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Europe -- as usual, just enough to calm the markets [ClearOnMoney]
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Europe -- as usual, just enough to calm the markets

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Commentary

Europe -- as usual, just enough to calm the markets

30 Jun 2012 by Jim Fickett.

I'm waiting to form a final judgement until some thoughtful commentators have a chance to fully read the output of the recent European summit. But so far, on the basis of the press conferences, it looks as if the high level agreement reached this week is, indeed, an important step while, at the same time, it by no means solves the crisis.

Here is a high level summary from the Financial Times:

The politicians do appear to have made more progress than expected. Critically, the European Stability Mechanism (ESM), the main EU-wide vehicle for aiding sovereigns in trouble, can henceforth aid banks directly. Until now, it needed to help banks via loans to their sovereign governments – meaning that the debt for those sovereigns would increase with any bank bailout. This could be important; the crisis is so severe in large part because it links two crises, for banks and governments.

Secondly, when the ESM makes “bailout” loans to governments, starting with Spain, it will not automatically enjoy sovereignty over other creditors. This could also matter a lot. Bailout funds so far have perversely driven existing private sector investors out, because they have been forced further back in the queue for repayment in the event of any default. Their exit pushes up bond yields (which are governments’ borrowing costs). So this could help to fix the dynamic that has pushed up sovereign borrowing costs throughout the crisis.

Finally, the ESM will be allowed to dive into bond markets to bring down yields, rather than make loans direct to governments, and it will be empowered to do so without first waiting for the politicians to agree to new austerity measures. That should make the ESM much nimbler.

But, conditions and timing remain unclear. Central problems remain: governments are running unsustainable deficits; austerity policies are only worsening government finances; Greece remains at risk of bankruptcy; and the moves to pool borrowing and banking regulation among the eurozone’s members, which would solve the crisis, continue to require the kind of ceding of sovereignty that could take years to negotiate, and that electorates may not accept.

In sum, this summit sharply improves the chances of keeping the capital markets in check, but does little to deal with the longer-term problem.

As usual, so many details remain unspecified that the agreement could still turn out to mean almost nothing:

Eurozone leaders have embarked on a process to surrender sovereign control of banks to a powerful central supervisor within six months, in a political pledge that kick-starts highly complex talks to forge a nascent “banking union”.

Proposals will be hastily drawn up over this summer to give the European Central Bank ultimate power to oversee euro area banks. While leaders chose to empower the ECB in Frankfurt as the new supervisor, there are a host of unanswered questions, including defining its exact powers, the banks it covers and its relations with countries outside the new regime. “It is a big decision that opens a Pandora’s box,” said one senior official involved.

François Hollande, the French president, hailed a historic deal that would be “a reality” by 2013. But some German officials are urging caution over the timetable and Angela Merkel of Germany, while endorsing the principle, pointed out all 27 EU countries still have a veto. …

While taking bold steps towards establishing a eurozone supervisor, EU leaders were more coy in endorsing measures to share risk for underwriting deposits – a key pillar of a banking union. “ Madame Merkel has had a very tough line on this issue of bank guarantees,” said Mr Hollande, in an indication of the complex negotiations ahead.

Many investor still have serious doubts, meaning the rally might fade as more realistic views settle in:

Alan Wilde, head of fixed income and currency at Barings, says: “Will the rally last a day, a week or be more permanent? The plans were the right first step, but there is a lack of detail that could start to worry the market.”

Didier Duret, chief investment officer at ABN Amro Private Banking, says: “This is a political milestone. The decisions are good and laying a road map. I am particularly impressed with the way they want to recapitalise the banks.

“This has the potential to bridge the confidence gap between the markets and the EU leaders. But it is too early to decide whether to increase exposure to the peripheral markets.”

Arif Husain, director of European fixed income at AllianceBernstein, is more blunt. “I am optimistic, but not optimistic enough to increase my exposure to the periphery.”

Critically, expectations had been lowered substantially prior to the summit, which goes some way to explaining the strength of the rallies in European equities, Italian and Spanish bonds and the euro-dollar exchange rate, say investors.

The decisions caught some market participants on the hop, particularly those who had increased positions in haven assets, such as German Bunds and UK gilts, before the two-day summit started.

“It’s the right thing to do but it is only likely to come into force in 2013, because getting the ESM to inject directly in to the banks is only feasible once the single bank supervisor is in place, which will take time,” says Philippe Bodereau, head of European credit research at Pimco.