Eurozone Crisis – New EU accord raises more questions than answers

<p>The new intergovernmental accord struck between 85% of EU members has effectively left the UK ostracised and raises yet more questions about the short term […]</p>

The new intergovernmental accord struck between 85% of EU members has effectively left the UK ostracised and raises yet more questions about the short term liquidity capacity of Europe to contain the debt crisis from escalating further. Whilst much of the accord merely cements the existing Franco-German agreements made on Monday to help bring about a greater fiscal union, many questions and uncertainty remains over the role of the ECB and whether the accord will be enough to convince Mario Draghi and the ECB to ramp up bond purchases with the sorts of vigour investors want to see.

How can the accord within an existing treaty work?
First and foremost, how will the intergovernmental accord work within the existing EU Treaty and the two member states, the UK and Hungary, that will reside outside of it? Whilst there is every chance that the UK is going to be ostracised from Europe, there are sincere questions about how the accord will actually work, both from a legal perspective and practical sense given the governance of the existing EU Treaty.

At the very least, the potential isolation of the UK from Europe is unlikely to significantly impact the FTSE 100, considering that much of the UK’s top listed companies rely on profits from operations outside of the UK’s borders. So whilst a potential isolation of the UK from Europe is likely to have far reaching questions about UK trade ties, it may not necessarily impact many of the firms on the FTSE 100 itself.

Accord details were already known
Much of the intergovernmental accord struck up by Merkel, Sarkozy and their European partners was already well known by the market and so as such, there has been very little upside to come from the agreements reached in trading this morning. There is no doubt that the detail of the accord, if implemented correctly, is a big step in the right direction. Creating a greater fiscal union with consequences if member states do not get their fiscal houses in order on a consistent basis could go some way to preventing another eurozone debt crisis in the future.

Question marks over liquidity scales
However, there remain unanswered questions as to whether or not the ECB can be convinced to ramp up its asset purchases through the agreements made this morning and whether there exist enough funds to help bailout indebted states should the debt crisis escalate further in the near term.

The size of the bilateral loans to help increase the funds at the IMF’s disposal are being seen as lacking in potency and investors will now need to see whether the additional €200 billion in bilateral loans to the IMF could trigger other nations such as China to loan to the IMF.

Despite the fact that Mario Draghi heralded the new EU accord as echoing his much desired fiscal compact, investors are wanting the ECB to ramp up its bond purchases to help contain the crisis.

Evidence from yesterday’s Draghi press conference indicated that perhaps even if the fiscal compact was to be achieved, the ECB was determined to help increase liquidity in banks and not governments. It would be some turnaround for this statement to be fully reversed some 24 hours later.

It is here where there remains a sense of disappointment from investors.

Key details of the new intergovernmental accord:

  • Talks lasted for 11.5 hours
  • Accord reached between all 17 euro adopted states plus 6 non euro states.
  • Sweden and Czech Republic yet to decide whether to adopt the new accord
  • The UK and Hungary have vetoed the accord and will not sign up
  • The UK vetoed because it wanted to be able to opt out of financial regulation decisions to help protect UK financial sector
  • Accord details that member states will receive automatic sanctions for deficits of over 3% and will lose a degree of fiscal independence
  • ESM, the long term bailout fund, to be capped at €500 billion and be used with an 85% majority vote by members (re-evaluated in March 2012)
  • ESM to be brought forward a year and start from July 2012
  • ESM will not have a banking license which would have allowed it to obtain funding through the ECB (Germany was against this)
  • Bilateral loans agreed to the IMF totalling €200 billion (150 billion from euro region central banks and 50 billion from non euro region central banks)
  • It is hoped that the IMF bilateral loans could entice China and others to do so as well
  • The Financial Transaction Tax will be discussed in January.


06/12/2011 (4.30pm) Joshua Raymond, Chief Market Strategist, City Index

 Can EU leaders deliver real change in a crucial week for the eurozone and euro?

The eyes of traders and investors all over the world will being watching developments with bated breath in Brussels this week, where the latest EU Summit is being fast heralded as a ‘make or break time’ for the euro and eurozone as a whole.

The Summit takes place on December 8 and 9, with German Chancellor Angela Merkel and French President Nicolas Sarkozy expected to take a leading role in heralding greater fiscal union through the implementation of stricter budgetary rules within a new EU Treaty.

The key however will be whether other European leaders share their appetite for these new rules and if the ECB can be convinced to take on a greater intervention role in bond markets as a result of any new measures agreed.

Merkel and Sarkozy agreement is the first step along a long path
On Monday Nicolas Sarkozy and Angela Merkel agreed fresh proposed changes to the EU Treaty that they believe would bring about greater budgetary oversight and a fiscal union of the eurozone that would help to prevent the sovereign debt crisis we see today from happening in the future.

Some of the proposals included:

  • Automatic penalties for states whose deficit surpasses the 3% threshold
  • A golden rule for balancing budgets
  • A pledge to bring forward the implementation of the European Stability Mechanism (ESM) by one year to 2012


It is hoped that any new EU Treaty changes could be agreed by March 2012 and then be implemented after the French election of April 2012.

However, the potential for a wide sweeping agreement between all 27 EU member states towards a new EU Treaty by March, with indications of an outline agreement in Brussels by Friday, could be hugely optimistic.

First and foremost, we have only seen some, not all, of Germany and France’s cards. They have outlined some of the agreed measures they hope to bring to the table in Brussels later this week. We don’t know what cards the other 25 EU member states are holding yet. The fact that the Merkozy duo (Merkel-Sarkozy) admitted that whilst their preference would be for all 27 member states to sign up to a new EU Treaty, they would settle for the 17 states which have adopted the single currency, shows just how sensitive any negotiations of a new EU Treaty is likely to be. Given the fact that ideological divide between EU members has hampered progress and abilities to contain the euro debt crisis so much over the last year, it could be folly to believe that a new EU Treaty would be a smooth implementation process.

