The EU summit at the end of last week produced some positive developments in an attempt to break “break the vicious circle between banks and sovereigns”, against a background of low expectations. Key parts of the summit proposals are:
• The European Commission will shortly present a proposal to establish a single banking supervisory mechanism. These proposals will be considered “by the end of 2012”.
• When an effective single supervisory mechanism is established, the European Stability Mechanism “could have the possibility” to recapitalise banks directly. Given that the supervisory mechanism will not likely be in place until year-end, direct bank recapitalisation appears unlikely to occur before early 2013. But once in place, direct bank recapitalisation will remove the need to provide funds via the respective government, and in turn increase the government’s stock of debt.
• The funds provided to Spain for its bank recapitalisation will not have “seniority status” relative to other lending to Spain. One of the factors behind the recent sell‐off in Spanish bonds has been concerns about possible debt subordination.
• The European Financial Stability Fund/ESM will be used in a “flexible and efficient manner in order to stabilise markets”. This implies that the EFSF/ESM funds will potentially be used to cap Spanish and Italian bond yields in the near term.
Market reaction has been very positive, both on Friday during NZ trading time and Friday night’s European and US sessions. There is, however, the likelihood that the positive sentiment fades over time. Although Europe made some important steps to try de-linking banks and governments, deep-seated problems remain. And Europe as a whole has slowing more sharply in recent months, with worrying signs that core economies like Germany are being pulled down by the contractions in the troubled countries.
The summit proposals still have some conditionality about them, and still need time to be enacted. As yet, the available rescue funds remain at €400 billion (after allowing for €100 billion for Spain’s banks). That amounts to around 17% of Spain and Italy’s outstanding debts, which may not be sufficient if either of them get locked out of funding markets.
More convincing measures would allow the ECB to be governments’ lender of last resort, enabling unlimited support in an acute crisis, with moves towards mutually guaranteeing a portion of government debts.
The latter, particularly, would also boost confidence in the euro’s survival through substantially reducing both the chances of default and the debt-servicing costs of troubled countries. Attention this week will remain firmly offshore. Some more immediate assistance to Eurozone economies is likely this Thursday night, with the ECB widely expected to (belatedly) cut interest rates 25bp.