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.

And on the second day...

The second day of talks on the formation of the new Greek government has so far seen no major surprises. As we predicted in our response to the election results that we put out yesterday, PASOK leader Evangelos Venizelos' refusal to join a 'national unity government'. unless left-wing SYRIZA were on board, for most part turned out to be political posturing. Things now seem to be heading towards a three-party coalition with election winner New Democracy, PASOK and Democratic Left.

The latest developments:

• As widely expected, both SYRIZA and right-wing populist Independent Greeks have said "Thanks, but no thanks" to New Democracy leader Antonis Samaras' offer to take part in the new coalition;

• Samaras also met Venizelos and Democratic Left leader Fotis Kouvelis yesterday. After the meeting, Venizelos insisted that the best solution would be to have a four-party coalition with SYRIZA in, although he stressed that "the country must have a government by tomorrow [i.e. today]";

• Kouvelis suggested that his party was willing to form part of the new government, although he added that he would sign "no blank cheques" to Samaras;

• Venizelos and Kouvelis (in the picture) met this morning. After the meeting, Kouvelis said an agreement is in sight and could be reached "within hours". A tripartite coalition with New Democracy, PASOK and Democratic Left would hold 179 of the 300 seats in the Greek Vouli - which the European Commission and other eurozone countries could see as sufficient to start talking of minor revisions of the Greek bailout programme; 

• Venizelos suggested that, in parallel to the new government, Greece should also set up a negotiating team to discuss the revision of the bailout terms in Brussels. This group, he said, should clearly include SYRIZA - now the second-largest party of the country. However, SYRIZA has dismissed Venizelos' plan as a "publicity stunt"; 

• Meanwhile, there seems to be a bit of confusion on what Greece could actually achieve from the re-negotiation of its bailout terms - which, according to us, will be a couple of minor adjustments but no changes to the thrust of the agreement. A senior European official is quoted as saying, "If we were not to change the [EU-IMF] Memorandum of Understanding we would be signing off on an illusion. There is scope for revision." He added that a new MoU would be signed "during the summer." However, the prompt reply from European Commission spokesman Amadeu Altafaj Tardio is that "nobody is talking about a new MoU". 

• On a slightly separate note, Die Welt notes that PASOK - the party - is actually proportionally in more debt that Greece itself. It owes banks some €130 million - i.e. 18 times its annual income. Election winner New Democracy is also reported to be heavily indebted. This is partly due to the fact that Greek political parties get state funding based on their share of votes in the general elections, and support for PASOK has been shrinking since its last victory in 2009. 

Do the election results mark a turning point for Greece? Think again...

Over on the Spectator's Coffee House blog, we argue,

Things in Greece could have been worse after the election, but that fact can’t be hailed as a ‘turning point’. Assuming that Greek political leaders form a coalition and push ahead with EU-mandated reforms, which is a very likely outcome given that Greece may only have enough cash in its coffers to soldier on for another month, any such government will inevitably include parties that completely disagree on how to resolve the crisis. The only glue would be the fear of economic catastrophe.

This uneasy government would be ill-suited to withstand pressure from Syriza and the rest, who will spare no effort in blaming it for the inevitable economic pain. The threat of new elections, which would probably lead to Greece's exit from the Eurozone, will constantly hang over the country’s head like the famous sword of Damocles.

A great deal of hope is being placed on the new government’s ability to renegotiate the terms of the EU-IMF bailout programme. At the G20 summit in Mexico, Angela Merkel went a long way to play down these expectations. This suggests that the upcoming revision will largely be a superficial exercise. Greece may obtain a slight reduction in the interest rates, an extension of the debt repayment deadlines, a few billion for investment, and perhaps even be given some slack on its deficit reduction targets. However, the thrust of the bailout agreement will stay the same — and many of the conditions will remain unachievable and poorly targeted at the substance of Greece’s problems, such as the dramatic loss of competitiveness since it joined the euro, and a number of systemic flaws in the country’s administration.    

So should Greece leave the Eurozone as fast as it can? The euro crisis has proved that Greece should never have joined the single currency in the first place, and the benefits of Greece trying to re-build its economy outside the Eurozone are well-documented. However, if Greece left the euro now, the risks involved would very likely outweigh these benefits in the short term. Our estimate is that, if Greece exited today, it would need external financial assistance worth up to €259 billion — or else face the serious threat of hyperinflation and a banking sector collapse. Given the blind alley down which Europe has led Greece, this is the unfortunate reality, failing to take these issues into consideration could lead to a terrible outcome for all, including the UK. 

Having said that, the key question about the future of Greece’s euro membership will not go away; and it will have to be answered, sooner or later. The impression is that, once Greece manages to balance its budget and put its ailing banking sector back in decent shape, dropping the euro will look a more sensible, even desirable, alternative — especially if the Greek budget is to be drafted in Brussels on a permanent basis.

What next for Greece?

We have today published a Q&A on Greece's future in the eurozone in light of the results of yesterday's elections. Here we go:

What happens now?
As the largest party, New Democracy (ND) will lead talks on forming a coalition government. The starting point will likely be negotiations over a ‘national unity government’ which tries to incorporate as many parties as possible. If ND fails, the mandate would normally pass onto the second and third largest parties, SYRIZA and PASOK respectively. However, SYRIZA has said it will reject the mandate, while PASOK called for it to be passed straight to Greek President Karolos Papoulias. ND still looks likely to lead the first talks, but if these fail Papoulias will take over. Given the risk of a eurozone collapse, most political leaders in Greece accept that not forming a government is not an option. Once a government is in place, negotiations with European partners will begin.

Is a national unity government likely or possible?
We don’t think so. SYRIZA has already ruled out governing in tandem with ND, and has consistently rejected the austerity measures attached to the Greek bailout programme. Throughout the election campaign, SYRIZA leader Alexis Tsipras has been incredibly critical of ND and the ‘old guard’ of Greek politics – which he blames for the corruption and economic problems Greece is now facing.

