Nicolaus Heinen of DB Research -
March has a decisive summit marathon in store for the EU and Eurozone. Since the version of the Treaty on the Functioning of the European Union (TFEU) currently in force does not allow for a permanent anti-crisis mechanism, the EU member states must agree on a treaty amendment. Two sentences are to be added to Article 136 TFEU with effect from January 1, 2013. As of that date, Eurozone countries will be allowed to install a permanent stabilisation mechanism granting financial assistance with conditions attached. Amendment of the Treaty requires unanimity on the part of all 27 EU member states - even though the amendment will have material effect on the 17 euro countries only. This paves the way for package deals, with the approval of any one country being made conditional on concessions by its negotiating partners.
What issues might form part of such a package deal? Three points are currently under discussion.
I: Amendment of the European Financial Stability Facility EFSF as part of the existing crisis mechanism
The key component of the present euro bailout fund, the European Stabilisation Mechanism, is the European Financial Stability Facility EFSF. It grants loans to Eurozone states in financial difficulties - such as Ireland - faced with imminent insolvency, raising the funds for this by issuing its own EFSF bonds on the capital market. However, whilst all 17 euro countries guarantee these bonds on a pro-rata basis determined by the ECB Capital Subscription Key, they are not jointly and severally liable. In order to secure top rating and an interest rate advantage, EFSF bonds must therefore be over-guaranteed. This means that guarantees of €440bn give the EFSF effective financing capacity of only around €255bn. Financial assistance of €18bn for Ireland will be funded by bond issues.
At present three adjustment measures are being debated:
1. Increasing the effective lending capacity of the EFSF to €440bn. One possible way to do so would be by altering the guarantee structures, with 'AAA'-rated countries assuming greater liability than assigned to them by the present key. Another alternative would be bond tranches with different ratings to fund the financial support. Also conceivable would be permanent cash reserves or additional loan securities provided by the states seeking assistance. However, Germany takes a sceptical view of all these options.
2. Expanding the scope of action of the EFSF. The possibility is also being discussed of the EFSF being empowered to purchase government bonds on the secondary markets to relieve the ECB of its present emergency measures (Securities Market Programme, SMP). The EFSF could also lend a distressed state funds enabling that country to buy back its own government bonds from investors at favourable market rates. However, proponents of voluntary debt rescheduling of this kind overlook that the prices of the bonds concerned would tend to head back towards their nominal value in anticipation of just such intervention. Even restricting intervention to a brief window of time might not conclusively solve the underlying incentive and pricing problems. The German Bundestag takes a particularly critical view of this plan - it remains to be seen whether and to what extent this will influence the German position and the outcome of the negotiations.
3. More favourable interest rates for distressed Eurozone states. Also up for discussion is whether lower interest rates for EU loans might encourage those states in trouble to make timely application for aid. But the examples of Portugal and Ireland illustrate that the logic of a cry for help is determined less by long-term economic considerations than by what is politically opportune. The point in time at which assistance is sought depends less on interest rate levels (at present: refinancing costs plus 247 bps) than on the political mood and actual solvency. It must also be borne in mind that low interest rates reduce the incentives for national policy-makers to cut spending - which is guaranteed to send risk premiums soaring.
The forum in which voting on amendment of the EFSF takes place is the Eurogroup, since the euro countries are the shareholders of the EFSF. As the EFSF rests on an intergovernmental treaty, it could be amended swiftly. In view of the urgency that individual countries and the markets currently assign to reform of the financial stability facility, its revision is likely to comprise part of the package deal.
II: Fleshing out the ESM as successor to the EFSF
A second key item on the negotiation agenda is how the European Stabilisation Mechanism (ESM) is to be fleshed out as successor to the EFSF and financial aid from the European Commission. At the moment the sum of €500bn is envisaged as the effective financing capacity. Whereas temporary liquidity aid will be granted in the initial stage, the second stage involves private creditors (through haircuts or debt moratoria). However, the latter raises problems not only due to the long-range conversion to collective action clauses; since the vote on transition to the second stage must be unanimous, it is to be feared that countries whose financial systems stand to suffer heavy losses from creditor involvement will not endorse such a step.
All 27 EU member states will decide on how the ESM is to be organised. As with the EFSF, the vote is purely intergovernmental and does not require a lengthy legislative process. But given that there is no great hurry, it is possible that the March summit will not reach a final decision on what shape the ESM is to take.
III: Economic governance package
The economic governance package will continue to form part of the overall package. The conclusions of the Ecofin Council meeting of EU economics and finance ministers on February 15 already signal the fundamental willingness to accept in principle the Commission's proposals on the Stability and Growth Pact and on macroeconomic guidance in the EU and the Eurozone. However, the previous ambitious target of lowering public debt in excess of the 60% of GDP threshold by 5% a year has been abandoned. And major differences of opinion also remain on macroeconomic supervision and the scoreboard indicators and permitted threshold values on which this is to rest.
The economic governance package is currently under negotiation by the Permanent Representatives Committee (Coreper). This is tasked with establishing a joint position by March 15 for approval by the Ecofin Council. The Ecofin and Coreper negotiations thus pave the way for the plenary negotiations at the European Council summit end-March.
Investors on the financial markets are now focusing their attention on the changes in the EU and the Eurozone adopted at the March summits. In all, four relevant European-level meetings are taking place in March - two of them with all 27 EU countries and two within the smaller Eurozone group.
Both processes and their outcomes will interest the markets.
* Market turmoil ahead of the European Council meeting on March 24-25 cannot be ruled out. Even if the foreseeable success of the three summits in the run-up to the endgame is boosting confidence, uncertainties still remain - notably with regard to the shaping and reworking of the ESM and EFSF respectively. Germany's position here could come under particularly close market scrutiny.
* In a medium-range context the question arises of the extent to which the upcoming changes will offer the right incentives and minimise the moral hazard risk to the EU and Eurozone member states.
* Even long-term ratification of the Treaty amendment could still provoke speculation. Whilst the simplified treaty revision procedure will remove the need for referenda, pressure could still be exerted by legislative bodies. In all likelihood approval by the Bundestag will require a two-thirds majority - calling for votes from both the German government and opposition.
So even if the summit marathon in March does produce results that succeed in convincing the markets, it will by no means mark the end of political debate - and this may still come up with some surprises.
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