- An array of critical events is due in the coming week. Market expectations have been building up over the past week which have helped fuel the rally in sovereign bond markets.
- Merkel and Sarkozy will later today present their vision for a stronger EMU. Additional measures aiming at ensuring closer economic integration and possible treaty changes are set to be presented at the European Council meeting Friday. This could open the door for a more decisive ECB response if the euro area leaders deliver.
- In the short term the primary tools to fight the crisis are the ECB and the EFSF possibly combined with further help from the IMF. In the long run euro bonds or redemptions bonds can be part of the solution, if treaty changes can be ratified.
All key players are likely to be involved in short-term fire fighting
Additional measures to ensure closer economic co-operation within the euro area which could include treaty changes are set to be presented in the coming week. Merkel and Sarkozy will later today present their vision for a stronger EMU. The institutional weaknesses make it close to impossible to find a solution through the usual negotiation process at the Council meetings, which has forced Germany and France to go ahead. With their proposal on the table the pressure on the remainder of the EU17/EU27 to follow will be high.
Furthermore, Eurozone members are now considering using bilateral agreements to achieve further fiscal integration, including the possibility to enforce budget discipline on individual countries. One of the pros of making bilateral agreements is that the implementation would be faster because it does not include treaty changes and it does not need to be ratified by every single member state (see below).
If the euro area leaders can come up with concrete measures, this could open the door for a more decisive ECB response. Despite the fact that it was not the original intention we expect that the ECB’s SMP programme and the EFSF will work side by side as long as the market turmoil remains at the current elevated levels .This could also be combined with additional help from the IMF.
Expectations have been building up
The market is back on the runway for another EU summit take off. Over the past week the news flow has turned increasingly constructive in terms of the meeting outcome and the market has responded correspondingly. Equities were up by an impressive 10% during the past week and both core and periphery spreads to Germany have tightened significantly. 10-year Italian bonds are yielding 6.47% – their lowest since the best level at 11 November, following the previous EU summit.
Interestingly, German bonds are also seeing huge relief. Although yields have not declined that much, German bonds have been tightening significantly versus the US.
Stronger fiscal integration
The proposals will be focused on increasing both surveillance and enforcement. The Commission has proposed that member states budgets should pass the Commission before they are submitted for final approval to national parliaments. Further automatic punishment schemes, debt breaks or incentive inducing mechanisms could also be part of the plan for a more “concrete union”. This should result in a regime of legally binding budget regulations. The new proposals will compliment the recently endorsed six-pack and the European Semester. In the short term it will require more than endorsing these regulations to restore market confidence, but it could help strengthen fiscal discipline in the future. However, it is still left to be seen that the EMU countries actually use their mandate to fine a member state.
There are at least three different ways to achieve further fiscal integration:
1. The least ambitious, but maybe the easiest to get through, is bilateral/multilateral agreements between the key countries in the euro area. France has been pushing this idea. One challenge in this scenario is what role the EU-institutions should play. This will most likely only be a temporary solution until real treaty changes can be pushed through.
2. Germany has been calling for minor treaty changes. To our understanding it would most likely require establishing a fast working European Convention, but maybe it could be done without this. According to several media the euro area leaders are considering using article 126 in the Treaty, where it is stated that the current Maastricht criteria regarding economic discipline can be changed if the heads of states and governments decide this unanimously. Most likely the EU parliament would have to endorse this to ensure a minimum of critical questions regarding the democratic legitimacy.
3. An overhaul of the treaty will require that the European Convention will have to be established with representation from both national parliaments and the EU-parliaments. Once the Convention, the Commission and member state leaders have agreed on the amendments it would need parliamentary approval in most countries and in some countries such as Ireland and Austria even referendums. Political pressure in other countries could result in more countries wanting a referendum, as was the case with the Lisbon treaty. This process could drag out and take years.
The European Council meeting
On the official agenda at the European Council meeting are the current economic situation as well as growth-enhancing initiatives and “The European Council will be informed by its President and hold an exchange of views on the reflections by the euro area Member States on the strengthening of economic convergence within the euro area, on improving fiscal discipline and deepening economic union, including exploring the possibility of limited Treaty changes”.
It will be the proposals for a strengthening of the fiscal integration through surveillance and possible enforcement instruments that will be in focus. The Commission’s proposals for possible euro bonds and the German economic experts’ proposal for redemption bonds are likely to be discussed as well.
ECB response will depend on Summit outcome
ECB officials appear to be opening the door for the ECB to play a bigger and more explicit role in stabilising the European bond markets, if the political moral hazard issues are diminished. The bilateral EU agreement on fiscal coordination could be the token needed for the ECB to step up the bond purchase programme, or to announce more explicit support for the sovereign bond markets. In a recent testimony to the European Parliament, ECB governor Draghi said that:
“We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility ...Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. “
There has been a few hints from the euro area leaders that the ECB could be expected to increase its crisis response if the politicians can come up with a proposal that mitigates the moral hazard problem in the EMU. Hence, communication from the ECB in the weekend following the summit will be key.
On Thursday at the ECB-meeting we expect a 25bp cut, which will bring down the refinancing rate to 1%, and for the ECB to retain an easing bias through a downgrade on the outlook for both growth and inflation. We expect another 25bp cut in January, which also means that we see the risk of Thursday’s meeting as skewed towards a 50bp cut. A refinancing rate of 0.75% will be a historical low. Furthermore, we expect the ECB to introduce 24-month LTROs with full-allotment and average rates, possibly combined with an easing of the collateral requirements on for instance covered bonds in an attempt to help the financial sector.
IMF could be third line of defence
It increasingly looks like the IMF will attempt to construct a third line of defence against the European debt crisis. Bloomberg writes “a European proposal to channel central bank loans through the International Monetary Fund may deliver as much as EUR 200bn to fight the debt crisis, two people familiar with the negotiations said”, but the story has not been confirmed nor rejected by either the ECB or the IMF. Two versions have been floated. One in which the ECB lends money to the IMF, which under conditionality provides the funds to the relevant country. In another model the IMF sets up a precautionary lending facility, which is pre-committed to the country in question.
As a standalone defence mechanism EFSF is no longer credible as financial markets have moved on and increasingly question Italy’s and Spain’s ability to cover their finance requirements in the market. A third line of defence could be constructed by the IMF sending a clearer signal to the market that in a worst case scenario it would be able to cover the finance requirements of Italy and Spain.
However, for such a commitment from the IMF to be credible the resources of the IMF would have to be boosted. Currently the IMF’s free resources are USD390bn (EUR290bn) – far from enough to cover the finance requirements of Italy and Spain.
Hence, there is now considerable focus on boosting the IMF’s resources and it looks increasingly likely that there could be a major announcement on boosting IMF resources in the wake of the EU summit. There could even be some specific commitments from IMF resources to support the firepower of the EFSF.