But wait, hasn’t PASOK ruled out joining a coalition without SYRIZA?
It is true that yesterday PASOK leader Evangelos Venizelos called for a minimum four-party coalition and suggested he would not join a coalition which did not involve SYRIZA. However, we believe this to be largely political posturing. PASOK has seen its vote share eroded by SYRIZA and is therefore keen to exploit its position of power as kingmaker to ensure it does not lose further support. The party is also wary of being stuck in a coalition with only ND where it would be overwhelmed. We believe PASOK would join a coalition as long as it involved other parties beyond just itself and ND. As an alternative, PASOK could pledge its votes in parliament to allow the new government to pass EU-mandated austerity measures. Ultimately, PASOK has supported Greek membership of the euro and the current bailout programme, while Venizelos is aware of how costly new elections could be meaning it is likely to compromise. Somewhat ironically, he has already argued that there is no time for “political games” when it comes to forming the new government.

What could a new government look like and how strong would it be?
We believe a likely coalition would be ND-PASOK-Democratic Left. This would have a fairly strong majority with 179 seats in parliament. However, it would face a strong, motivated and more unified opposition in SYRIZA. This coalition government, although broadly pro-euro and accepting of the bailout programme, would still be marred by disagreements over the level of ‘austerity’ and the correct way to promote economic growth (ultimately it is an ideologically mixed right-left coalition).

Is a third election possible?
Yes, although it seems the least likely option at the moment. Interestingly, there is a precedent in recent Greek history – the Greeks have previously had to vote three times in less than a year (June 1989, November 1989, and April 1990) before a stable government could be formed. All the political parties know that a third election would now be the worst possible outcome – not least because Greece would run out of cash before the new vote takes place, probably towards the end of the year, while eurozone leaders look unlikely to lend into a black hole (in governance terms). Therefore, a compromise is likely. However, if SYRIZA stays out, the new coalition would inevitably be a weak one (as noted above), meaning that new snap elections may well be called in six months’ time.   

What prospect is there of a renegotiation in the bailout agreement?
Eurozone leaders hinted strongly ahead of the election that if a broadly ‘pro-bailout’ coalition was formed some easing of terms would be forthcoming. This looks to have been confirmed by German Deputy Finance Minister Steffen Kampeter who said Germany expected the new Greek government to honour its existing commitments but added that Athens should not be pushed too hard, saying, “It is clear to us that Greece should not be over-strained.” German Foreign Minister Guido Westerwelle said there could not be “substantial changes” to the agreement but that he could “well imagine talking again about timelines.”
One big question is whether eurozone leaders will push for SYRIZA to provide a supporting signature – we think this is unlikely given the party’s opposition – but ultimately the support of a broad coalition with 179 seats may be enough for eurozone leaders.
Any adjustments are likely to be small focusing on lower interest rates, extended repayment periods and EIB funds for Greece. Some adjustment in the deficit cutting programme may be possible, although only to account for the delays to the plan due to the two Greek elections.

Will this solve the eurozone’s and Greece’s problems?
No. Even with adjustments to the bailout programme, it still looks virtually impossible for the country to meet the various austerity targets. Missed targets will continue to be a source of disagreements and controversy, particularly inside Germany, while the continued EU/ECB/IMF Troika presence on the ground in Greece means that any delays will come to light quickly. Therefore, Greece’s future in the eurozone remains uncertain. For the single currency as a whole, should a compromise be possible in Greece, the focus of attention will shift back to Spain – whose banks remain a major liability for the euro. 

So what chance is there for a third Greek bailout?
Politically, providing a third bailout for Greece would be incredibly difficult for the likes of Germany, Finland and the Netherlands, which would all struggle to get parliamentary approval. From the Greek side, it is hard to imagine even a pro-euro coalition signing up to a new strict ‘Memorandum of Understanding’ detailing further ‘austerity’ for Greece. At best, extra cash might be put on the table if a move towards a fiscal or banking union is close, but this will not happen anytime soon. We expect that a more fundamental decision over Greece’s eurozone membership will need to be made before this money runs out, within the next six to nine months.

Why doesn’t Greece just leave the euro now and move forward?

• There are clear economic benefits to Greece leaving the euro, but the risks involved in an imminent exit could well outweigh these benefits in the short term. We estimate that if Greece left the euro now, it could still need between €67bn and €259bn in external short-term support, potentially split between the IMF, the Eurozone and non-euro countries including the UK. These figures do not include longer-term support or contagion costs to the rest of the Eurozone.
  

• A Greek exit and the withdrawal of ECB support would almost certainly lead to the undercapitalised Greek banking sector collapsing. To avoid a massive bank run and huge losses to pensions, we estimate that banks and pensions funds between them would instantly need a €55bn injection of fresh capital, which would be difficult for Greece to afford without external support.
  

• The new Greek Central Bank would also need to create at least €128bn worth of the new currency (63% of Greek GDP) in liquidity to help keep Greek banks afloat. This could trigger high levels of inflation, though these might only be temporary.
  

• Despite a compromise being likely in the short term, as Greece approaches a balanced budget and a more stable banking sector, though still messy, an exit will look increasingly attractive – particularly if the only alternative for Athens is to permanently give up economic and political sovereignty.
  

P.S.: You can find more details on this specific point in this briefing we published last week.

How exposed are EU countries to Greece now?
Open Europe estimates that the EU countries have a total exposure of €552bn to the Greek economy. This comes through various sources including: the two direct bailouts, central bank lending (ECB monetary policy, ECB Securities Markets Programme, Target 2 and Emergency Liquidity Assistance) and exposure of these countries banking sectors to Greece. This has increased by a massive 67% since June 2011, despite little progress being made on reforming the Greek economy or solving the wider problems in the eurozone.

€ Billion	Total Exposure to Greece
Eurozone:	Austria	15.5
	Belgium	17.7
	Cyprus	1.1
	Estonia	0.7
	Finland	8.5
	France	138.9
	Germany	139.4
	Greece	7.7
	Ireland	7.8
	Italy	84.9
	Luxembourg	1.3
	Malta	0.6
	Netherlands	30.7
	Portugal	19.8
	Slovakia	2.7
	Slovenia	2.3
	Spain	55.7
Non-Eurozone:	Bulgaria	0.2
	Czech Republic	0.3
	Denmark	0.5
	Latvia	0.0
	Lithuania	0.1
	Hungary	0.3
	Poland	0.4
	Romania	0.3
	Sweden	0.9
	United Kingdom	13.5
Total		551.8

A eurozone banking union will fundamentally change the rules of the game for Britain in Europe: Is Cameron ready to pull another veto?

