Market Economics

12 December 2011

Daily Economic Spotlight

EU Summit: The Agreement
Luigi Speranza & Gizem Kara The agreement reached at the EU summit was another step forward, but probably not the definitive solution to the eurozone crisis the markets were looking for. Virtually all of the proposals from France and Germany were approved, even if not at the EU-27 level. The ESM will become operational sooner than planned, likely in June 2012. The previous emphasis on private-sector involvement was scrapped. This is particularly important in our view, as it should reduce concern that the resolution of the Greek crisis will become the benchmark rather than the exception. The EU will provide EUR 200bn in additional funding for the IMF in the form of bilateral loans. Parallel contributions are expected from other countries. The Van Rompuy task force proposal to transform the ESM into a credit institution was not approved. But this is not a major surprise, as opposition from Germany was well known. Overall, the meeting delivered all that could have been hoped for. However, combined with the less encouraging message from Thursdays ECB press conference on the potential for beefing up central-bank asset purchases, the overall message from policymakers over the past few days has been less than overwhelming. The ECB has still got room to step up its purchases to a significant extent, but markets will remain concerned that it did not commit to an enhanced role in resolving the crisis, especially after speculation in this regard fuelled by Mr Draghi himself. Overall, this is not quite the bazooka markets would have liked, but we are in a better position than we were two weeks ago. Comments from ECB President Mario Draghi, as he exited the meeting of EU leaders, pretty much sum up the outcome of the EU summit: "It's going to be the basis for a good fiscal compact and more discipline in economic policy in the euro area members," he said, adding that "we came to conclusions that will have to be fleshed out more in the coming days". All in all, then, a positive step forward, but not yet the definitive response to the fiscal crisis the eurozone is facing. There is also more work to do on the legislative front to implement the decisions the leaders adopted in principle. This could prove troublesome more than thought, as we have seen on other occasions during this crisis. More specifically, broadly in line with the proposal put forward by France and Germany a few days ago, EU leaders reached agreement on three key areas of action: Fiscal discipline Rigid rules will be put in place for budget control, which need to be enshrined in a new legal framework. Specifically: This publication is classified as objective research. Please refer to important information at the end of the report. www.GlobalMarkets.bnpparibas.com

(i) General government budgets need to be balanced or in surplus. This will be deemed to be achieved if the annual structural budget deficit does not exceed 0.5% of GDP. (ii) This rule will be introduced in member states' national legislation at the constitutional or equivalent level and will contain an automatic correction mechanism that will be triggered in the event of deviation. In each member state, it will be defined on the basis of principles proposed by the Commission. The European Court of Justice will verify the transposition of this rule at the national level. (iii) Member states will work to bring their deficits down to specific reference levels, according to a calendar proposed by the Commission. (iv) Member states that are subject to the Excessive Deficit Procedure will need to submit an economic partnership programme to the Commission and the Council for endorsement, detailing the structural reforms needed to ensure a correction of excessive deficits. The implementation of the programme will be monitored by the Commission and the Council. (v) A mechanism will be put in place for the ex ante reporting by member states of their national debt issuance plans. Automatic penalties The Excessive Deficit Procedure for member states will be reinforced. As soon as a member state is recognised to be in breach of the 3%-of-GDP deficit ceiling, there will be automatic consequences, unless a qualified majority of euro area member states is opposed. Steps and sanctions proposed or recommended by the Commission will also be adopted unless a qualified majority of the eurozone countries is opposed. Stabilisation tools The EFSF will be leveraged in the form already agreed at the October summit (providing credit enhancement to new debt issued by member states and maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through SPVs) and will remain operational until mid-2013, with the ECB acting as an agent in its market operations. The ESM will become operational sooner than planned; the leaders intend to have it up and running from June 2012. This means the EFSF and the ESM will overlap for at least a year. The leaders explicitly stated that the combined ceiling of EUR 500bn will be discussed in March, leaving the door open for a further strengthening of the firepower of the two vehicles, which we regard as a positive. Previous emphasis on private-sector involvement, as the ESM kicks in, was scrapped. The statement made it clear that the solution adopted for Greece will be considered an exception rather than the rule for crisis resolution. Note, however, that Collective Action Clauses (CACs) will still be included in the terms and conditions of all new government bonds. Overall, the decision is particularly important in our view. Last, but not least, the EU countries agreed to provide the IMF with additional financing to the tune of EUR 200bn (of which EUR 150bn from the eurozone, the rest from non-eurozone EU countries) in the form of bilateral loans. The expectation expressed by the statement is that other countries will provide parallel contributions. This increases significantly the IMFs ability to provide support. Overall, the summit has produced a significant increase in the resources available as supporting tools, even if probably still falls short of the bazooka many in the market deem necessary to resolve the crisis once and for all. It is significant that the leaders left the door open to a further strengthening of the EFSF/ESMs combined firepower.
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As proposed by French President Nicolas Sarkozy and German Chancellor Angela Merkel in their letter to European Council President Herman Van Rompuy, urgent decisions on the ESM will be taken by qualified majority, or 85% of member votes, not by unanimity, as previously required. This prevents small countries from exercising a veto over ESM decisions. Finland opposed this point, however, and threatened to withdraw from the ESM, should the decision go ahead. The clash is a good example of the potential risks embedded in the ratification process. Contrary to the proposal by the task force headed by Mr Van Rompuy, the ESM will not be transformed into a credit institution, which would have allowed the vehicle to leverage funds via the ECB. An important point in all this is that the decisions taken will not involve treaty changes, as there was no agreement at the EU-27 level, due to the opposition of the UK. They will be enacted in the form of an international agreement between all those countries that wish to participate, potentially all EU countries with the exception of the UK. The implications for the ratification process are not clear. The involvement of the EU Court of Justice, for example, could be questioned. On other issues, the ratification process could actually be quicker this way. The aim is that the agreement will be formally signed in March, at the latest. Conclusions The summit was a positive step forward. Virtually all the Franco-German proposals were approved by all of the other eurozone countries. The ESM will not be transformed into a credit institution, but this is not a surprise, given expectations prior to the meeting. The additional funds for the IMF are good news, as is the possibility that the EFSF/ESMs combined firepower can be enhanced at a later date, possibly as soon as March. The outcome of the meeting, however, should be considered in conjunction with yesterdays ECB press conference. The credit enhancement through three-year LTROs and the widening of eligible collateral were, overall, more aggressive than expected. The markets are probably underestimating the potential implications of this decision. The 25bp cut was in line with expectations, but the fact the decision was not unanimous and that a 50bp cut was not even considered was slightly disappointing. More importantly, Mr Draghi ruled out the possibility that the ECB might significantly step up support for countries in difficulty in either a direct (bond purchases) or indirect way (through IMFs financing), as this would not be in line with the provisions of the EU Treaty. This is disappointing, given the expectations fuelled by Mr Draghi himself in his speech before the EU parliament last week. In practice, the ECB will continue to support the eurozone bond market through the SMP. It could step up weekly purchases in a potentially significant move. Still, the lack of a formal commitment on bond purchases will keep markets nervous. Overall, the two-day policy decisions were probably not the bazooka markets would have liked but still an important step in the right direction, which leaves us in a better position than we were two weeks ago.

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