EU Summit: Some Good Progress, But Any Game Changers?

This EU summit marked many firsts for eurozone crisis era EU summits: it was the first time Greece hasn’t been discussed in years, it was the first time Italy and Spain bonded together and it was the first time President Hollande attended an EU summit. By dinner time on Thursday, the EU summit seemed a colossal failure, with Spain and Italy refusing to sign off on a growth initiative without some short term measures to alleviate pressure on those two countries in the bond markets. EZ leaders went back to the negotiating chambers and emerged around 4am on Friday morning with a deal. The measures agreed exceeded market expectations, though based on Merkel’s pre-summit assertion that Germany would not be signing up to anything significant, expectations were not difficult to beat. The markets rallied, but was investor euphoria justified, or was this just another EU summit fudge? Some important steps were taken at this summit, but none of them game changers and a number of details have yet to be hashed out.

Short-term measures to benefit Spain, Ireland and Italy

While Monti left the EU summit grinning and declaring a victory (both in football and at the heads of government powwow), the short-term measures stand to benefit Spain and Ireland much more than Italy. Most of these measures were to do with the Spanish bank bailout. The EU bailout funds will now provide a direct capital injection to the banks, contingent on the ECB becoming the joint eurozone bank supervisor (see below) on January 1st 2013. The EFSF/ESM loans will go through the state up until then, but Spain’s public finances will be adjusted come January 1st so that the bank bailout circumvents the sovereign. A second measure was agreed for the Spanish bank bailout: the EFSF loans for Spanish banks will not gain preferred creditor status when they are rolled into the ESM. Will either of these changes be a game changer for Spain? I doubt it. Spanish public debt will reach around 100% of GDP by the end of this year if all of the off balance sheet liabilities are included. Given Spain’s primary deficit and growth outlook over the next few years as the country implements austerity measures and structural reforms, this debt burden is unsustainable. This is the case whether the EUR100bn bank bailout it routed through the state or not. The change in seniority of the ESM loans in my view is a complete fudge. Seniority is only really an issue for sovereign bond markets if the loans are going through the sovereign, which will only be the case before January 1st. If there is a sovereign debt restructuring before January 1st—highly unlikely—it is doubtful the ESM will accept a loss on its loans. Just as the EFSF and ECB did not have preferred creditor status yet were de facto senior in the Greek PSI deal, so would the ESM be in a PSI deal for Spain.

In the official communiqué, EZ policymakers indicated that the direct EFSF/ESM capital injection for Spanish banks may be applied retroactively to the Irish case. The Irish government immediately hailed this as a seismic shift, and Irish long-term bond yields fell sharply. Is this a game changer for Ireland? It is hard to say, given that we have virtually no details on how they plan to parse out bank and sovereign debt in Ireland. We can expect that it is going to be extremely difficult to take the model applied to the Spanish bank bailout and transfer it over to Ireland, where the bank bailout for zombie and solvent banks was funded by the national pension reserve, promissory notes/Exceptional Liquidity Assistance (ELA) and bailout cash. Separating bank and sovereign debt in Ireland is a bit like trying to unscramble an omelet. While the reduction in public debt as a result of this may mean Ireland can return to the markets on time in early 2014, I expect those who bought the government’s rhetoric on this being a colossal victory for Ireland will be underwhelmed. Furthermore, it is rumoured Germany will only allow direct capital injections to banks from EU bailout funds in those countries that have signed up to a financial transactions tax (FTT). With the UK rejecting an FTT, Ireland is keen to also avoid it in order to protect its financial services industry; if Ireland is subject to an FTT and the UK is not, business could easily move to London. If this German-supported piece of conditionality is imposed, Ireland will potentially have to choose between getting immediate relief from the ESM to reduce its public debt burden or supporting one of its biggest industries.

The measure announced that might be most useful to Italy is a vague commitment to using the EFSF and ESM more flexibly in the bond markets to reduce borrowing costs for weaker countries without full troika reviews. The idea that there will not be troika reviews is hardly a victory, given that both Spain and Italy are already subject to the excessive deficit procedure with built-in fiscal targets and to IMF visits. Could EFSF/ESM bond buying help Spain or Italy? Whether in the secondary or the primary markets, I’m skeptical.

Long-term measures

Two long-term measures were also agreed at the summit. First, EZ leaders agreed a growth initiative, which will see around EUR130bn used for jobs creation and investment in the region. This might help on the margins, but is more likely to slightly mitigate the recession than actually stimulate growth. Second, EZ leaders agreed that the ECB will serve as a eurozone bank supervisor. This is potentially the first of many steps towards a banking union in the eurozone and was the easiest step to agree. The other two steps necessary for a full banking union are a deposit guarantee scheme and a bank resolution scheme. They will be much more contentious and will surely be discussed at future summits.

While most analysts expected EZ leaders to discuss the long-term vision of the eurozone at this summit—including a banking and fiscal union—policymakers focused more on immediate crisis fighting mechanisms. All of the measures agreed will likely help on the margins, which has not always been the case at previous EU summits, and some of the measures could be important first steps towards a fiscal and banking union. However, next steps towards a banking and fiscal union will be extremely difficult—and in some cases impossible—to agree, so expect the EZ rollercoaster to continue this summer.

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