Over on the Telegraph blog, we argue:

Talk of a banking union for the eurozone has become fashionable. Many, including the British government, see the idea as a way to provide some sort of backstop for the eurozone, where shaky banks remain a huge threat not only to the single currency, but also to the British economy.

Banking union, as a concept, has merits – it tries to deal with the ever elusive question: what happens when cross-border banks fail? But, viewed from London, a banking union is also political dynamite. It cuts to the heart of both a key national industry and Britain's future place in the EU as the eurozone integrates further.

There are only embryonic proposals on the table at the moment, and a lot is unclear. A banking union could involve a wind-down mechanism, resolution fund and deposit guarantee scheme – all on a cross-border basis. It could also take various different institutional shapes, putting the Commission, the ECB or national capitals respectively at the centre (expect turf battles). All of these vital decisions will take a lot of negotiation and time to sort out and may involve EU treaty changes – while there’s huge resistance in some member states, not least Germany. It may not be politically possible to achieve.

Regardless, the UK cannot take part in the banking union itself: politically, it would involve a massive transfer of powers to the EU, which no British government will go anywhere near. Economically it would be virtually impossible too, given the disproportional risk accounted for by the City of London, which neither side would be willing to accept. Instead, in a scenario reminiscent of David Cameron’s December veto, the question is whether London will simply nod through the changes (whether a Treaty change or not, the UK will have veto over at least some elements) or whether it will name a price for its approval.

George Osborne and No 10 have said they will seek safeguards to ensure that “British interests are secured and the single market is protected… anything affecting the single market should be agreed by all 27.” But is Cameron really willing to veto the same union that he is calling for?

Because if, according to UK wishes, a fully-fledged banking union indeed materialises, it’s very difficult to see how it would not cut right across the single market. The most obvious risk is over ‘location policy’ – whether in future a certain firm or financial activity must be supervised by eurozone authorities in order to do business there. This would essentially serve as a massive barrier to UK firms doing business in Europe – in an extreme case, the City of London would effectively become ‘offshore’ for the purposes of trade with euro countries.

But more probably, for a banking union based on cross-border liabilities to really work, it would need to be backed by perfectly harmonised regulations, to avoid a bank in one country essentially free-riding off the back of guarantees by taxpayers in another country. This is precisely why the Germans are so sceptical – without a single set of rules the banking union would spill over to fiscal union but without the corresponding central controls. Not only because backstopping banks is a big part of state liabilities, but also because banks flush with new eurozone-wide guarantees could lend to their domestic sovereigns at incredibly low rates, essentially providing artificial subsidies to states and removing market pressure for reform (sound familiar?). That would give rise to moral hazard of ridiculous proportions.

Instead, the eurozone will need a ‘single rulebook’ for banks, which may or may not be compatible with the current rules governing the single market in financial services. For example, to counter free-riding risks, individual countries could have no discretion whatsoever on capital requirements for banks. It would be a single target for all euro countries, with zero flexibility. This may not be a disaster for the UK – it could even be a benefit. But it could also go the other way, ending with an in-built eurozone majority voting to apply the single eurozone capital target for the EU as a whole, which could be substantially different to the needs of the UK. A eurozone banking union would also alter the basic relationship between the home and host countries of cross-border banks (i.e. subsidiaries), shifting the previous fragmentation from national borders, to the euro/non-euro divide.

Again, this may or may not be a problem for the UK, but the point is that inherent in the creation of a full-scale banking union is the fragmentation of the EU single market – which means that, if you’re sat in London, you should tread extremely carefully around the issue. A compromise may be possible (though it won’t be pretty) which would allow for the gap between the eurozone and the single market to remain narrow (we’ve suggested some potential compromises here). But the political dilemma for the UK government is clear: is it prepared to use another veto to block a banking union absent UK-specific safeguards – risking being perceived as hampering efforts to save the euro? Or will it simply nod through potentially game-changing proposals, risking the wrath of its backbenchers?

Quotes of the Crisis

The eurozone crisis can't be accused of one thing - providing good quotes from politicians or commentators, most notably some of the comments from Slovakian MPs when that country was debating whether to approve an extension of the EFSF.

This morning as part of our daily look through the European press we found another couple of examples that we thought were worth sharing with a wider audience.

Firstly, in the IHT, we have the ever outspoken Hans Werner Sinn, President of the IFO Institute, rebuking US politicians including President Obama for their stance during the crisis:

“Some critics have argued that Germany, having benefited from the Marshall Plan, now owes it to Europe to undertake a similar rescue. Those critics should look at the numbers…Greece has received a staggering 115 Marshall plans, 29 from Germany alone, and yet the situation has not improved. Why is that not enough, Mr Obama?”

Secondly, we have Alexander Dobrindt, the General Secretary of the CSU lambasting the leadership of the opposition SPD for travelling to Paris to meet with French President Francois Hollane in order to discuss a common approach to the eurozone crisis, who said that:

"This grotesque pilgrimage is certainly not the German interests, but at most in that of the Socialist International.”

Italy’s Five Star movement isn’t funny for Monti

We've got a piece in City AM today, looking at the potential spillover from Spain to Italy, particularly in light of the increasingly worrying political situation there. By all accounts it seems that technocratic Italian Prime Minister Mario Monti has slightly lost touch with domestic issues in search of a grand eurozone solution.

See below for the full piece:

SPAIN’S €100bn bailout plan has failed to reassure markets. The permanent fear of contagion means nervous glances are once again being directed at Italy. Austria’s Finance Minister Maria Fekter was the first political leader to claim that Italy may have to tap into the Eurozone’s rescue funds – a statement which did not go down well in Rome.

Since entering office last November, Italy’s Prime Minister Mario Monti, and his cabinet of technocrats, have done more to reform the country’s stagnating economy than almost any previous government over the last few decades.

