Merkel comes out swinging against debt pooling

Debt pooling in practice? (h/t Phil's Stock World)

In recent weeks Chancellor Merkel has come under ever-increasing pressure to “do what is necessary” and take the plunge on debt pooling within the eurozone. This pressure has been applied from a wide of actors including the other big eurozone countries (France, Italy and Spain), the EU institutions (Commission President Barroso, Council President van Rompuy, Eurogroup chief Juncker and ECB head Draghi), the IMF and last but not least UK Prime Minister David Cameron and US President Barack Obama.

However, Merkel - who in her time has crossed a fair few ‘red lines’ - has come out swinging ahead of Thursday’s summit of EU leaders, with Handelsblatt reporting that she is has lashed out at discussions ahead of the for focusing "far too much on all kinds of common liability [including] eurobonds, eurobills and a European common deposit guarantee fund with common liability". She described the proposals as "economically false and counterproductive" and asked Van Rompuy, to rework the report he published ahead of the summit to shift the focus from debt pooling to budget discipline.

According to Reuters, at a meeting today with representatives from the FDP, her junior coalition partner, she went even further, claiming that: 

“Europe would not have shared total debt liability as long as I live” 

If accurate, this is strong stuff and - though intended for a very domestic audience - certainly a departure from the measured and stoic tone Merkel usually adopts. Likewise Merkel’s reaction to suggestions that Germans would be getting a referendum on a new constitution allowing for greater EU integration in the immediate future – after Finance Minister Schäuble had suggested this in an interview with Der Spiegel –suggest that she does not anticipate full debt pooling as an immediate possibility, with FT Deutschland citing her spokesman as saying “clearly we are not there yet.”

However, to split some pretty big hairs, the qualification of “shared total liability” hints that Merkel is not ruling out all forms of eurobonds during her lifetime, such as debt redemption fund as favoured by the SPD and Green opposition. Likewise she could offer other concessions, something hinted at by the news that Germany could be prepared to drop the provision that ESM loans are senior to other debt, something which has been perceived to have contributed to rising Spanish debt yields on the assumption private creditors would take the biggest hit.

However, nothing will happen on any form of debt pooling before the German elections in the autumn 2013.

Towards a genuine Economic and Monetary Union...

That is the optimistic title of the report to be presented at this week's EU summit. You can find the full report here.

The report was compiled by the President of the Council Herman Van Rompuy with the aid of the Commission to lay some ground work for the eventual move towards a fiscal and banking union in the eurozone. Although it is clearly in its very early stages being only seven pages, the report gives a flavour of what's to come - importantly, though, the Commission has said this morning that the next report on the issue will be provided in December, so anyone expecting progress on this issue within weeks and months was sorely mistaken.

We'll update this blog with our thoughts and analysis as we delve deeper into the report.

UPDATE 11:00

The final version of the report is now available on the European Council website (see here).

The eurozone crisis in 140 characters

The eurozone crisis - with its numerous rolling summits, announcements, proposals, simultaneous economic and political developments in multiple member states and fast-paced market reactions - has brought Twitter to the forefront of EU reporting and analysis.

Unlike English football commentator Mark Lawrenson, at Open Europe (as in @openeurope) we like twitter and use it to keep up with various euro developments, as well as to flag up key events and our own analysis. It's a great supplement to our increasingly popular daily press summary. Of course, the key is not only to tweet fast - and summarise often complex economic and political concepts in 140 characters - but to also get it right. Which is why we were very pleased to see that Barron's - a leading American financial magazine - has selected Open Europe's twitter account as one of five that “consistently provide great information and trenchant analysis” on the Eurozone crisis.

Barron’s notes

"Once again, Twitter is proving its mettle as a source of instant news and analysis—this time on the euro crisis. Just as it did last year during the Arab Spring and the meltdown at Japan's nuclear plants, the social network is producing a constant stream of real-time information on the big news story of the day—some of it spot-on, some not. The trick is to follow the right people, or tweeps, and Barron's is here to help with that." 

