The Eurogroup provides a reality check

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The last sentence of the European Council Communique from the June meeting simply states “We task the Eurogroup to implement these decisions by 9 July 2012.” This was always going to be a stretch and as expected the marathon 10 hour meeting of the 9th of July has failed to do any such thing as is clear from the Eurogroup communique.

As we discussed in detail in our report following the European Council, there were four important decisions taken that day: 1) A decision to centralize banking supervision for the Eurozone 2) A decision to allow a direct Euro area injection of equity capital into troubled banks 3) A decision to waive seniority status for the ESM for Spain 4) An agreement to activate EFSF/ESM  bond purchases to tackle rising borrowing costs for Spain and Italy.

While we said that this showed some tangible progress, we laid out our scepticism about how delays in implementation, disagreements that were likely to emerge and differing interpretations of what was agreed would mean that there would be less than met the eye. We were right to be rather pessimistic. Rather than ‘implementing’ the Council decisions the Eurogroup meeting yesterday has shown how limited these were and how deep the disagreements between member states are.

The main decisions of the Eurogroup were 1) the signing of an agreement wherein the ECB would serve as the agent for the EFSF and when it’s established the ESM in their market operations 2) the EFSF will provide up to Euro 30 billion of loans to FROB, the Spanish government’s financial stability fund to help recapitalize the banking sector in Spain and the agreement for this is likely to be reached by the 20th of July. It also agreed that these would not be senior, even when the loans are transferred to the ESM 3) the decision that Spain will now have an extra year, till 2014 to meet its 3% fiscal deficit target as specified under the Stability and Growth pact 4) the decision to treat countries facing banking problems equally meaning that the direct injection of equity, when it happens, will also apply to Ireland 5) welcoming the European Commission’s plan to present proposals on a single supervisor for banks, involving the ECB by early September

We consider these one by one but before that we look at what has not been referred to in this communique. The most glaring element that is missing is any reference to reducing the borrowing costs for Spain and Italy. After Mr Monti’s premature declaration of a ‘double victory’ at football and in getting an agreement on reducing Italy’s borrowing costs he is starting to look silly on both fronts. Spain convincingly beat Italy in the final of the Euro 12 football championship and it seems that all Mr Monti had managed was to get other leaders to agree that the EFSF and the ESM may buy Italian (and Spanish) bonds in the primary and secondary market, if necessary and after all the conditions were met.

There was nothing new here – the crisis funds already have these powers. Mr Monti may have managed to get somewhat easier conditions wherein the humiliation of full-fledged conditionality of the kind that applies to Portugal, Ireland and Greece may be avoided, but the precedent for this was already established in the discussions on Spain. So the Eurogroup has clearly revealed that there has been NO progress on taking actions that would reduce the borrowing costs for troubled sovereigns and that NO new steps have been planned in this regard.

This brings us to what was in the Eurogroup conclusions – an agreement wherein the ECB would serve as an agent for the market operations of the crisis management funds. The agreement may have been signed now but there is nothing new here. The political decision to do this is not new and in any case it is no big deal. It may signal EFSF intentions to activate bond purchases as Mr Monti had gloated, but once again this is not a breakthrough by any measure. The ECB’s balance sheet will not be used to support troubled economies a step that Re-Define has long believed is necessary, but the ECB will merely execute transactions on behalf of the crisis funds thus avoiding the need to duplicate manpower.

The second decision is that FROB, the Spanish financial stability fund, will get up to Euro 30 billion in loans from the EFSF to support troubled Spanish banks. This is not new and the in-principle agreement was already reached several weeks back. The downside of the decision is that this will be on the books of the Spanish sovereign which reinforces the already deadly links between banks and sovereigns and the sovereign bank dance of death continues. This will do little to tackle the suffocating borrowing costs for Spain which already exceeded 7% for 10 years and 5% for 2 years on the day of the Eurogroup and look set to rise further. The residual risk of losses on rescuing banks remains high and under this mechanism the Spanish state remains liable for it. Adding to the uncertainty is the fact, that the German Finance minister has contradicted assertions about losses being borne by the crisis management funds by saying that even when the direct Eurozone injection of equity does happen, the state will retain the residual liability for losses. It seems that Germany may be envisaging some form of a counter-guarantee from the sovereigns to the crisis management funds indemnifying them again losses that may occur on the equity capital injected.

While the agreement to eventually allow for a direct injection of equity into Spain’s banks was repeated but it is increasingly clear that the realistic timeline for this as per current plans is 2014 at the earliest which is not particularly helpful given the urgency of the problems. This increases the likelihood that Spain my need to go for a fully-fledged bailout of the kind that Portugal has had to. The only piece of good news here is that the terms of the loans are likely to be easy and they may have as much as a 15 year maturity and undoubtedly the interest rates would be significantly less than what Spain can borrow at in its own name. However, this is hardly important given the magnitude of challenges that Spain faces.

The third main agreement was that Spain would now be given an extra year to meet its fiscal deficit targets. It means that it will now need to reduce the deficit from the 8.9% registered in 2011 down to 6.3% in 2012 instead of the previous target of 5.3%. This looks like progress but will do little to arrest the downward ‘deficit cuts-recession-falling tax revenues-rising unemployment-falling asset prices – shrinking GDP’ spiral that Spain is trapped in. At a time when unemployment is already at 24.6% and rising, the GDP is shrinking and asset prices are falling the 2.6% expenditure cut/tax increase required will simply push the economy closer to the edge. Spain has consistently fallen behind on its targeted tax revenues and once again, despite this decision, unemployment, tax revenues, GDP and asset prices will do worse than has been forecast.

The fourth main agreement was that other countries will also be treated as Spain is on the subject of a direct injection of equity capital into troubled banks. This is positive for Ireland, if and when this does happen and particularly if the final liability for losses lies with the Euro area crisis management funds not with the national governments. This would significantly reduce the headline public indebtedness figure and would also reduce the remaining large downside risk for the Irish state particularly as the banking situation has still not stabilized. However, this is unlikely to happen anytime soon.

On the last point, of the ECB getting responsibility for Euro area wide bank supervision, it now seems that the most favoured proposal is that of the creation of a new supervisory agency that would report to the ECB rather than the ECB itself becoming the supervisor. Given the very strong opposition from German savings banks and from the national supervisors in many member states, it also seems that the discussion has now moved to direct supervision only for the systemically significant banks with the responsibility for smaller banks staying with national supervisors but overseen by the newly created Eurozone wide authority and the ECB. In short, there is everything to play for here and nothing has been decided yet and this once again highlights that the timescale being discussed is one of years not months.

Thus the Eurogroup meeting provided a good reality check for those who may have got carried away after the better than expected (only because expectations were managed so low) results from the European Council meeting in June.

Sony Kapoor 

Managing Director