However, Monti has recently become more concerned with convincing Germany and others to go ahead with grand plans for a political union in the Eurozone – Eurobonds and a banking union – than completing crucial domestic reforms. Worryingly, the pace of reform has slowed down, even though there are no shortage of items on the Italian government’s to-do list – including plans to increase labour market flexibility in the public sector, a comprehensive anti-corruption bill and, ideally, a new electoral law to be adopted ahead of the next general elections in 2013.

There’s a lesson here: the loss of momentum in Italy’s reform programme perfectly summarises why, beyond the pro-integration rhetoric, Germany remains so wary of a political union in which Berlin joins liabilities with Athens, Madrid or Rome – from Eurobonds to a single bank resolution fund. From the government to the media, Germans are simply too concerned that Club Med countries would see risk-pooling in the Eurozone as an excuse to delay the necessary reforms and give in to the temptation to fund growth via more debt – which is what put them in the current mess.

But there’s another reason why Monti should focus more of his attention on the home front. Recent polls show that support for the Italian Prime Minister is at its lowest since he took office, and the political parties that back him in parliament are also struggling. Voters have had their heads turned by a rather unlikely alternative – the so-called Five Star movement, led by the comedian Beppe Grillo.

A political maverick, Grillo has mainly been campaigning for a clean-up of Italian politics. But he has also suggested that Italy should consider dropping the euro while still remaining a member of the EU, and write off at least part of its gigantic public debt. Despite having very little cash to fund its campaign, the Five Star movement did incredibly well in the latest mayoral elections, and is polling at 20 per cent – leading Silvio Berlusconi’s People of Freedom party by several percentage points.

Instead of planning new grand European projects, Monti should re-focus his attention on the domestic reform programme. This is not the time to have your head in the EU clouds. As the rise of Beppe the comedian illustrates, public support for the euro in Italy can no longer be taken for granted.

Is Italy next in line?

As Spain teeters on the edge of the abyss, Italy now also finds itself back in the crosshairs of the market and eurozone leaders.

A debt auction this morning saw Italy pay 3.9% to borrow for 12 months, an exorbitant rate despite there still being strong demand. Tomorrow’s auction of 10 year debt will be more telling, while comments from the likes of Austrian Finance Minister Maria Fekter that Italy may need external aid as well do not inspire confidence.

With all the concern over Italy we’d recommend (re)reading our report from last November. The politics focused on Berlusconi are clearly irrelevant now, but economic analysis on Italian borrowing costs is still valid, notably on how much longer Italy can stomach higher borrowing costs for (now back to the levels seen then):

• Italy’s funding needs over the next three years are between €825bn and €907bn. This is broken down as follows:

• Open Europe estimates that rolling over expiring debt at the higher rates seen today will cost Italy an extra €27.8bn over the next three years and up to €58.7bn over the next five years. Given the size of Italy’s economy this is not disastrous, but would undo a significant amount of the €60bn in budget savings by 2014. Considering the difficultly in passing these measures (which are yet to be implemented) this could easily cause Italy to miss its debt and deficit targets over the next few years. In addition to the markets losing faith in Italian finances, this would further the growing political division between the EU/IMF and the Italian government;

• At these higher yields, rolling over its existing debt load would cost Italy an extra €225bn over the life of the debt. Combined with low growth, this could have a substantial impact on Italy’s longer term debt sustainability. Italy could still absorb higher borrowing costs for a few months given its low average interest rate and the liquidity of its bond market. However, it is clear investors are beginning to lose patience and need to see some progress soon.

So is all this concern over an Italian bailout valid?

Not quite. Sure, Italy has a mountain of economic and political problems, but there are far fewer short term triggers which can push it into a bailout in the near future. Its banks are solid – they have little external exposure to problem countries, a solid deposit base, large domestic sectors and decent liquidity following the ECB LTRO – and they did not face the same Spanish boom and bust.

Italian households and corporations are not heavily indebted. There is less chance of this being a drag on spending in the economy as in other countries, while the state is unlikely to have to guarantee any private sector burdens anytime soon.

Although the state is facing higher borrowing costs as the figures above suggest, it can handle this in the short term given the size of the economy. If it persisted then it would surely cause problems but with the horizon of a few months, it is likely to be manageable. The government can also rely on its domestic banking sector to buy up large amounts of its debt using liquidity from the ECB. This strengthens the dangerous sovereign-banking-loop and will store up problems in the long term but in the short term it would keep Italy out of a bailout. In many senses Italy is closer to Japan than some of the other eurozone economies – this may not seem like a favourable comparison but remember that despite its huge debt load Japan has managed to finance itself at low rates.

Ultimately, the main problems in Italy are political – this is the key source of uncertainty. Technocratic Prime Minister Mario Monti has failed to deliver on many of the reforms promised, while the chance of a stable succession in the spring 2013 elections looks slim. The best chance Italy has had of reforming for over a decade could soon be squandered. Over the long term Italy’s economy looks far from positive – worrying demographics, inefficient government spending, low economic growth, poor business climate and no willingness to reform (the list could go on as well).

The concern then over Italy should be political and focused on the wayward reform programme. Unless funding to eurozone countries locks up completely it is unlikely to need a bailout in the immediate future and besides, if that happens it is likely to be all she wrote for the eurozone anyway.

Dear Herman, dear José...

Spanish Prime Minister Mariano Rajoy has appeared much more often than usual over the past few days. This morning, he was talking to the Spanish parliament about the €100bn eurozone bail..., perdón, "credit line" for the Spanish banks. Quite interestingly, he insisted on presenting the rescue package as some sort of victory for his government, and said,

"This is a loan that the banking sector will pay back on its own, and we have to celebrate the fact that our European partners have helped us."

You can read our take on Rajoy's attempts at spinning the bailout here. But the Spanish Prime Minister also revealed to the parliament that he has written a letter to European Commission President José Manuel Barroso and European Council President Herman Van Rompuy. The five-page letter is dated 6 June - i.e. three days before Spain officially sought financial assistance - and is available here.

The letter contains a couple of interesting points, including:

"It is essential that we, the European leaders, highlight our resolved and convincing commitment to the single currency. That is, we need to make clear that, in the medium term, the [monetary] union will strengthen its common institutional architecture. This undoubtedly means moving ahead with integration, or, if you prefer, a greater transfer of sovereignty, particularly in the fiscal and the banking domain."