The magazine notes that Open Europe's strength is its "Deep bench of analysts tracking political developments", describing us as

“a think tank based in the UK that deploys a small army of research analysts fluent in more than a dozen languages to keep tabs on the crisis, both reporting and commenting on the news. A recent typical tweet dismissed any reasons for optimism for Spain after its 10-year bond yield fell below the critical 7% level. If investors were buying on rumours that the European bailout fund would buy the troubled bonds, forget it. Yes, all that in one tweet.” 

Many thanks for that. Please forgive us the shameless self-promotion but if you don't already, do follow us on twitter @openeurope.

Ps. The other four selected are @pawelmorski, @economistmeg, @LorcanRK, @alea_ - all worth following.

Funding needs of Spanish banks could top €110 billion

We have this morning published a new briefing looking at the funding needs of Spanish banks and the Spanish state. Taking into account that Spanish house prices may drop another 35%, we estimate that the country's banking sector could need an immediate €110bn capital injection to withstand potential losses – an amount which is substantially higher than the recent official estimates provided by both the IMF and the two independent auditors hired by the Spanish government.

Our briefing coincides with the letter sent by Spanish Economy Minister Luis de Guindos to Eurogroup Chairman Jean-Claude Juncker, in which Spain officially requests a bank bailout. Unsurprisingly, the letter stops short of mentioning any specific amounts. The details will be nailed down ahead of the next meeting of eurozone finance ministers on 9 July.

Here's the letter in full, translated from Spanish: 

I have the honour to address you [Eurogroup Chairman Jean-Claude Juncker] on behalf of the Spanish government, to formally request financial assistance for the recapitalisation of Spanish financial entities which will require it.

This financial assistance falls within the framework of financial aid for the recapitalisation of financial institutions. The choice of the concrete instrument through which this aid will materialise, will take into account the different options that are currently available and others that might be decided in the future.

The Spanish government considers very positively the declaration made by Eurogroup ministers on 9 June, which expressed support for the determination of the Spanish authorities in restructuring [Spain’s] financial system and their intention to seek financial assistance for the recapitalisation of financial entities, of an amount sufficient to cover the capital needs plus an additional safety margin, up to a maximum of €100 billion.

The [Spanish] Orderly Bank Restructuring Fund (FROB), which will act on behalf of the Spanish government, will be the institution which will receive the funds and transfer them on to the financial institutions.

The Spanish authorities will offer all their support in the assessment of the eligibility criteria, the definition of the financial conditionality, the monitoring of the measures to be introduced and the definition of the financial aid deals, with the objective to finalise the Memorandum of Understanding before the 9 July so that it can be discussed at the next Eurogroup meeting.

In this regard, the two Independent audits of the Spanish financial sector, as well as the FSAP analysis carried out by the IMF, should be used as a starting point.

Perhaps Il Cavaliere wasn't joking, after all...

Italy's former Prime Minister Silvio Berlusconi claimed he was "joking" when he suggested, earlier this month, that Italy should consider saying "ciao ciao" to the euro if the ECB is not allowed to print money and become the single currency's ultimate backstop. However, jokes aside, he made very similar remarks at a book launch yesterday. He said,

"I don’t think the hypothesis of leaving the euro and using competitive devaluation is blasphemy." 

"The best solution is to convince Germany that the ECB must act as [the eurozone’s] lender of last resort…What could happen otherwise? Some people expect Germany to leave the euro. I have spoken to several German financial experts who think [Germany’s] euro exit is not such an odd idea, after all." 

"If Germany sticks to its negative positions, it can either happen that individual [eurozone] countries return to national currencies, or that Germany leaves the euro." 

Italy leaving the euro remains a distant prospect. But as we noted before, Berlusconi's influence on his political creature - the People of Freedom party - remains huge, even if he is not going to run for Prime Minister in next year's general election. Should Il Cavaliere's new line of thinking become party policy, we may well have one of the mainstream political parties in Italy (most likely in the opposition, but still) saying that the country's support for the single currency is not unconditional.

