EXCLUSIVE: First translation of draft German Grand Coalition agreement

We have seen a first draft of the German coalition government agreement (the final agreement is expected tomorrow), courtesy of Green politician Malte Spitz who published the draft on his blog late yesterday evening.

The German media has begun delving into the document while the English speaking press continues to lag behind.

The document contains some key insights about how the new government will view Europe and conduct its EU policy, below we pick out the most important parts:

Overall vision of the EU
The agreement stresses that German must become an official working language of the EU alongside French and English – not entirely surprising given that it was a CDU/CSU electoral pledge, but it highlights that Germany is slowly becoming more comfortable with its role in Europe.

There is also a strong emphasis on “subsidiarity” and that the EU must only act where action on other levels is not sufficient. It also highlights that Germany is keen to deepen ties with Poland and maintain the “unique” Franco-German partnership. This may not mean much, but it definitely isn't a nod to David Cameron.

In terms of democratic legitimacy, the agreement calls for a "strong role" for the European Parliament and "close involvement" of national parliaments  in the decision making process. It also calls for a standard minimum threshold for the allocation of seats under European elections and a "single European suffrage" to add to stable majorities at the European Parliament. The final point here is the call for a "stringent and efficient" set of Commissioners - possibly a hint towards reducing the number of Commissioners and focusing them on policy areas rather than allowing one for each member.  

Eurozone crisis
The agreement contains few details on the new government’s approach to the banking union and specifically the resolution funds – given that this is known to be a part of the negotiations it is surprising nothing has been included, maybe a sign that an agreement has been hard to come by.

The document also contains a rare admission from Germany that the causes of the crisis are "varied" and extend well beyond fiscal profligacy. Specifically to "competitiveness", "imbalances" and "design defects" in the EMU which led to problems in the financial markets.

As for the way out of the crisis - as we predicted - much more of the same can be expected:

“[The eurozone must] combine structural reforms to increase competitiveness, and a strict, sustained continuation of budget consolidation for increased competitiveness with future investment in growth that combines employment in socially-balanced way.”

Again as we pointed out in our pre-election briefing, the widely mooted ‘Reform Contracts’ are likely to be a key tool in enforcing these changes. In particular, the contracts will be democratically grounded and enforceable (although the exact mechanism for this is still unclear):

“We are committed to ensuring that the euro countries agree on democratically- legitimised binding and enforceable contractual reform agreements on the European level. [These reform contracts] will be directed to achieving the goals of competitiveness, sound and sustainable finances, growth and employment.”

Any form of debt pooling is strictly ruled out, as we predicted in our pre-election briefing:

“The principle that each Member State is liable for its own obligations must be upheld. Any form of pooling of sovereign debt would jeopardise the necessary national policies in each Member State. National budget responsibility and supranational, joint liability are not compatible.”

The new coalition will not rule out further bailouts and will consider them but “only as a last resort” when the “stability of the eurozone as a whole is at risk”. Importantly, the agreement reiterates that any use of the ESM, the eurozone bailout fund, needs “approval of the Bundestag”.

The City of London may also have some grounds for concern, given that the document hints at more action on financial sector regulation, saying:

 “The financial markets must be involved in the costs of the crisis, and must be guided back to their function as serving the Real-economy.”

Remember, this is only a draft. Nonetheless, the agreement looks to be very much as expected – no change of course on the eurozone, some mention of limiting EU power but a continued commitment to the EU and Europe. The draft however, remains vague on some key details. With important negotiations coming up on the eurozone banking union as well as in terms of the future of the EU, the new German government will have to flesh out its position significantly.

Ireland prepares to exit financial assistance…with further assistance…

Talk surrounding the Irish exit from its bailout programme has been picking up in recent days and weeks given that it is supposed to get off its current bailout programme at the end of this year (the final disbursement of funds is expected sometime in November).