"In the fiscal sphere, this mean creating a fiscal authority in Europe, which can steer fiscal policy in the eurozone, harmonise the fiscal policies of the member states and allow centralised control of [public] finances, in addition to acting as a European debt agency."

"In the banking sphere, it is necessary to rely on supervision at the communitarian level and a common deposit guarantee fund."

"We do not need to decide now how we will do it. It is sufficient to show commitment to this objective and start working to achieve it."

Well, if it is quite obvious for Spain to argue in favour of a single banking watchdog given the circumstances, the idea of a single fiscal authority in charge of supervising the national budgets of eurozone countries is actually a bold one - especially given Rajoy's previous unilateral decision to adjust this year's fiscal target without consulting eurozone leaders. Rajoy will discuss his plans with Merkel, Monti and Hollande in Rome next week, with a view to submitting them to all EU leaders the week after.

The central fiscal authority will likely be music to the German Chancellor's ears, although doubts remain over how many eurozone governments (and voters) would be ready for such a massive loss of sovereignty. On a slightly separate note, the Spanish Prime Minister should probably get a grip on reality and stop thinking that the simple promise to do something will be enough to calm the markets - the Spanish package has shown anything, its that a promise of action but without details or clarity creates more problems than it solves.

An EU banking union within a year? Don't think so.

In an interview in today's FT, Commission President Jose Manuel Barroso is raising the stakes in the talks on a 'banking union' in the EU and/or eurozone, involving an EU-wide deposit guarantee scheme, a rescue fund paid for by financial institutions and giving an EU-wide supervisors the power to order losses on banks, without the approval of national authorities. The Commission, keen to get back in the game following the shift in focus to national capitals in the wake of the crisis, says it'll present a proposal for a banking union at the EU summit at the end of June.

According to the FT, Barroso said all of this could be achieved within the next year and didn't necessarily require an EU Treaty change. He said, "there is now a much clearer awareness" in national capitals, including Berlin and London, that Europe needed to press ahead with more integration "especially in the euro area."

Barroso noted,

“We have a chancellor of Germany that is indeed proposing a political union for Europe, which is extremely ambitious. We have a French president that has been highlighting the need for a more European approach regarding crucial issues like growth and investment. And we have a British government – and this is indeed a very interesting development – that while stating its willingness to stay out of the euro, assumes as indispensable and desirable to further integration in the eurozone.” 

Good marks for optimism. In reality, though, there's no way a banking union will be up and running within a year. Even if he was hinting at an agreement in 2013, that too is optimistic - at least on the chunkier stuff. A number of member states still have huge reservations. The UK won't be part of a banking union regardless, and anything requiring unanimity and/or Treaty change may be used by Britain to re-heat demands for safeguards over UK financial services, which Osborne has already floated. Other non-euro members also have reservations, with the Swedes opposing a banking union based on cross-border liabilities on a point of principle and the fear of moral hazard (unlike the Treasury, which seems happy for the eurozone to do this as long as the UK is not on the hook).

Merkel will face resistance from various corners: the Bundesbank, the legal class (hello Treaty change), its financial supervisors BAFIN, the media and a host of backbench MPs. This will have to go through the German Parliament, which per definition takes time. And as for the French, we're not entirely sure that Hollande quite has his head around what a banking union would involve - and that France's position is somewhat fluid at the moment.

And remember, a proposal by the Commission for limited cross-border bank deposit guarantees has been stuck in the Brussels machinery for two years, at the hands of resistance in member states.

This will be a drawn-out one.

Leaving the EU would raise more questions than answers - what we need is a new model of EU membership

Open Europe's Christopher Howarth has written the following article for Conservative Home:

Growing public frustration with the costs of EU membership is making the UK’s EU membership unsustainable and cannot be ignored. Moves in the eurozone towards fiscal union also mean the status quo EU membership terms we have may not be an option even if we wished it. Given this, Open Europe has published a study of the UK’s trading interests and the most likely options for the UK if it were to choose to leave. We conclude that there is no clear-cut or easy option for the UK outside the EU making leaving the EU as complicated as staying in and renegotiating.

We found that the EU continues, on a purely trade basis, to be the most beneficial arrangement for Britain. If we left the EU we would have to negotiate a new trade agreement with the EU and probably one that would not, at least for now, serve the UK’s trading interests as well as the present one.

But, plainly, trade is only one part of the equation when it comes to assessing the costs and benefits of EU membership. Although, at present, all the alternative options come with major drawbacks in terms of trade, the price of membership remains far too high. Many of these costs are not directly related to trade, such as the UK’s contribution to the EU budget, the loss of national control over key political decisions that affect the British economy and society, and an increasing regulatory burden. These are the alternative options:

• The ‘Norwegian option’ or EEA membership: This would free the UK from the Common Agricultural Policy (CAP), EU fishing rules, EU-wide regional policy, and reduce our budget contribution. However, while guaranteeing access to the Single Market in services and goods, outside the customs union, access for goods would be subject to complex rules of origin and Britain would still be subject to EU regulations on employment and financial services but with no formal ability to shape them.
  
  • The ‘Swiss option’ or free trade agreement: If we had the same Swiss-EU bilateral deal, we would also be without the CAP, EU fishing rules, EU-wide regional policy, and have a reduced financial contribution. This would offer more sovereignty and less EU regulation. However, the UK’s access to the Single Market would be dependent on the deal we could negotiate with the EU – the Swiss deal currently excludes the vast majority of services, including financial services.
  
  • The ‘Turkey option’: The UK would continue to benefit from full access to the EU’s Single Market in goods by remaining in customs union with the EU but Britain would be bound by any external deals that the EU strikes in trade in goods without any formal way of shaping them. A separate deal on services would be required to maintain UK access to the Single Market in these sectors. It would be free from EU social and employment regulation, the CAP, CFP and EU-wide regional policy.
  
  • The full break ‘WTO option’: If the UK left the EU without securing a version of the options above, the UK could fall back on its World Trade Organisation membership. This would see some exports facing relatively high tariffs (i.e. 10% on car exports) and market access for services would be limited.

