David Morris

FRIDAY’S trading brought the first half of the year to an extraordinary conclusion. Risk assets soared, as investors responded to news from the EU summit. Expectations for a positive outcome from the meeting were low to non-existent. Yet, despite the well-publicised objections by Germany in the lead-up, European leaders cobbled together an agreement to alter the way that bailout funds can be used. European bailout facilities will be used to recapitalise banks directly. In this way, future loans – including the latest one for Spain – will not add to troubled countries’ debt loads. On top of this, traders cheered the announcement that loans from the proposed European Stability Mechanism (ESM) will not be senior to other debts. So investors will be happier believing that their existing holdings will not become subordinate. The fact that this was already implied in previous statements was ignored.

But before all this can happen, a single bank supervisor for the Eurozone must be established, with European Central Bank (ECB) involvement. This suggests a move towards a banking union, although supervision is a long way short of the deposit guarantee scheme, or a bank resolution authority, that many economists believe is vital for the Eurozone’s continued existence. European leaders also agreed to negotiate closer fiscal cooperation and a €120bn (£96bn) package to help stimulate growth and job creation.

Much was made of the announcement that funds from the European Financial Stability Facility (EFSF) and ESM will be used to buy up the sovereign debt of troubled countries, with the aim of keeping a lid on bond yields. Previously, the ECB controversially bought sovereign debt of troubled peripheral counties in the secondary market through its Securities Markets Programme. The ECB has held off for over four months now, so it looks as if the baton has been passed on. But it is worth remembering that there is only around €200bn left in the EFSF. The credit facility in the ESM should total €500bn. While significant, this will not be enough to backstop Spain, let alone Italy. Of this €500bn, the ESM has paid in capital of €80bn; the rest is pledges from Eurozone countries. In terms of which countries stand behind the two funds, Germany provides guarantees for 27 per cent; France for 20 per cent; Italy for 17 per cent; and Spain 12 per cent. In consequence, if yields on Spanish and Italian sovereign debt rise back up to danger levels, then these two countries stand as significant guarantors to a bailout fund that will be used to buy their own bonds. Understandably, given the extent of its potential liability, Germany opposes any increase in the ESM.

Nevertheless, the summit has been viewed as a major victory for France, Italy and Spain, and a climb-down for Germany – as German Chancellor Merkel has always insisted that liability and control must go together. But as more flesh is put on the agreement, the more likely it is that Germany will insist on some conditionality. Already there is talk that Germany wants individual governments to be liable should their own country’s banks fail to pay back bailout loans. In addition, it has been reported that Germany is ready to push for the implementation of a financial transaction tax (FTT), and banks will only be able to access funds from the ESM if they are in countries that have signed up to the new tax.

The bullish view is that the agreements made at this EU summit have broken the chains linking sovereign and banking risk. Many also see progress towards political and fiscal integration, which will, it is hoped, ultimately keep the Eurozone together and so ensure the survival of the euro. An alternative view is that EU leaders have once again come up with yet another short-term fudge, which simply buys the Eurozone a bit more time. Peripheral countries remain burdened by debt and solidly in recession with no apparent way of achieving economic growth. Last week’s summit has done little to change this fundamental dynamic.