German election ended – return to EU issues

The German elections are now behind us and financial markets and politicians should soon begin to focus on what is next on the EU agenda. Prior to the elections, sensitive EU issues were de facto paused in order not to upset the German voters. Most of these issues will probably remain on hold until a new government is formed, which is likely to take weeks or even months. When a new government is formed, we may see renewed progress on many issues. This said, the reform speed has also slowed for another reason. The pressure from financial markets has been an important driver of reforms and, now that markets have calmed, we believe politicians are likely to be less eager to show progress on politically sensitive issues such as the Banking Union.

The German constitutional court in Karlsruhe will rule on the ECB’s OMT programme. The court has no jurisdiction over the ECB but if it rules that the German government should seek to impose limits on the OMT or change the ECB’s mandate to reduce its scope of action, it could bring into question the effectiveness of the OMT instrument and cause the debt crisis to reignite. In our view, bond purchases have become part of the central banks’ standard toolbox and the ECB has not gone very far compared with the Fed, Bank of England and Bank of Japan. As long as it uses the instrument to correct market failures and not to keep insolvent states artificially alive, we do not see this as a problem. It would be wise of Karlsruhe to rule in favour of the OMT programme. We think that the ruling will be a lifted finger at most.

The political eagerness to create a fully fledged Banking Union has declined as the debt crisis has calmed down. The European Commission is still aiming for a fully fledged model and presented in July its proposal for a Single Resolution Mechanism to cover all euro area lenders as a supplement to the Single Supervisory Mechanism. The European Commission hopes that final agreement can be reached this autumn. Germany is resisting a strong centralisation of power that puts fiscal sovereignty into question without changes to EU treaties. Germany is opting for a network of national resolution authorities but might be willing to accept a single resolution authority for the 130 euro area banking groups that will be supervised by the ECB from the second half of 2014. The main hurdle is to agree on a EUR55bn single resolution fund replacing national funds. The intention is that banks gradually pay into this central resolution fund and losses will be shared across the euro area.

Government budgets for 2014 will also be in focus during the autumn. A number of countries need to come up with austerity measures to reach their deficit targets. In Portugal, the government is struggling to find new austerity measures following the constitutional court’s rejection of cost-cutting measures on two occasions. In the Netherlands, the government is struggling to find support for the austerity budget presented on 17 September 2013.

The ECB intends to undertake an asset quality review of European banks in 2014 before taking over the supervisory role. The ECB has strong incentives to run harsh stress tests before taking over supervision. There is a risk that the review will reveal weaknesses in some banks. The ECB’s asset quality review will be followed by the EBA stress test.

We expect the ECB to hold fire with regard to lowering official interest rates. Instead, we expect the ECB to provide a new 3Y LTRO when excess liquidity has declined so much that it pushes the short market rates towards the refi rate. This is likely to happen late this year or early next year.

Greece will need a third programme, as there is a EUR4.4bn funding gap next year rising to EUR6.5bn in 2015 according to IMF estimates. The funding gap is caused partly by central banks not willing to roll their holding of Greek debt. The issue attracted some attention during the German election campaign but the need for another programme should not be much of a surprise as the IMF had already stated that there will be a funding gap. Both the EU and Greek authorities have indicated that it is manageable.

In our view, some kind of debt relief from the EU will eventually be unavoidable as Greek government debt has already reached 160% of GDP again. It will probably be agreed during 2014 if Greece has succeeded in reaching a primary surplus. Private investors do not hold Greek bonds in substantial amounts following the PSI and it, thus, seems unlikely that private investors will be asked to participate in a second PSI. In our view, OSI (official sector involvement) could be positive as Greek public finances would become sustainable and the losses taken by taxpayers in the rest of the euro area are unlikely to have a significant negative effect there.

Portugal has to return to the market in June 2014 at the latest. Portugal has a funding gap of around EUR14bn in 2014. However, if it proves impossible to return to the market in spring 2014, we are confident that the EU will improve provide a new (small) loan package. The main risk is the political situation, where austerity measures seem hard to implement due to political resistance and constitutional rejections. Hence, there is a risk Portugal will meet a closed door in Brussels due to a lack of commitment but we see this risk as small.

In Italy, a vote on whether to expel Berlusconi from the Senate following a conviction for tax fraud is expected to fall in October. New elections may follow if Berlusconi’s party PdL withdraws its support from the government. However, this risk seems to have diminished as Berlusconi said he will continue leading his party outside parliament and, at the same time, toned down the threat he will withdraw from the coalition government as long as Enrico Letta keep his promises on tax cuts. Additionally, if the situation intensified, President Napolitano might try to find another solution than early elections, as there is a high likelihood that the outcome would be inconclusive because the electoral law has not been changed. However, the electoral law could be changed before year-end.

In Spain, one of the main risks is the banking sector and the conduction of the EBA stress test, which has been delayed until 2014, could lead to added concern about risks in the system. However, it is important to keep in mind that a backstop is already in place. Spain has been granted up to EUR100bn in financial assistance to the country’s banking sector from the ESM, of which it has only received about EUR41bn so far.

The key issue for Ireland in Q4 will be its exit from the EU programme and Ireland’s return to full market access as we enter 2014. We expect the Irish government to request an ESM precautionary before the current EU programme ends in December (as has also been indicated by the government). This would in itself serve as a backstop as the facility could be used to intervene in both the primary and secondary market. Furthermore, a precautionary credit line is a necessary condition to qualify for the ECB’s OMT programme. These facilities will serve as backstops and we do not expect Ireland to have to draw upon them.