So how do these alternatives stack up against the UK’s trade interests?

Well, 53.5% of UK goods exports currently go to the EU but only 39% of services exports. This makes the EU important - but the EU is likely to be an area of slow growth, while fast growing areas such as China and India together account for only 3.75% of UK exports, this proportion needs to grow. The UK is currently the second largest global services exporter but the single market in services has stalled. Services account for 71% of total EU GDP but only 3.2% of this is a result of intra-EU trade.

Given the proportion of goods trade we do with the EU the UK’s trading interests are currently best served by remaining within the EU’s customs union to allow goods to flow free without complex ‘rules of origin’. Our interests also demonstrate the need to push the EU to back services liberalisation at home and in EU trade talks abroad. However, the EU could retreat into protectionism and so thwart UK trade in the internal market or globally thus reducing its relevance to the UK. This makes it all the more important for the UK working with our allies to speak up for free trade: for instance, regaining an economic commissioner in 2014.

The Coalition should also conduct a full in-depth analysis of the options open to us, to move the debate onto a higher level and help us figure out the genuine reason why we were in the EU in the first place - as well as the areas we would do better on our own. With this the Coalition could then set out a vision for EU reform, and “examine the balance of the EU’s existing competences” and as it is pledged to do. The UK should also continue to concentrate on growing its trade in the wider world where growth will be faster, and if at some point in the future the proportion of UK trade with the EU has shrunk our options will have grown.

Renegotiate our membership

In order to continue to justify its membership, the UK needs to achieve a new model for EU cooperation based on different – and equally legitimate – circles of EU membership. In this structure, the UK should remain a full member of the single market in goods and services and of the EU’s customs union, but take a ‘pick and mix’ approach in other areas of EU policy. This would achieve a vital reduction in the non-trade costs of EU membership, such as the EU budget and the burden of regulation, while allowing the UK to remain at the heart of the EU’s cross-border trade.

What a new UK membership of the EU could look like:

There will be those who say that such a model is not possible - that there can only be one form of EU membership. That is plainly wrong as it ignores current fact as well as moves, by others, towards further integration. The status quo is not an option, we now need to decide for ourselves what we want.

Do not adjust your television set, this is not a Spanish rescue (despite looking an awful lot like one...)

Well, that was the line that Spanish Economy Minister Luis de Guindos was spinning yesterday. Sorry Luis, this is essentially a Spanish rescue - external funding sources filling a gap which the state can't (check), monitoring of a large chunk of the economy (check), involvement of all the big international organisations (check - EU, IMF, ECB etc.), the list goes on.

Meanwhile, the oft absent Spanish Prime Minister Mariano Rajoy held a press conference today, declaring the package a 'victory' for the euro and stating that if it were not for the current government's reforms it would have been a full bailout package. If this is a victory (finally dealing with a glaring problem after four years) then we don't want to see a defeat, but at least Rajoy made a public appearance this time. That said, in the midst of the worst crisis his country has faced since the financial crisis hit, Rajoy is now jetting off Poland to watch Spain vs. Italy (a mouth watering prospect admittedly but his timing could take some work), while the likes of the Education Minister are heading to Roland Garros to watch Rafael Nadal - the Spanish government not quite in crisis mode then, we're not sure if that should inspire confidence or not...

In any case, as we predicted over two months ago, European assistance to help Spain deal with its banks is now official, so what does this rescue mean for Spain and the eurozone, below we outline some of the key points and our take:

The plan
Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the bank restructuring fund) but will still be a state liability (it will not go directly to the banks). However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector.

Open Europe take:
Firstly, the ESM will not be in place in time to provide the loan (the treaty is yet to be ratified by numerous countries and has faced many delays) so at least initially it will come from the EFSF. As others have pointed out, this is important because ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with (as it removes the threat of legal challenges based on clauses in other Spanish sovereign debt which could be triggered if it suddenly became junior), however, Finland has already raised concerns over its exposure and role in the rescue - an issue we tackle in more detail below.

The lack of additional fiscal conditions is fair given that Spain is already subject to a deficit reduction programme and that this is ultimately a financial sector problem. There are questions over conditionality and moral hazard though - we would like to see bank bondholders and shareholders sharing more of the burden (bail-ins) to ensure the necessary reforms take place. As things stand its hard to see how the banks will 'pay' for this capital, particularly given the Spanish regulators previous failures (during and after the property bubble).

De Guindos confirmed that the funds would be counted as Spanish debt, so Spanish debt to GDP could be about to jump by 10% in the near future and given its current path this could put Spain over 90% debt to GDP (the level beyond which sustainability becomes questionable) much sooner than had been anticipated. This will require adjustments in its reform programme and lead to increasing market pressure.
 
Size - is it enough?
This is the key question - the total amount has been put at "up to" €100bn. That is much higher than was suggested by the IMF assessment released on Friday night, which suggested €40bn.

Open Europe take:
It sounds like a big number, but upon closer inspection it may not stretch as far as many expect. Consider that Bankia requires €19bn, while three other very troubled cajas need around €30bn (Banco de Valecia, Novagalicia and Catalunya Caixa) meaning half the money could already be eaten up, leaving only €50bn for the rest of the huge banking sector.

This compares to around €140bn in doubtful loans, and a total €400bn exposure to the bust real estate and construction sector. Doubtful loans to this sector total around €80bn currently, but we expect house prices to fall by a further 35%, broadly meaning that the number of doubtful loans could easily double. On top of this we have further losses on mortgage loans as well as losses on other corporate debt and a decrease in the value of Spanish debt held by banks. So huge number of issues - putting a clear figure on it is difficult due to the difference between tier one capital and 'loss provisions' (tier two capital). But even if this €50bn is given in tier one capital and stretched to increase provisions its hard to see that it will be enough given the huge exposure to mortgages and the bust sectors, especially at a time when growth is falling further and unemployment continues to rise.

Finland and Ireland - flies in the ointment?
If the EFSF is used (which looks likely) the Finnish government is obliged to ask for 'collateral' as it did with Greece - the noises coming out of Finland suggest it will, especially given its objection to 'small' countries bailing out 'larger' ones. Ireland has also suggested that if Spain is able to avoid fiscal conditions on its bank bailout then it could request similar treatment (i.e. a loosening of 'austerity').

