European Union Summit: The jigsaw pieces are slowly coming together

After an 11-hour marathon of negotiations in Brussels, the euro area’s heads of state sealed an agreement in response to the crisis at 5 o’clock in the morning on Friday. While a euro break-up is still not completely unthinkable, an exit to the crisis now appears to be feasible. Decisions were taken on two fronts.

  • First, short-term measures were adopted to tame the crisis. Euro area central banks will make available €150bn to the IMF and an additional €50bn should come from EU central banks outside the euro area. Also, efforts to convince non-European countries to increase their contribution to the IMF will continue. Moreover, Despite recent setbacks, the will to proceed with the EFSF leveraging is maintained and the two options agreed upon on 29 November will be used. These are a) a partial guarantee of sovereign emission and b) the creation of a Special Purpose Vehicle (SPV). The ECB will act as an agent for the EFSF in its market operations but, this will not imply the ECB expanding its balance sheet. In addition, the ESM (the permanent  stabilisation mechanism) entry into force will be brought forward. It is now supposed to be operational in July 2012 instead of 2013. The EFSF will remain active even after the ESM entry into force but will concentrate on current countries under aid support (Ireland and Portugal). The overall available funds of the EFSF/ESM combined (€500bn) will be reassessed in March 2012. Also, the binding involvement of the private sector (PSI) in any aid package has been given up and the well established IMF principles and practices will be adopted from now on. Accordingly, the PSI included in the Greek case is considered as exceptional. 
  • Second, measures were taken with regards to long-term reforms. Most importantly, euro area governments are to commit to new fiscal rules, i.e. balanced budgets will be the rule and annual general government deficit should not exceed 0.5% of nominal GDP. Such a rule will be introduced in Member States’ constitutions. Moreover, the Excessive Deficit Procedure will be reinforced for euro area Member States. A breach of the ceiling will trigger automatic consequences unless a qualified majority is opposed. Nevertheless, measures regarding policy coordination and governance remained vague and full of wishful thinking.

In conclusion, the EU Summit has undoubtedly delivered some guarantees to the Germans.  Once the agreement is adopted (which could last for a while due to the habitual length of the adoption process) we will not be fare to the sum of guarantees that Germany needs to accept some form of fiscal transfer: fiscal union, Eurobonds, increased ECB role, etc.

Things are going in the right direction but the tempo of institutional reforms is not the same at financial markets’ rhythm. So tensions in the sovereign debt market are still very likely. Even if a euro break-up is not completely unthinkable, it is difficult to imagine that actors like the German authority or the ECB which have the means to tame the crisis won’t step up at the last minute if required.

In terms of the money currently available, we are still somewhat short of the target. 250bn euros are still available in the EFSF, which if leveraged 2 or 3 times, could sum up to 750bn euros, but a more likely figure is 500bn euros. An additional 500bn euros for the ESM should come next spring. But it is far from sure that the ESM funds will add with the EFSF ammunitions. To be cautious we bank on 500bn euros for the combined EFSF/ESM. Another 300bn euros are currently available in the IMF and are unlikely to be totally devoted to the euro area. We can add the 200bn euros that were just committed, plus some additional international aid, which makes 400bn.

All combined, the available funds will totalise some €900bn, which is still short of 1,500bn euros that will be probably necessary if you take into account the combined financial needs of the periphery and the banking recapitalisation costs. Due to this funding gap it is difficult to imagine an exit of the crisis without a step up of the central bank’s intervention. This could be done in several ways in order to respect Mr Draghi’s wish to keep with the “spirit of the Treaty”: Increased IMF financing by euro area national central banks and/or a bank status given to the EFSF/ESM and/or the Special Purpose Vehicle being guaranteed or funded by central banks.

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