European Summit: More Talk Needed, but Something Emerging

The European debt crisis turns two years old. On average there is a crisis management summit a little more frequently than every other month on average. The most concrete and certain thing to emerge from the weekend's summit is that there needs to be at least one more before the November 3 G20 summit, which is a deadline of sorts for a resolution. The rhetoric of a "durable" or "comprehensive" solution again, proved more difficult in implementation than in declaration as did similar claims this past March and July.

Nevertheless, there has been some important progress over the weekend and additional developments are likely in the days ahead. At the same time, we note a frequent pattern in the currency markets in which Monday activity often sees follow through from Friday, before a consolidative or corrective phase ensues. The euro closed firm near its recent highs before the weekend and sterling and the Australian dollar made new highs in the recent advance. The developments over the weekend may not stand in the way of this pattern.

France appears to have backed down in the face of a German-ECB joint position that strenuously objected to the EFSF becoming a bank to borrow from the ECB. Instead, it appears that the insurance/guarantee function of the EFSF is going to dominate. Although the situation still appears fluid, the momentum seems to favor those who want to have this guarantee function only for new issuance of Spain and Italy. There is another twist that emerged. Alongside the guarantee, the EFSF may set up a special purpose vehicle that would invest in sovereign bonds and would potentially attract other investors, like sovereign wealth funds.

There also seems to have been some progress in the plan to recapitalize European banks. The size of the need is estimated at around 100 bln euros, which is at the end of market estimates. Banks will have probably until the middle of 2012 to raise the capital on their own, including retained earnings. If that proves insufficient, bank can turn to national governments and only if that proves insufficient can negotiations be opened with the EFSF.

There is some talk that of a role for the IMF as well. There were some officials who want the IMF to have a role in the potential SPV, but this seems rather difficult from a procedural point of view. Others see a role for the IMF in granting precautionary lines of credit to Italy and Spain for example.

The size of the haircut that private sovereign bond holders are likely to be asked to "voluntarily" to accept will be greater than the 21% (net present value) that was agreed upon in principle in July. While officials seem to be talking 50-60%, through their lobbying arm, the banks have reported made a counter offer of 40%. Negotiations appear to be ongoing.

To the extent that the sub-text of the summit was to get France and Germany singing from the same hymn book, Germany appears to have won the insurance model and have the national governments, rather than the EFSF, backstop the banks. France and the ECB appear to be winning the issue of voluntary swap rather than a hard restructuring of which Germany seemed more sympathetic.

The financial pressures on France that have emerged in recent weeks has weakened its negotiating position. The constraints in Germany seem decidedly more political in nature. The recent Constitutional Court rulings underscore a greater role for the German Bundestag, the lower house of parliament. Because it insisted on being briefed on the details of the "comprehensive" package before granting Merkel negotiating authority, it in effect forced the need for a follow up summit and appeared to harden Merkel's negotiating position over the weekend. The political evolution in Germany appears to toward the Danish and Finnish models of parliament/government relations.

In addition to some rating outlook pressure and the increased spread between Germany and French yields, France is likely to be compelled to provide for greater savings in the months ahead of the national election in which the polls put Sarkozy behind the Socialist candidate. Currently the government forecasts 1.75% GDP in 2012. This will likely be cut to something closer to 1%. Slower growth is going to risk its effort to cut the deficit from 5.7% this year to 3% in 2013 without additional measures.