Open Europe take:
The Finland issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will help the (True) Finns who are already launching a campaign against further bailouts. It could also lead to legal challenges - as we pointed out with Greece, it could trigger 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain. Not guaranteed, but a legal grey area which adds to the confusion.

As for Ireland, they have a fairly strong case here. Ultimately, their fiscal troubles stemmed from bailing out their banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system - this will only add to this ill feeling. Given Ireland's perceived 'success' in Germany some flexibility may be forthcoming but we doubt enough to assuage Irish anger.

Impact on the UK?
The IMF will only play a 'monitoring' role, meaning the UK will not be liable for the money provided to Spain. However, given the links between the UK and Spanish banking systems it is imperative that the problems in the Spanish financial sector are finally dealt with - whether that will happen this time around is yet to be seen but given the points above it is not off to a great start.

Impact on the eurozone - Open Europe concluding remarks:
Markets responded positively to rumours of external aid for Spain on Friday afternoon, but, given the points above, a huge amount of uncertainty remains which will keep markets jittery and increase pressure on the eurozone. That is far from needed given the uncertainty surrounding the Greek elections. Given the ongoing assessment of the actual needs of Spanish banks the rescue will now enter a state of limbo as attention turns back to Greece, in the meantime Spain is likely to find it difficult to access the market (since this is broadly an admission it cannot raise any substantial funds itself).

Questions will also arise over the strength of the eurozone bailout funds - Spain guarantees around 12% of them, surely its guarantees are now worthless or would do more harm than good. Additionally, now that one of the larger countries has asked for support pressure will intensify on Italy (particularly with the falling support for the technocratic government and the slow pace of reform).

Referendum confusion: Is Cameron protecting Britain from British plans for a eurozone superstate?

The eurozone crisis alone is complicated enough. Add in UK domestic politics and calls for a referendum on EU membership, and this stuff becomes maddening.

Today's Europe coverage in the UK press was a wonderful cocktail of a euro Armageddon, EU-UK relations and a huge dose of British domestic politics.

The Telegraph reported that:

"The Prime Minister dismissed as 'nonsense' a suggestion from Angela Merkel, the German chancellor, that the European Union should eventually have a single national identity and described as 'nonsense' the idea of loyalty to a common European flag."

It also noted that Merkel said yesterday, “We need more Europe, a budget union, and we need a political union first and foremost”, which led the paper to proclaim that "David Cameron promises to 'protect' Britain from German plans for a eurozone superstate with common banking and political systems".

But is that really what's going on here? It's true that both Cameron and Osborne have floated the idea of "safeguards" if the eurozone presses ahead with a banking union and further integration. But here's the thing: Germany's default position remains strongly anti-fiscal burden sharing, meaning that Merkel's 'budget union' is still based on exporting German fiscal discipline to the eurozone-level by introducing stronger budget oversight and enforcement mechanisms - only then could some form of debt mutualisation be considered. A German-led superstate still seems years off - if it ever will be agreed (no matter how much other parts of the eurozone or markets might like to see it right now).

In contrast, David Cameron last month called for a bigger bailout fund, shared eurozone bonds and a more active monetary policy from the ECB - in other words, the eurozone quickly moving to "joint and several liabilities" with stronger states indefinitely underwriting weaker ones. That would really be a German-led super state.

So, who's plans are Cameron and Osborne really trying to 'safeguard' themselves against? Of course, Cameron is right to stay well clear and seek safeguards in return for nodding through treaty changes designed to achieve a fiscal or a banking union, for example for UK financial services. But this discussion leaves the impression that Cameron is actually seeking safeguards against his own plans for eurozone integration. Not necessarily a contradiction, but not a good starting point for future negotiations over EU treaty changes either.

There's also a second confusion: an EU referendum.

In response to questions about the impact on Britain of more eurozone integration, Osborne yesterday told the BBC Today Programme that:

“I think what the public are concerned about, the British people would be concerned about, would be if there was any transfer of power...A reshaped relationship with Europe would imply, would involve, a transfer of sovereignty or powers from the UK to Brussels.” 

In reality, Osborne merely re-stated what's in the 'referendum lock', i.e. a substantial transfer of powers to the EU will, by law, trigger a public vote. But the context is confusing. In all likelihood any eurozone focused treaty change would not legally and constitutionally impact the UK enough to trigger a referendum. Furthermore, the government's talk of safeguards suggests that, if none are present, the UK would veto any treaty change before it actually gets to a referendum. So a referendum still looks unlikely, at least on the back of the eurozone crisis.

Osborne and Cameron are in an unenviable position - the eurozone crisis threatens to send Britain into a deeper recession, and remains a fundamental threat not only to the UK economy but also now to the Conservatives' 2015 election prospects. Tory backbenchers and UKIP are both breathing down the necks of the Conservative leadership over an EU referendum. All factors considered, Osborne and Cameron are doing a decent job balancing all these interests.

At the same time though, as we hint at in today's Telegraph, the UK government could end up in a rather strange position by sending all these political hares running at the same time. Is it going to veto the same Treaty changes (to establish a fiscal / banking union) that it is now effectively calling for? If it's deemed that these treaty changes de facto transfer powers away from the UK - i.e. by shifting the institutional balance of power towards the eurozone at the UK's expense - will it then also call a referendum on those treaty changes? What would the question be?

This may all work out both in the polls at home and in talks in Europe. But given the unrealistic expectations it raises - and how very difficult it will be to square all these various factors - it may well come back to haunt the Tory leadership, at home as well as abroad.

Is a bailout of Spanish banks now imminent?

At the beginning of April, we published a briefing predicting that Spanish banks were heading for a eurozone bailout - hoping that we wouldn't be right. Well, alas, it looks like we were. It's been another frantic week for the eurozone, with Spain taking centre stage amid reports that a request for a bailout to help deal with its troubled banking sector might actually be a matter of hours away. Here is an overview of where we are at.

When?

