Key Disagreements at Late Stage Weigh on Euro

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The EU Summit begins in a little less than 24 hours and the signals coming from European officials are anything but encouraging.  We did not expect the kind of closure than many investors want to emerge from this meeting.  We did expect some important steps toward erecting the scaffolding to facilitate great fiscal union. 

There are several areas of disagreement.  It is simplistic just to cast this as a German vs France difference, but it does suffice to capture the fissure. 

First, there is still no agreement on the role of the private sector participation in future sovereign restructurings.  France (Spain, Portugal and Ireland) do not want the private sector burden sharing and want to regard Greece as a unique event.   

Germany (and Netherlands) have emphasized the role for the private sector, but have softened their stance, it appears, but offering to reconcile the ESM rules with the IMF.  The IMF does not appear to have a general position, but is decided on a case-by-case basis. French PM Fillon claimed, according to press reports, that Germany agreed to drop the private sector demands entirely. Merkel's chief spokesperson retorted that  was not corrected, and Greece is unique in terms of magnitude of the private sector role. 

Second, there is a disagreement over whether the EFSF and ESM can be  in operation concurrently.  On one hand, this would seem to increase the fire power if they would both be in operation simultaneously, especially in light of the apparent limited leveraging ability of the EFSF.  The idea is that the EFSF has 440 bln euros and the ESM will have 500 bln euros, so betwixt them both, there is nearly 1 trillion euros. 

There are all sorts of problems with this common view.  The EFSF no longer has 440 bln euros, as 190 bln has already been committed.  Moreover, the EFSF has not money.  It has guarantees.  The ESM is to have real funds, but if countries do not appear prepared to pony it up early and if they would contribute more, it would boost next year's spending and deficits. Reports had suggested countries would gradually pay into the ESM, so in any case the ESM would not have 500 bln euros as of July 1, without new and expensive efforts.   Germany is opposed to combining the EFSF and ESM.                           

Third, there is a disagreement over role of the IMF.  Recall there have been numerous reports suggesting the European national central banks and the Federal Reserve would make bilateral loans to the IMF for which they could finance enhanced lending to the euro zone countries.  Although we have argued that the IMF is the backstop for sovereigns, not the ECB, we think the process is more complicated than can be resolved at this summit.  There does seem to be a significant role for the IMF, but the details have not been worked out.           

Fourth, there seems to be differences over a procedural issue that has substantive impact.  Germany and France are pushing for treaty changes.  Under normal conditions treaty changes are a long drawn out process, subject to horse trading and vulnerable to domestic political considerations and the outcome is far from guaranteed.  There some voices, including Van Rompuy, who want to "fast-track" treaty changes without requiring parliament approvals or referenda.  Others disagree. 
              

The S&P decision to put 15 euro zone countries on watch, including the AAA countries and warning that France could be subject to a two notch move, which would of course undermine the credit rating of the EFSF itself (and ESM by implication) has raised the stakes, even though Italian and Spanish bond yields have fallen sharply in recent days and the spread between France and German has narrowed considerably. 

We suspect that there will still be moves that will, in broad strokes lay the foundation for greater fiscal convergence and union.  The ECB meets first and today's press reports lend credence to what we have been saying:  The ECB is going to cut 25 and possibly 50 bp.  It will broaden the collateral it will accept and possibly reduce the haircut on existing collateral.  It will offer 2 and possibly 3-year repos.  It may also announce an increase in its SMP program of buying sovereign bonds.  Of these measures, the last is the most questionable in that the ECB has never pre-announced the amount it buys.  Some reports have suggested a 20 bln euro self-imposed weekly cap, which was been surpassed once or twice, but most often is well shy of the "existing" cap.             

Then we come to the summit proper.  If the disagreements make the outcome of it uncertain, the market positioning makes the reaction less obvious as well.  Although some short euro positions appear to have been squared in recent days, we still see the short-term speculative market short euros in size.  Under more normal times, we would be highlighting the risk of sell the rumor buy the fact kind of trading, but various polls show an increasing number of people expect a country (Greece?) to leave EMU and the skepticism about European officials ability to get ahead of the curve is very strong.