Friday, June 29, 2012

Eurozone: Second Italian victory or extra time?

Last night, Eurozone leaders agreed on a first step towards a banking union. Short-term relief for Spain and Italy, however, remains very cryptic and limited.

After a nerve-racking night, Eurozone leaders this morning made a first step towards a banking union and at least gave the impression that Spanish and Italian pleas for emergency action have been addressed. Both countries had earlier withheld their agreement to the 130bn euro growth package.

In the early morning, Eurozone government leaders had agreed on the following: 1) start of a single bank supervisory mechanism with first proposals by the end of the year; 2) EFSF/ESM loans for Spanish bank recapitalisation will not have seniority status; 3) once a single supervisory mechanism is established the ESM could have the possibility to recapitalise banks directly. Moreover, Eurozone leaders emphasised that existing EFSF/ESM instruments will be used in a flexible and efficient manner. What this latter exactly means remains to be seen. Judging from comments after the meetings, the flexible use could mean more preventive liquidity support but also more active bond purchasing by the EFSF/ESM.

Despite the initial enthusiasm by some politicians and also market participants, it is important to stress that this morning’s meeting did not agree on direct bank recapitalisation for Spanish banks (yet), neither did it decide on debt collectivisation nor on immediate support for Italy (although EFSF/ESM intervention might do the trick). Even the possible direct bank recapitalisation once a banking supervision has been established remains conditional. The only real concrete decision taken this morning is the start of a single bank supervision. In the end, the German principle of conditional integration is still intact.

All this means that there are still many hurdles ahead. Just think of national parliaments and legislation, starting already today when the German parliament will vote on the fiscal compact and the ESM Treaty. At first glance last night’s decision could look like the second Italian victory over Germany within less than 12 hours. At second glance, however, it is rather a draw, bringing the game on the euro crisis into extra time. If the aim is to take to ease tensions on the Italian and Spanish bond market on a more sustainable basis, we probably will need to have more assurance on the fire power of the ESM. Therefore liquidity support from the ECB looks inevitable. It is not impossible that we might already get an answer on that point before the markets open on Monday morning.

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