by the ECB can be justified on monetary policy grounds given that traditional monetary policy transmission channels have broken down in Europe.

In short, we are expecting not too much more than further incremental progress in Europe.  That approach limits risk of disappointment, but provides some glimmer of hope of being pleasantly surprised.