Lowered Expectations
Just a few days before the next European Union summit in Brussels begins, it is time to lower expectations. This will not be one of those gatherings that lends itself to be branded as a make or break moment for the euro zone.
Those who expect the summit to include a Spanish bailout request, a deal to keep Greece afloat, and serious progress towards a banking union could end up being seriously disappointed. Europeans are not close to a breakthrough on any of these three topics. After all, they are also waiting to see what happens on November 6th, as well as in the following weeks when the U.S. will try to tackle its own fiscal cliff. Nevertheless, this week’s gathering in Brussels is still a serious test. It should at least allow us to better understand how committed European leaders still are in completing the tasks they gave themselves at their ‘historic’ summit meeting in late June. Most importantly it will shed some light on Germany’s true intentions.
Let’s begin with Greece. All the noise coming out of the German government indicates that a ‘Grexit’ is not in the cards − not now, not in the future. “It will not happen that there will be a ‘Staatsbankrott’ in Greece,” German Finance Minister Wolfgang Schaeuble said while touring Asia after the annual World Bank and International Monetary Fund meetings in Japan. He added that speculating on Greece leaving the euro does not make any sense. German Chancellor Angela Merkel’s recent visit to Athens, while largely tailored to meet demands of her domestic audience, carried the same message. However, in order to avoid sudden, unforeseen hick ups, Berlin needs some help from Athens, i.e credible reforms. That is where things get complicated, and that is also why timing events matters. In order to avoid market turbulence before the U.S. election, a decision on Greece will probably be taken later in November. There is just enough time to do that. By its own accounts, the Greek government will run out of cash at the end of that month.
This takes us to Spain. It is not only the government in Madrid that still resists making a bailout request. Spanish Prime Minister Mariano Rajoy’s stubbornness is equal only to Schaeuble’s refusal to expedite the process. Germany is trying to hold off as long as it possibly can, as the Germans are not at all convinced that Spain needs a new bailout.
They believe that Spanish banks’ needs are already taken care of through the 100 billion euro heavy war chest dedicated to that very task. Schaeuble believes that financial markets have not yet understood how much progress Spain has made. When they do, he argues, Madrid will be rewarded and pressure on Spanish sovereign bonds will ease. Unfortunately, the German posture is almost exclusively driven by the need to protect German taxpayers and voters from a new round of financial transfers to the periphery, not by underlying economic realities on the ground. Germany wants to bundle any help to Spain, Greece and Cyprus into one big package in order to confront the German Bundestag only once and not three times. Even Berlin knows that despite some recent competitiveness gains, the Spanish economy is not likely to bounce back anytime soon and will likely need more help. The recession continues to negatively impact tax revenues and is putting additional strains on the Spanish budget. Austerity could indeed become self-defeating. Moreover, if Spain does not request a ‘full macro economic adjustment program’, the European Central Bank’s bond buying program cannot be activated. Financial markets could end up perceiving the Outright Monetary Transactions (OMT) as a giant bluff. We know what that means: a negative reaction by financial markets, pushing yields for Spanish and possibly Italian bonds up dramatically. More importantly, investors could even start questioning the ECB’s credibility.
Finally, the most important topic at the Brussels summit is of course the banking union. Governments and European Institutions are bargaining hard and they are in a phase of classic European brinkmanship. Every statement made by euro zone officials at this point should therefore be taken with a grain of salt. Even German resistance against a rushed decision could be seen in this light. However, any delay on the banking union would dash hopes by some countries that the European Stability Mechanism (ESM) could soon start recapitalizing banks directly and lift that burden from the already weighed down shoulders of sovereigns (i.e mostly Spain and Ireland). As we know, as long as there is no agreement on a banking union, the ESM will not be able to put more capital into banks directly.
The October 18th summit should at least allow us to better understand whether Germany is still working towards an agreement on the banking union by the end of the year and what kind of agreement is likely to emerge. It is clear that if bank oversight only starts in 2014, as the head of the ECB Mario Draghi seemed to suggest just a few days ago in Japan, any direct bank recapitalization by the ESM could end up being pushed further into the distant future.
But we are not there yet.
The October summit is just the stepping-stone for the more important EU gathering in December. It is therefore still too early to establish whether complacency has once again infected European politicians.