After the rise of anti-euro comedian Beppe Grillo, this would be another sign that support for the euro can no longer be taken for granted in Italy.

Does European solidarity have a new champion?

Apparently, Cameron told the BBC the following this afternoon:

"I understand Angela Merkel’s difficulties and her political difficulties because the Germans have run their economy very effectively over many years. But it’s their currency, they need their currency to work, so they need to have guarantees from other parts of the eurozone that they’re putting their house in order, but there has to be solidarity as well."

Solidarity? As long as it doesn't involve Britain itself of course. Not. Smart. Politics. 

Are the rumours of a new(ish) eurozone backstop true?

The press have got very excited over suggestions from European leaders at the G20 meeting in Los Cabos, Mexico, that they will activate the EFSF to buy eurozone government bonds from the secondary market in an attempt to reduce borrowing costs for Italy and Spain - a function which the fund has always had but has never been used (since the ECB has filled this role with its bond buying programme). Berlin has already moved to deny this, but there could be truth in it - not least because it's legally possible but also because we've seen over the past few weeks that the ECB has refused to buy bonds despite the persistent rise of Spanish borrowing costs. It has become increasingly clear that Spain cannot withstand these interest rates for long - something needs to  be done.

If true, this could prove a important change. Despite always being possible, bond buying from the EFSF has up until now only been theoretical. When it comes to the unenviable task of backstopping Spanish and Italian government debt, the ECB has now officially passed the buck to eurozone governments. Over the last two years, the ECB has effectively managed to manipulate government bond yields by buying a limited amount of government bonds – some tens of billions a month at its peak (although with mixed success). In August last year, for example, the mere willingness of the ECB to buy Italian government debt may have prevented a full-scale run on that country as political uncertainty ran wild. But there’s a key difference between the ECB and the EFSF – while the former has deep enough pockets to move markets, the EFSF’s lending capacity is inevitably limited, meaning that making it into a lender of last resort for a country the size of Spain (let alone Italy) could prove risky. The ECB could stand behind Spain and Italy with, at least in theory, the ability to massively expand its balance sheet and thereby quarantine these problem countries. But the EFSF only has €250bn left to lend – to top up its lending capacity, it will need to pass 17 hostile national parliaments, which ain’t gonna happen anytime soon.

This is to say that, if the buck has indeed been passed from ECB to the EFSF, then the Eurozone’s firewall just became a lot weaker - many have rightly previously questioned its capacity to purchase bonds and fund lending programmes to struggling countries simultaneously. Furthermore, the EFSF treaty states that secondary market intervention can only take place at the request of the recipient country and will come with some conditions (although probably not a full reform programme). Clearly this will come with significant stigma (once you go down the path of any external aid it is hard to return, as Spain is now finding out), while it is hard to imagine a country signing up to extra conditions just to manage its secondary bond market (especially since the ECB was previously doing this without any clear conditionality).

There are additional questions over what this means for the permanent eurozone bailout fund, the ESM, which is meant to be up and running this summer. Presumably, it will have to take over this bond buying role once it comes into force. The same problems apply here as do with the EFSF, but the ESM is also senior to other debt, meaning that as it buys up debt of a country other holders of this country's debt become subordinated - this can result in further market uncertainty making it counter productive. Ultimately, if the ESM is to serve as a lender of last resort in any way, it almost has to be equipped with a banking license in order to allow it to lend and borrow freely, without being hostage to national parliamentary politics or very limited in size. Giving the ESM a banking license is a hot potato in Germany, but will Berlin have any choice if the markets start to question the firepower of the fund?

On the current path, presenting the EFSF/ ESM as lender of last resort – for Spain in particular – but without equipping it with the cash to actually allow it to fulfil this function, could set the stage for a showdown between markets and the funds - in that scenario we can only see one winner.