The last few days in particular has seen increased interest with Eurogroup head Jeroen Dijsselbloem telling the European Parliament yesterday that there would be “measures to support [Ireland’s] gradual exit” from its programme. Irish Finance Minister elaborated on this suggesting that Ireland will seek a €10bn credit line to help aid its transition back to fully funding itself.

All this means that it is looking increasingly likely that Ireland will request some form of ESM credit line towards the end of the year. This could take two forms:

Precautionary credit line (PCCL): open to eurozone states that have sound economic and financial situation including: sustainable public debt, access to capital markets, sustainable external position and solvent banking system (amongst others).

Enhanced credit line (ECCL): essentially for member states who do not meet the criteria for PCCL but do not require a full bailout programme. Conditions will involve improving shortcomings that prevent PCCL access.

Looking at the above criteria Ireland is likely only to be eligible for the ECCL, given the on-going banking sector issues and the questions over debt sustainability after the bank bailout. The procedure is pretty similar to any other bailout request and given Ireland's relative success in implementing reforms, approval seems likely. Importantly, “enhanced surveillance” (read strict conditions) will apply in either case, so Noonan’s hope that this can be done without further austerity and/or reforms seems unlikely to be fulfilled.

The key aim of such a loan is to gain access to the ECB’s OMT, its bond buying programme. Under a credit line Ireland would be eligible for the OMT as the programme applies the much needed conditionality. The combination of the loan (the size is not particularly important) and the OMT means it may not have to be tapped.

All that said and despite the many resounding endorsements for Ireland’s progress, many problems remain. In particular, toxic loans at Irish banks continue to increase while households struggle under the burden of such loans. The issue of how to deal with the public debt created by the previous round of bank bailouts remains unsettled and leaves a cloud hanging over the Irish economy.

Eurozone compromise on using ESM to directly recapitalise banks - a stopgap at best?

Eurozone finance ministers finally reached a compromise yesterday which will allow the ESM, the eurozone

bailout fund, to directly recapitalise ailing banks.

This is likely to be an important element of any ‘solution’ to the eurozone crisis, especially since it will probably be incorporated into the plans for a eurozone banking union and single bank resolution fund.

Below we summarise and analyse (in bold italics) the key points of the agreement:

€60bn limit: ESM funds available for direct bank recaps will be limited to €60bn out of the total €500bn, since this method of funding eats up the capital of the ESM more quickly. Given the size of the eurozone banking sector – around €34 trillion or 360% of eurozone GDP – this seems far from sufficient.

Burden sharing: National governments will have to contribute 20% of the funds for the first two years and 10% thereafter. Furthermore, ESM funds can only be injected once the bank has reached a core tier one capital buffer of 4.5% - any recapitalisation to achieve this minimum level will also fall on national governments. This is a logical compromise, but it means that the link between sovereigns and banks is not completely broken. It is only "diluted" (as EU Economic and Monetary Affairs Commissioner Olli Rehn put it). Combined with the above funding limit, this places some tight constraints on the level of capital injection possible.

Strict conditions: The funds can only be used for banks which are deemed 'saveable' and have no other alternative. These banks must also be systemically important (in the relevant member state at least). It must also be impossible for the member state to bailout the bank on its own without harming its fiscal sustainability. There must also be independent stress tests performed ahead of any ESM contribution. Any contribution will come with strict conditions both on the bank and possibly on the member state.

Bail-ins: The agreement states that “sufficient contributions from existing shareholders and creditors of the beneficiary institution”will need to be explored. This suggests that the final agreement on the Bank Recovery and Resolution Directive will play an important role in determining how and when this fund is tapped. The emphasis on bail-ins is of course positive but until related plans are settled uncertainty will remain.

Final liability: A subsidiary of the ESM will be set up to directly purchase equity in ailing banks. This allows final liability for the rescue programme to rest with the ESM rather than states.

