Sunday, October 21, 2012

Further incremental progress in Europe

I’ve come to learn the best one can hope for out of any European Summit is incremental progress.  The latest Summit didn’t disappoint.

The key outcome was further progress on European banking union.  Remember if full fiscal union is too challenging (at least right now) a banking or financial union is the next best thing.  The June summit commitment to banking union was really nothing more than a commitment to consider the concept.  After the latest Summit we now have a firmer timetable for the establishment of the Single Supervisory Mechanism (SSM), which will be run by the ECB.  The communiqué commits to agreeing the legislative framework for its establishment by 1 January 2013.  That’s a positive step forward.

However, what excited me most about the June summit was the possibility the ESM would be used to recapitalise banks directly.  On that there is still less clarity.  The communiqué states that work on the operational implementation will take place over the course of 2013”.  That’s still too vague for my liking.  At issue is whether the ESM will be able to act retrospectively.  Under current rules, Spain will have to finance its own bank bailout, just as Ireland is (Ireland has won agreement its bank bailout will be treated the same as Spain’s).  However, German Chancellor Angela Merkel is not keen on the ESM being able to bailout banks for past mistakes stating that debts incurred in the past should be the responsibility of national governments and that if direct recapitalisation is possible “it will be for the future”.  There’s obviously still a lot of detail to work through.  Watch this space.

There was no major development with respect to Spain at the Summit.  Spanish bond yields have moved sharply lower in recent weeks, helped recently by Moody’s sovereign rating decision.  In my view lower bond yields do not reduce the need for a bailout, that’s because yields are mostly lower in anticipation of a request for assistance.  However, it’s also important to acknowledge progress is being made in Spain: the latest budget was another step forward (although built on likely too optimistic growth forecasts), labour costs are falling and the current account deficit is reducing (albeit mostly due to the recessionary impact of lower imports).  We still expect the Government to request a formal bailout; it seems to me to be just a matter of when.  Spain has significant refinancing needs next year which they seem to be unlikely to achieve without ESM/ECB assistance. 

With respect to Greece, the Government won praise for its efforts to get the fiscal consolidation plan back on track.  That should open the door to receipt of the delayed bailout tranche next month.