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June 29, 2012

EU Summit: Progress, but Much More Needed

By Megan Greene

Spain and Italy essentially held the growth compact hostage yesterday afternoon, agreeing to it inprinciple, but refusing to sign off until shorter-term measures had been announced. In doing so, they

managed to drive a small wedge between French President Francois Hollande and German Chancellor

Angela Merkel, with the former supporting the demand for measures to immediately alleviate

pressure on Spain and Italy.

The measures agreed exceeded market expectations, which Merkel had been carefully managingdownward for the previous two weeks. Consequently, we expect a brief market rally but, in our view,

this is unlikely to last.

Although some progress was made on short-term measures and these measures might buy a littlemore time, the much more fundamental long-term vision for the eurozone (EZ) remains up in the air.

What was agreed and what do we think of it? As is always the case in this crisis, the devil is in the details, many of

which have yet to be hammered out. Below, we list the measures agreed last night (June 28), along with our

prognosis for their effectiveness.

ECB to serve as a joint EZ bank supervisor. This measure is the first of many steps toward a bankingunion, but it was agreed by all EZ policy makers even before the summit, so is no great surprise.

Having the ECB as the European bank supervisor indicates that it is the EZ that will form a banking

union and not the EU. This measure is supposed to be agreed in October and implemented by

January 1, 2013. An EZ-wide bank supervisor falls very short of setting up a real roadmap for a

banking union, which will need to also include a European-wide deposit scheme and a bank-

insolvency regime. These other measures will be much more difficult to agree politically and, even if

guaranteed, a bank deposit guarantee scheme will lack credibility as EZ leaders cannot guarantee

against redenomination.

Once the ECB becomes the joint EZ bank supervisor, the EFSF/ESM can recapitalize banks directly. This is a big step in terms of breaking the negative feedback loop between the banks and the

sovereigns. Initially, the Spanish bank bailout will come from the EFSF and will be routed through the

sovereign but, once the joint bank supervisor is in place, Spains public debt will be adjusted and the

credit risk will go from the Spanish sovereign to the EFSF/ESM and, consequently, the EZ countries

contributing to the EU bailout. This will therefore become a form of liability pooling. For Spain,

concerns about fiscal sustainability will persist even if the bank bailout is injected directly into

financial institutions; Spains public debt is already around 80% of GDP, even higher if a number ofoff-balance-sheet liabilities are also included. Furthermore, this measure does not address the

balance-of-payments crisis in Spain.

EZ policy makers have agreed that Ireland will be treated similarly to Spain, suggesting thatIrelands public debt levelswhich soared as a result of the bank bailoutscould be adjusted. The

Irish government has hailed this as a seismic shift for Ireland and it could certainly make a difference

to Irelands ability to return to the bond markets in early 2014. It will be extremely difficult at this

http://spaineconomy.blogspot.com.es/2012/03/homeric-similes-and-spanish-debt.htmlhttp://spaineconomy.blogspot.com.es/2012/03/homeric-similes-and-spanish-debt.htmlhttp://spaineconomy.blogspot.com.es/2012/03/homeric-similes-and-spanish-debt.htmlhttp://www.roubini.com/analysis/173886.phphttp://www.roubini.com/analysis/173886.phphttp://www.roubini.com/analysis/173886.phphttp://www.roubini.com/analysis/173886.phphttp://www.roubini.com/analysis/173886.phphttp://spaineconomy.blogspot.com.es/2012/03/homeric-similes-and-spanish-debt.htmlhttp://spaineconomy.blogspot.com.es/2012/03/homeric-similes-and-spanish-debt.html

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point to parse banking from sovereign debt in Ireland; they are trying to unscramble an omelet. There

might be a deal on the Irish promissory notes, but it is unclear how much Irelands public debt burden

might be relieved.

The ESM will no longer be senior to other debt in the Spanish bank bailout. Until January 1, 2013,when the ECB becomes the EZ bank supervisor, the Spanish bank recapitalization will be channeled

through the sovereign, first from the EFSF and eventually through the ESM. The EFSF loans that are

rolled into the ESM will not have preferred-creditor status. However, this is a one-off and the ESM

will maintain its preferred-creditor status in other operations. This is only important as long as the

loans are directed through the sovereign. Seniority once there are direct capital injections in the

banks is less of a concern.

There was a vague announcement about the EFSF/ESM engaging in bond purchases, presumably torelieve some of the pressure on Spain and Italy. There will be no conditionality for such programs

and the intervention will be led by the ECB. No details have been provided on how exactly the

EFSF/ESM will be used to intervene. We believesecondary bond market purchases are an extremely

inefficient and ineffective use of the EU bailout funds, benefitting the creditors more than the

debtors. Primary bond market purchases would be slightly better, but ultimately the bailout fundswould likely run out of gunpowder before Spain and Italy manage to implement structural reforms

and have them bite and support growth. It is possible the EFSF/ESM will be used for first-loss

insurance as Chancellor Merkel has recently suggested. This idea was mooted last autumn and was

rejected because it creates new tiers of seniority in the bond market. There is little reason to expect it

to be any more acceptable this time around. That the ECB will lead the intervention obscures the

division between fiscal and monetary policy even more in the EZ. In our view, the lack of a full troika

program makes little difference, as Spain and Italy are already subject to fiscal targets in the Excessive

Deficit Procedure and have been pressured into announcing and legislating structural reforms by the

markets.

A growth initiative was agreed to provide 130 billion for job creation and investment. This was thecenterpiece of Hollandes presidential election campaign and will help on the margins, moderately

mitigating the recession in the EZ. However, it is not enough to reverse the recession and actually

stimulate growth and will not be a game changer in this crisis.

Some important steps were taken at this EU summit and Merkel made more concessions than most expected.

However, while these measures may buy some more time, none of them is sufficient to draw a line under the crisis.

Ultimately, EZ leaders will need to offer a clear, credible roadmap for a banking and fiscal union to put this crisis

behind them. These issues were only discussed on the margins at this meeting and will undoubtedly be the focus

of future EU summits.

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