Retroactive use (legacy assets): The funds can be used to retroactively takeover the burden of previous bank bailouts, although this will be decided on a case-by-case basis. German Finance Minister Wolfgang Schäuble described this as "a concession to our Irish friends". This gives hope to Ireland that the cost of its bank bailout can be shifted. However, given the above limits and the conditions, this still seems a distant prospect.

At first look then, it is positive that an agreement has been reached but this looks to be a stopgap at best. It is clearly tightly constrained by the limits on lending but also by the conditions – in particular the need for a strict independent stress test which could eat up precious time in a crisis. The hurdles to retroactive use are also significant – there is far from sufficient funds to cover for the Irish, Spanish and Greek bank bail-outs (up to €125bn in total), while opening a country's economy to further oversight is far from desirable.

To be fair, given how tied in this is with the single bank resolution mechanism, banking union and the Bank Recovery and Resolution Directive, it may be too early to fully assess how effective it might be. It's also worth noting that the plan will likely need approval from some national parliaments, notably the Bundestag (H/T Bruegel).

The most conerning point is probably that if this is a precursor to the eurozone's single resolution mechanism, it is likely to fall short of fully breaking the dangerous sovereign banking loop in the eurozone.

Merkel and Letta shadowbox on 'growth' vs 'austerity'

New Italian PM Enrico Letta paid his first official visit to Germany yesterday, only hours after delivering his inaugural address to the Italian parliament. Much has been made of his strong 'pro-European' yet 'anti austerity' stance - so how would this go down with Die Kanzlerin? Here are some quotes from yesterday's press conference:

On 'growth' versus 'austerity'

Letta: "We have done our bit [on budget consolidation]…Europe has to implement growth policies."

Merkel: "We have to free ourselves from this misconception that growth and budget consolidation are opposed. Solid public finances are a precondition for growth. And growth is not only the state giving money, but it's creating conditions for small and medium enterprises to feel at home, to be able to invest and open up jobs. And for that we need structural reforms, good schools and universities, investments in research."

On national responsibility vs 'European Solidarity'

Letta: "In the past five years of crisis we did not find sufficient solutions because there was not enough Europe. This is my objective - and also that of Germany, because both our countries have a federalist vocation... If we reached these objectives [banking union, a fiscal and economic union and a political union] we could solve our domestic problems much easier."

Merkel: "We want to ensure Europe emerges from this crisis stronger than it went into it. As part of that every country must do its part."

On meeting EU targets

Letta: "How and where we will find the resources is a domestic matter. I don’t owe explanations to anyone. I’m not here to justify domestic choices... We have no intention of telling German citizens what they have to do, and we know German citizens have no intention of telling us what we have to do.”

Merkel: "Every country must complete its own tasks... [Italy] has already made significant progress on this path."

Overall, the tone of the press conference and meeting was fairly amicable and concilliatory. That said, there are clearly a number of potential flashpoints. For all the pro-European rhetoric, for Letta 'more Europe' clearly involves more financial help for Italy, be it via a bank resolution fund or debt-pooling and not more EU scrutiny of national tax and spending decisions which is the German approach - note Merkel specifically referred to the fiscal treaty as an "element of consolidation" and the ESM as "an element of solidarity".

As we've pointed out previously, Italy still faces a number of challenges - finding a way of balancing the books without money from the planned property tax (the cancellation of which was demanded by Berlusconi) and also re-starting the structural reform agenda which stalled under Monti following a promising start. Failure to achieve progress on these fronts will inevitably trigger tension with Germany.

A sign of things to come could be this comment from (German-born) Josefa Idem, Italy's new minister for Sports and Equal Opportunities who told ZDF that she "understands that the people most directly affected by the crisis and who draw a direct link with the austerity measures bear an aversion towards Mrs. Merkel."

Aufstand im Bundestag: Who are Germany's most rebellious MPs?

