Monday, July 2, 2012

EU Summit: necessary progress, but not sufficient

Last week’s European leaders Summit took some important and necessary steps forward, but didn’t make any real progress on the underlying structural problems.

The major positive was the creation of a single banking supervisor.  This role will most likely be played by the European Central Bank (ECB) with possibly some role also for the London-based European Banking Authority (EBA), although that will depend on coverage (euro zone or European Union).  There is considerable work to be done which will take some months.

A single supervisor paves the way for direct recapitalisation of banks from the European Stability Mechanism (ESM).  That will break the negative feedback loop between lenders and sovereigns as we saw with the Spanish bank bailout recently.  Insistence the funds are channelled through the Government simply meant that Spain’s debt to GDP ratio would rise and markets simply shifted their angst from the Spanish banking sector to the sovereign.  Another positive step was the agreement not to subordinate other creditors in the bank recapitalisation.  That reduces concerns for private sector bondholders.

In a major concession from Germany, the ESM is also to be allowed to purchase sovereign bonds directly.  That is a clear sign of the shifting political sands in Europe as Italian Prime Minister Monti led the charge, supported by French President Hollande and Spanish Prime Minister Rajoy, on the need for some short-term measures to ease financial stress.  Chancellor Merkel was at pains to point out that such action would not come without strict conditionality and formal adoption of a Memorandum of Understanding should such action be sought by any government.  The key question now is whether the 500 billion available to the ESM will be sufficient.

Unfortunately Germany gave no ground on its refusal to contemplate Euro bonds.  Some form of debt mutualisation remains a key element of broader fiscal union.  However, Germany did demand that Leaders negotiate the steps necessary to building a more fulsome fiscal union, including full banking and budgetary union and closer economic policy co-ordination.  As we have said before, these have been the key missing ingredients in the euro experiment.

Leaders also committed to a 120 billion growth package.  This is clearly the concession to the lack of progress on allowing a greater balance between growth and austerity.  Markets will see this for what it is – no more than a bit of window dressing to suggest that something is being done about economic growth.

In summary some important steps have been taken that again show the capacity and willingness of Europe’s leaders to do whatever it takes to hold the euro together.  However, progress on the real structural issues remains arduous.  That means there will be further periods of stress and angst ahead.