Research Blog
Euro summit: A step forward?
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX
+44 (0)20 7597 8334
Chris Scicluna, Economic Research
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX
+44 (0)20 7597 8326
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9 December 2011
Mario Draghi’s comments yesterday, ruling out a more significant role for the ECB in buying euro area government bonds, had cast a dark pall over markets as EU leaders gathered last night in Brussels for their latest make-or-break summit. But while market reaction to the agreement reached last night on additional measures to strengthen the policy response to the crisis was initially downbeat, there are (possibly) a few reasons to be cheerful with what euro area leaders agreed last night.
Last night’s agreement had two main strands:
- a new ‘fiscal compact’ to set tighter budgetary rules enforced by sanctions; and
- proposed enhancements to the financial resources available to provide support to countries facing funding difficulties.
Predictably, the main elements of the fiscal compact are based closely on the Merkozy agreement reached earlier in the week.
- Budgets will have to be balanced or in surplus (or, to be more precise, annual structural deficits should not exceed 0.5% of nominal GDP);
- That objective will have to be introduced in Member States' national legal systems at constitutional or equivalent level, verified by the European Court of Justice;
- If budgets deviate from balance, an automatic correction mechanism will be triggered to tighten policy;
- Member states will have to have their debt issuance plans approved in advance. And the Commission will be able to examine draft budgetary plans, with powers to request revised plans.
- Penalties for deficits breaching 3% of GDP will not be automatic, but they will be more difficult to avoid than currently.
The plan is to reach agreement on the details by March, with national implementation thereafter. But to the extent that countries know that these rules are on their way, where policies do need adjusting, we would expect governments to do that sooner rather than later.
To the extent that these arrangements will be enshrined in a new intergovernmental agreement (of 23-25 member states) rather than a new EU Treaty, it should be easier to be adopted. And for market participants who feel that current euro area government commitments to budgetary adjustment are not credible, then the fiscal compact might provide some additional comfort. However, with new governments already in place in key countries - such as the Monti administration in Italy, which has already committed to aggressive fiscal tightening and adopting a balanced budget rule in the national constitution - for many investors this is probably not the key concern. Moreover, to the extent that the budgetary automatic correction mechanisms will also deliver pro-cyclical fiscal policy right across the euro area, they risk making adjustment all the more painful, with deep recessions almost certain in some countries, and fears of deflationary spirals not all that far fetched. And, of course, given that Spain and Ireland ran budget surpluses ahead of the crisis, the fiscal compact wouldn’t have prevented the crisis in the first place. Indeed, some of the chief transgressors if these rules had been in place during the noughties would have been the Germans and French!
While the agreement on stricter fiscal rules will not necessarily do anything significant to tackle the current crisis, securing that agreement did allow the Germans to green-light additional financial resources. So, while Draghi’s refusal yesterday to contemplate greater ECB bond purchases dashed hopes of a ‘silver bullet’, there is arguably cause now for more cautious optimism than yesterday evening.
In terms of the detail of the proposals on financial resources:
- The implementation of the €500bn permanent bailout mechanism, the European Stability Mechanism (ESM), will be accelerated. The objective is for the ESM to enter into force in July 2012. Ahead of the summit the Germans had been resisting this.
- The leaders thus see scope to run the ESM concurrently with the EFSF up to mid-2013, although they will decide in March 2012 whether to allow the EFSF and ESM together to have combined firepower of more than €500bn.
- There will be less automaticity of private sector involvement in bailouts financed by the ESM (although PSI will remain an option), with the ESM’s voting rules amended to make for swifter decision-making and disbursement at times of crisis.
- Finally, Member States will consider, and confirm within 10 days, their intention to provide additional resources to the IMF of up to €200bn to help finance the new liquidity facility designed with troubled euro area member states in mind.
So, in theory, last night’s agreement delivers the possibility of additional financial resources to tackle the crisis. However, there are plenty of uncertainties also. In particular it remains to be seen whether national parliaments (not least in Germany, where Merkel’s Free Democrat coalition partners have signalled strong opposition to the permanent bailout fund, and Finland too) will agree. And even if agreement is reached on bringing the ESM’s start date forward, there is no guarantee that the total resources at the EFSF and ESM’s disposal will ultimately be above €500bn. And, of course, if the market’s appetite for EFSF debt does not improve, serious doubts will remain whether it will be able to raise the sorts of quantities of monies required for significant bond market purchases and/or bailouts of Italy, Spain, etc. if required.
But in our opinion, the commitment to consider an enhancement of the IMF’s resources by €200bn, which overlooks the reservations expressed yesterday by Draghi, is the most encouraging step forward. Since other countries – not least the BRICs, which made commitments to purchase IMF SDR bonds in 2009 – might be expected also to lend further resources to the Fund, this could go some way to alleviating concerns that sufficient resources will be available to provide support to Italy and Spain through to 2013. Of course, we hope that it will never come to that. But, if it does, last night’s agreement at least opens the door to additional financial resources to help countries facing funding pressures if they are required.
It does not, of course, mark an end to the crisis. Uncertainty about implementation will continue to weigh on market sentiment, as will uncertainty about whether the action announced will be sufficient to prevent both Moody’s and S&P from following through on their threats of wholesale downgrades of euro area sovereigns and related borrowers. And, more fundamentally, with the euro area economy probably already in recession, doubts will persist about the ability of governments to hit the fiscal targets set out and eventually return to a sustainable growth path. Nevertheless, last night at least demonstrated that euro area leaders are alive to the fact that a larger firebreak is required and that it is up to them, not the ECB, to provide it. In that sense, it represents a step forward.
Grant Lewis, Head of Research
Chris Scicluna, Head of Economics
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