To add a caveat to this issue is the fact that several governments within the eurozone have been significantly weakened by the recent crisis enveloping the euro region. It has toppled previous leaderships of Greece, Italy and Spain, whilst various strict austerity measures being adopted in other states has also turned public sector workers against governments, leading to street protests and general unrest. A recent poll suggested that Nicolas Sarkozy could even be toppled in the French general election next year if the vote was held today. This is likely to put additional pressure on European leaders to force ahead their own agendas within any new EU Treaty to win back public approval back home, and this could further scupper any negotiations in Brussels this week.

Emphasis is to bring about a closer fiscal union
The emphasis behind any new EU treaty would be to bring about a closer fiscal union of the EU and induce stricter budgetary responsibilities.

This is likely to give the markets both long term and short term benefits. The long term benefits are clear for all to see; stronger budgetary responsibility, increased lender confidence etc. However, there are arguments to be had that more prudent government spending or restraint from running deficits induced from high borrowing could dictate the need for consistently high tax revenues and reducing the spending power of both consumers and businesses. If you take away the credit card and spend by your means, your credit rating is better but your spending power is significantly reduced.

In the short term at least, greater fiscal union could be enough to convince the European Central Bank to scale up their bond purchases and take on a much more aggressive role in containing the debt crisis from spreading further.

It is this short term benefit to which many in the market are pinning their hopes towards and what has triggered a 10% rally in the FTSE 100 over the last two weeks.

Hopes on greater ECB role
Investors are pinning their hopes on a greater role of the ECB due to a multitude of failings of Europe’s leaders to adequately convince that the European Financial Stability Facility (EFSF), the temporary bailout fund, has the required scale to combat a debt fallout of both Italy and Spain, the two most likely casualties should the debt crisis escalate even further.

Currently the EFSF has around €250 billion worth of uncommitted resources whilst hopes to leverage this up to over the €1 trillion mark have failed. Initial attempts to muster up enough foreign or third party funds into the EFSF’s co-investment funds – partly due to the high risks of doing so whilst there remains an open question mark of the solidarity of the euro area – has failed and so as such, the current estimates for the newly leveraged size of the EFSF stands at approximately €600 billion, though many leaders refrain from specifying a predicted amount. This is likely to change over the months ahead as talks continue with emerging economies to source co-investment funding.

The idea of a common euro bond has also been firmly moved off the agenda by Angela Merkel’s public determination to throw this idea to the side of the curb whilst Germany and France have little legal control or influence into member budgets. Whilst it may have been investor folly to believe this was still a possibility, given Merkel’s antipathy towards such a proposal in the near term, there was some relief that the German Chancellor did back down from original requests to include clauses in new bond issues from mid 2013 that private bondholders would have to play a role in future bailouts. On Monday she announced that the Greek haircut on bonds was a one off, and this gave shareholders of major banks some welcome relief.

IMF role versus ECB intervention
This leaves two immediate options to help to contain the crisis.

On the discussion table is the potential to increase the lending power of the International Monetary Fund (IMF), by allowing National Central Banks to loan money to the IMF directly, so that it may provide a backstop against any further escalations in sovereign bond markets, essentially turning the IMF into a fiscal Alamo. It is still unknown as to what sort of figures are being talked about and the potential for this option has only come to the surface in the last few weeks. Indeed, an interim report comes from EU’s Van Rompuy on Tuesday, ahead of the Summit, putting his weight behind this option through calls for bilateral loans to the IMF.

A second option is for the ECB to take a much more advanced role in containing the crisis. Up until now, the ECB has been purchasing Italian and Spanish bonds in an effort to prevent their yields from rising too high and too fast into unsustainable territory. The problem here is that they have been doing so with the handbrake on and so as such, attempts have been largely futile with Italian 10-year bond yields trading as high as 7.3% before falling back to 6% in the last week as investor optimism surged ahead of the week’s Summit.

Fiscal compact
So what will it take to convince ECB President Mario Draghi to step up the Central Bank’s activity? It all hinges on the term ‘fiscal compact.’ Last week, the ECB President said in a speech to the European Parliament that if there was to be a new ‘fiscal compact’, ‘other elements might follow.’ The market quickly took this line as an indication that the ECB would be prepared to take on a much greater and influential role in containing the crisis. The key now is whether investors believe the Summit itself will deliver the ‘fiscal compact’ Draghi wants to see that might convince him and the ECB into employing those ‘other elements’.

Investors tend to pay close attention to the short term effects of decisions, as opposed to long term consequences, particularly during moments of financial crisis and this is where the weight of investors’ eyes will be over Thursday and Friday this week. Will the ECB step up to the plate?

Of course on Thursday, Mario Draghi will be preoccupied with an ECB interest rate decision, where he is expected to announce another 25-basis-point cut in rates, whilst there are also tentative expectations that he could also announce longer term liquidity operations or an extension of existing 12-month and 13-month operations. So for now, all eyes remain transfixed on Brussels. After a week whereby increased investor optimism has lifted the price of equities strongly in anticipation of progress (perhaps foolhardy) being made, the sustainability of these gains will be dictated by what Merkel, Sarkozy and Draghi deliver. Can Angela Merkel and Nicolas Sarkozy deliver the fiscal union required to restore the euro area’s fiscal credibility enough to convince ex Goldman Sachs banker Mario Draghi to take one small step for the ECB and one giant leap for market confidence? We wait with bated breath.

Build your confidence risk free
Join our live webinars for the latest analysis and trading ideas. Register now

StoneX Financial Ltd (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.

No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

For further details see our full non-independent research disclaimer and quarterly summary.