Eurozone leaders duck all the big issues

It is amazing to me that these discussions totally leave out how the people will feel when they lose their democratic rights to fiscally control their own countries. It is as if the people simply do not exist! ~Jean

The EU treaty agreement reached by eurozone leaders last week isolated Britain and proposed a new ‘fiscal compact’, but in reality it looks like just a ‘lousy compromise’.

Eurozone leaders duck all the big issues

Britain might be isolated, but the odds of a eurozone collapse even after an agreement on a strict new treaty remain high.

 9:30PM GMT 10 Dec 2011

If in doubt, ask a bookmaker. So much noise has accompanied the latest EU crisis summit that it’s easy to miss the main point. Is a eurozone break-up now more or less likely?

Prior to the bad-tempered Brussels meeting, William Hill had priced up the collapse of the eurozone before 2013 at 3/1. The odds post the summit? Also 3/1.

“We can’t see it’s really changed anything,” is spokesman Graham Sharpe’s verdict on a conflab that produced a more isolationist Britain and a potential two-tier EU – but failed to convince anyone, least of all the markets, that monetary union at last had some durable political oomph behind it.

Simon Smith, chief economist at FxPro, says the fate of the eurozone has now become “binary”: “Either one or more of the countries will leave or you’ll see an accelerated path to fiscal union. But what has been agreed at this summit doesn’t go far enough towards fiscal union. The momentum on that is too slow. I’m less optimistic than I was a couple of months ago.”

German chancellor Angela Merkel insisted the agreement was not a “lousy compromise”. But, like many economists, Smith suspects it is exactly that. It is built around a toothless-looking “fiscal compact” that is not only reminiscent of the discredited Stability and Growth Pact but does nothing to address what many see as the real eurozone problem – the current account imbalances that are reinforced by, say, Greece’s lack of competitiveness compared to Germany’s. Instead, Merkel remains focused on deficits.

The latest agreement attempts to cap structural deficits at 0.5pc of GDP and requires countries to employ an “automatic correction mechanism” if they exceed that. It also calls for “intrusive” measures if a country’s budget moves above 3pc of GDP – though there is a potential get-out here if a qualified majority of member states votes against any sanctions.

Smith reckons, though, that the “enforcement and surveillance mechanism remains weak”. That, he says, was a “key flaw” in the stability pact. “Between 1990 and 2007, of the founding nations of the euro, stability pact deficit levels were breached 19pc of the time and debt 42pc of the time. Only half met the debt criteria in the first year of the single currency,” he says, fingering France and Germany as the pair that first softened the rules.

“A system of central surveillance, with a sub-optimal sanctions regime wrapped around a discredited deficit benchmark, is not the right step towards having some degree of eventual fiscal harmonisation,” he says.

Indeed, the agreement ducks all of the big fiscal decisions, such as debt pooling or some sort of centralised EU Treasury. Neither is there a banking licence for the so-called “permanent” rescue fund – the European Stability Mechanism (ESM) – that is planned to displace the European Financial Stability Facility (EFSF).

Or, for that matter, any change of mandate for the European Central Bank to allow the bond-buying blitz that could rescue bombed-out sovereign states that its president Mario Draghi claims he cannot legally sanction. His claim is rather undermined by the ECB’s smaller-scale bond purchases to help the likes of Italy and Spain via its “securities market programme” – but, hey, that’s a central banker’s casuistry for you.

As David Mackie, chief European economist at JP Morgan put it: “We have a very modest step forward on the journey to a fiscal union – certainly not a quantum leap.”

A promise to direct €200bn (£170.8bn) of EU funds to the IMF in the form of bilateral loans – to be used circuitously to rescue Italy, if required – sounded broadly positive. But, as John Hardy, head of forex strategy at Saxo Bank, points out: “That is a mere token measure seen in light of the size of the funding shortfall.” Indeed, Italy’s external debt alone tops €1.8 trillion.

The ESM will now be set up by July next year, instead of 2013, with a potential cap of €500bn to appease Merkel. But, as Hardy notes, there’s “no word on where those funds would come from”.

In a note to clients, Charles Stanley analysts point out that, for now, whatever the bail-out fund is called it has no “hard funding resource” apart from the €11bn the EFSF “has just about managed to raise from three bond auctions”, which has now “been spent as loans to BBB+ Ireland and BBB- Portugal”. With Standard & Poor’s last week threatening to downgrade 15 of the 17 eurozone countries, “the EFSF’s only assets are not even likely to be investment grade”.

“The bottom line is that, yet again, the eurozone’s politicians are seeking to mollify watchers with fine words,” says the Charles Stanley note. “Ignore these words. Bluntly, there is no ‘firepower’ in the proposed bail-out vehicles and there are no funds available right now to be disbursed, leveraged or combined in any way shape or form.”

Add all that up and it does not look good for the eurozone. But that’s before you consider the political, financial and social pain of a break-up.

Says Richard McGuire, senior fixed income strategist at Rabobank. “We think there’s a 70pc chance that de facto fiscal union is the end game and a 30pc chance of a break-up.”

He cites three main reasons for believing that, on balance, the eurozone will survive. “The peripheral crisis is a core banking crisis in disguise,” he says, highlighting the exposure of France’s banks in particular to Portugal, Italy, Ireland, Greece and Spain. The £483bn exposure equates to 24.3pc of France’s GDP. Similar exposure of UK banks (mainly to Ireland) is equivalent to 14.4pc of GDP. For Germany it is 14.7pc.

Not only that. Just as crucial, says McGuire, is the exposure Europe’s banks have to France’s banks. The exposure of Dutch lenders, for example, is equivalent to 10.1pc of Holland’s GDP, while for Britain’s the figure is 12.2pc.

“If you don’t bail out Greece, you will bail out your banks. This is Europe’s Lehman moment,” says McGuire, recalling the way the decision to let the US investment banks go under triggered a full-blown financial crisis. “Greece is as important to the eurozone as a plug is to a bath.”

There are two other considerations. First, the economic ramifications of a eurozone break-up, with trading partners plunged into chaos, which McGuire says “there’s no way of quantifying”. And second, “the potential enormous loss of political capital. We are 60 years into this project, since the formation of the European Coal and Steel Community, and no politician wants to be responsible for the break-up.”

All this, he reckons, points to eventual fiscal union and more aggressive intervention by the ECB. But that won’t happen until the shilly-shallying politicians have no choice but to act.

He reckons “crunch time” could be the first half of next year, with Italy having to refinance €36bn of debts in February, €27bn in March and €28bn in April. That is part of a programme that will see almost €400bn of debt issuance by Italy next year – not to mention around €150bn by Spain. Yields on Italian 10-year debt currently stand at 6.8pc. On Spain’s, the figure is 5.8pc. If either stick above the bail-out alert level of 7pc, eurozone leaders will have to come up with something better than last week’s flim-flam.

That day has not yet arrived, however. As Trevor Greetham, Fidelity’s director of asset allocation, says: “There are probably only two stable equilibria, full political union or break-up. With neither imminent, I’d say volatility is here to stay.

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