On Thursday, the German Bundestag is expected to vote on the Cypriot bailout. The package is likely to be approved with a clear majority - the opposition SPD and Greens will mostly back it. In addition, the symbolically hugely important "chancellor's majority" - the threshold for the government to get an absolute majority with only the votes of its own MPs - is likely to be reached as well. Only around 12 MPs from the coalition parties (CDU, CSU, FDP) are likely to vote against. This is not particularly surprising. Remember, the bill for this rescue package was largely passed on to Cypriot depositors, and therefore enjoys much greater support in Germany.

Still, with the eurozone bailouts remaining ever-so contentious - and with a new anti-euro party on the German political scene - we thought we'd see how many coalition (CDU, CSU and FDP) MPs have so far rebelled on the various eurozone bailout votes. 

As the table below shows (click to enlarge), according to our calculations, at least 36 MPs have rebelled against Merkel on at least one occasion. Four MPs - Klaus-Pieter Willsch & Manfred Kolbe (CDU), Peter Gauweiler (CSU) and Frank Schäffler (FDP) - have a 100% record in rebelling on eurozone votes - for the rest, there's a surprising spread.

Cyprus bailout: What are individual EU member states on the hook for?

Now remember, contributions via the European Stability Mechanism (ESM) are loan guarantees, not upfront cash. But here's the break-down of how much each EU country is on the hook for in the Cyprus bailout:



Update 05/04/2013 12.10: 
By popular request, we've been asked to put together a quick explainer/refresher of how this money will be provided. ESM loans do not require direct cash from countries but are based off loan guarantees which the eurozone countries give to the ESM. The ESM then issues debt on the market to raise the actual cash to provide the bailout loans. So, not extra cash contribution on the back of this bailout. That said, the ESM does require paid-in capital (€80bn), the payouts of which should have been factored into eurozone government budgets and certainly has been included in the bailed out countries. Also due to a eurostat ruling, each eurozone member's share of ESM bailouts will not count towards its national debt. As for the IMF, the funds usually come from the IMF's general reserve fund which countries will have already contributed their subscription (see here for more details). Again, in a sense, no new cash.

Could the UK be asked to contribute to a Cypriot bailout?

As we have noted before, the potential impact of the Cypriot bailout has the capacity to extend well beyond what would be expected of a country accounting for only 0.2% of eurozone GDP.  This impact is now also lapping at the UK shores.

As we flagged up in our press summary today, new Cypriot Finance Minister Michalis Sarris said over the weekend:

"There are indications that London would participate in a package…for a country that has special links with the U.K., if it were necessary, some way could be found to help in a transitional manner."

This comes a bit out of the blue since there has generally been an unspoken agreement - as well as some formal guarantees - that the UK would not participate in any further eurozone bailouts.  That said, the inclination here seems to be that given the historic ties between the UK and Cyprus, the UK may be more willing to contribute – similar to the Irish bailout.

Apart the IMF - which could play a role and to which the UK contributes - there's another plausible avenue: the European Financial Stabilisation Mechanism (EFSM), which the UK partly underwrites via the EU budget. This fund has around €11.5bn left to lend if needed, while there is always the Balance of Payments facility (which we discussed in our paper on Grexit last summer). The EFSM is also decided by QMV although consensus is usually sought since it is politically controversial to activate. In any case, theoretically the UK could still be dragged in.

That said, it seems pretty unlikely and it would be seen as a pretty hostile move – we also imagine other non-euro countries such as Sweden, Denmark and Poland would not be keen to fund a country to which they have few links. Unsurprisingly, the WSJ cites UK diplomats dismissing the prospect out of hand.

But Sarris’ comments are a reminder that the eurozone crisis continues to impact the UK in a number of ways.

The inbuilt political stand-off in the ECB's bond-buying programme

One of the many sub-stories of the Italian election is how it calls into question the ECB's bond-buying programme - the Outright Monetary Transactions (OMT). Not so much because of the ECB's ability to expand its balance sheet and stand behind Italy and Spain (though there's a clear cost to that). The reason is another one: unpredictable politics.