• EU and German sources told Reuters this morning that Spain is expected to make a formal request for a bailout over the weekend, possibly as early as tomorrow afternoon;

• Another EU source told La Stampa's Brussels correspondent Marco Zatterin, "We need to intervene before the Greek vote on 17 June." The message here is clear: if the second Greek elections fail to deliver a stable, pro-bailout government, the contagion to Spain could be almost immediate;
   
• Quite significantly, the Spanish government has been slower than on other occasions in denying the reports. A spokesman initially just said, "The government doesn't comment on speculations". A couple of hours later, Spanish Deputy Budget Minister Marta Fernández Currás said it's "false" that Spain is going to ask for a bailout this weekend;
   
• As flagged up on Twitter by the Telegraph's man in Brussels, Bruno Waterfield, an EU source has called the Spanish government "incoherent" in light of the latest remarks;

• In a press conference early this afternoon, Spanish Deputy Prime Minister Soraya Sáenz de Santamaría has also denied that eurozone finance ministers are to hold a conference call tomorrow - as suggested by the sources quoted by Reuters. The Deputy Prime Minister insisted that the government will wait until after the publication of the IMF report on the Spanish banking sector (due on Monday) and the results of the two independent audits of the real estate assets held by Spanish banks (due on 21 June at latest) before making a decision on whether to ask for financial assistance.   

How much?

• Media reports seem to be converging on the estimates the IMF is due to publish on Monday. It looks like the IMF will put the recapitalisation needs of the Spanish banking sector at €27 billion in a basic scenario and up to €37 billion in an adverse scenario;

• However, sources who have seen the draft report have said that the IMF will recommend a fresh capital injection of at least €40 billion - with the additional money to be used as a buffer against potential short-term downturns, especially after the Greek elections (see above);

• All kind of numbers have been floating around during the week, from the €80-100 billion mentioned by Spanish MEP Antonio López-Istúriz, who also happens to be the Secretary General of the European People's Party (EPP), to the €60-100 billion estimated by credit rating agency Fitch. At the end of the day, Santander boss Emilio Botín, the first to mention the €40 billion figure while he was accompanying the King of Spain on a visit to Brazil last weekend, might have got it right.

How?

• At the moment, the eurozone bailout funds are not allowed to lend money directly to banks. This is possibly the main reason why the Spanish government has not tapped the EFSF yet: saving Spain, the eurozone's fourth-biggest economy, from the 'humiliation' of a fully-fledged bailout with strict conditions attached;

• Germany is reportedly considering a 'face-saving' compromise, which would see the bailout money going directly into Spain's national bank restructuring fund (FROB). A senior German official explained that, under this plan, "conditionality would be focused mainly on the banks, because Spain has already tackled the other reforms."

• In theory, this arrangement would not break EFSF rules - it would be money going to the Spanish government first, and then to the banks. Most importantly for Spain, it would also mean that the country would be imposed softer conditions than those attached to the Greek, Irish and Portuguese bailouts.   

Millions of Spaniards are bracing themselves for what could be a decisive weekend for the future of their country in the eurozone. If a request is made for external assistance, even a win for La Roja against Italy on Sunday evening may not be enough to soothe their fears.

The UK should throw its weight behind a Europe based on sound money

In today's Telegraph, we argue:

Whatever the future of the single currency – and the entire European project – it will largely be decided in Berlin. The most important relationship for David Cameron is therefore with the German Chancellor, Angela Merkel. But there is a risk that the Prime Minister will miss a vital chance to cement a new Anglo-German deal on the future of the European Union.

For years, the UK’s European diplomacy has been defined by its relations with the Élysée, but the eurozone crisis has demonstrated that Germany now stands alone as Europe’s leader, however reluctantly. Despite there being a great deal of cultural and political overlap, however, the basic problem is that Britain does not really understand Germany, and vice versa. Britain perceives itself as a seafaring country of traders, Germany as a continental land of engineers.

Much like the UK, Germany is undertaking a highly charged internal debate about its place in Europe. For the first time, the twin pillars of Germany’s extraordinarily successful post-war settlement are in conflict: its commitment to Europe, and its belief in sound money and stable budgets. Whatever the outcome of this debate, it will have a defining impact on the future of the EU.

The UK, however, risks ending up on the wrong side of the debate. To the great annoyance of Berlin, Cameron and George Osborne have developed a fondness for calling on the eurozone to move towards fiscal union, including eurobonds, and for the ECB to effectively start the printing presses. Britain has a right to voice its opinion – a full-scale crisis would have implications well beyond the eurozone – but its advice is misguided.

Eurobonds and cheap money create huge incentives for more spending, which is exactly what the Coalition is arguing against at home, and feel awfully like solving a debt crisis with more debt. Cameron has also stressed that “Europe’s lack of competitiveness remains its Achilles’ heel”. But, as Merkel has rightly countered, eurobonds do nothing to address this. If anything, allowing countries to piggyback on Germany’s credit rating takes away pressure for the vital reforms that many of these countries need.

After having spent a decade in opposition calling for a more dynamic European economy and a slimmed-down, more democratic EU, the Conservative leadership’s cocktail of Eurosceptic fiscal federalism is not only intellectually inconsistent but, in the key debate about the future of the EU, needlessly aligns the UK with European federalists and socialists such as François Hollande.

At the same time, it locks Britain into a weak negotiation position over future EU treaty changes – which will be needed if the eurozone is going to move to fiscal union – as Britain can hardly block the same treaty change that it has effectively argued for.

Instead of prejudging the eurozone’s future, Britain should spend all its political capital on convincing Merkel that Europe as a whole needs to move in the direction of free trade and structural reform. This means that, instead of talking about “digital government” as Cameron and Merkel did yesterday, Cameron should have said the following: “I will support the Chancellor’s vision for a Europe based on responsible spending, sound money, liberal cross-border trade and respect for the rule of law. Like the Chancellor, I believe that Europe must learn how to live within its means and reform itself if it is going to remain a vibrant economic actor on the world stage. But just as Germany will need to seek the right conditions to be comfortable with its new position in Europe, so must Britain. Since we cannot join the euro, Britain will need a different – and more flexible – set of arrangements under EU law than euro members. This is the only way to reconcile continued EU membership with UK public opinion.”

In the end, this would benefit Germany, Britain and Europe as a whole.