This is something we highlighted immediately following Mario Draghi's announcement to launch the OMT, in September 2012. We said:

"It will also be virtually impossible for the ECB to impose effective conditionality on debtor countries, meaning that the ECB can only hope that a series of unpredictable political decisions in member states will go in its favour."

To inject such conditionality, the OMT was linked to the European Stability Mechanism - the eurozone's permanent bailout fund - which comes with strict conditions (or at least is supposed to). To tap the OMT, a country has to be on an ESM programme. But, in effect, this made the OMT - despite it being run by an independent central bank - hostage to parliamentary and electoral politics.

As we argued in our analysis on the German Constitutional Court ruling on the ESM - a few days after the OMT announcement in September last year:

"...the ruling and the role of the Bundestag highlights that activating the OMT will be challenging, since in order to qualify for ECB bond-buying, a country must first get funding from the ESM – and be subject to conditions. If the Bundestag agrees to activate more bailouts, it will most certainly push for harsher conditions than what debtor countries – most importantly Spain – are willing to accept. In the long-term, under current arrangements of linking ESM and OMT, the latter is also effectively capped and subject to a Bundestag veto."

Well, enter the Italian elections (and Beppe). Discussing the election results, we told the Telegraph on Monday that:

“People have forgotten that the OMT cannot be triggered without a vote in the German Bundestag. This is going to be a huge problem, and we may be back to the political stand-off between the North and South of Europe,”

And in our flash analysis yesterday, looking at the Italian election results, we noted:

“A fragmented, anti-austerity Italian parliament could also make it far more difficult for the country to tap the ECB’s OMT. This is because it would need to access the European Stability Mechanism simultaneously, meaning a series of strict conditions – which Berlusconi and others could resist – and approval from several Northern Eurozone parliaments, including from the Bundestag.”

Other analysts are now waking up to this issue as well.

Then again, if it ever came to a point where Italy actually needed to tap the OMT, things might be so bad that politicians on both sides (probably during a panic-stricken weekend) could be scared into accepting whatever ESM-deal that could be struck.

But it all goes to show that in the eurozone, there's no escaping the politics.

How realistic is Cameron's timetable for EU reform?

As Open Europe Director Mats Persson notes over on his Telegraph blog, in his speech today, Cameron has set himself a concrete timetable, despite the fact that timetables in Europe are notoriously difficult to control. A treaty change discussion could drag on for years. Here we look at how a few examples of how slowly or quickly it takes to reach a decision in Europe.

Basically, EU treaty changes or fundamental reform can take an enormous amount of time - or it can happen in months. It's all a matter of political expediency - and how bad Europe needs it / wants it. The single EU patent, for example, took 37 years to negotiate. Setting up a €440bn bailout fund took 12 hours (though it was followed by a year of bickering over what they actually had agreed).

So here are some examples. Those who say Cameron is stuffed, could point to:

Single EU patent – 37 years 
The Convention for the European Patent for the common market was signed at Luxembourg on December 15, 1975, by the 9 member states of the European Economic Community at that time. However the CPC never entered into force as it was not ratified by enough countries. It took until last December for a an agreement on the creation of a single patent system across 25 member states.

Fisheries reform – 21 years and counting 
In 1992, it was determined that there had been over-investment in vessels, overfishing and that numbers of fish landed were decreasing, and that reforms were needed to address these issues. Completing the reform of the Common Fisheries Policy (CFP) by the end of June 2013, in a single reading if possible, is the goal of the current Irish EU Presidency.

UK Rebate – 10 years 
In 1974/75 the Wilson Government sought to resolve the UK contribution question - which was the highest in net terms - during the “renegotiation” of the UK’s terms of accession which it had promised in its October 1974 election manifesto. The UK did achieve a new corrective mechanism but the revised formula (which placed more emphasis on national wealth when calculating our contribution) in practice produced no real benefit to Britain. In 1984, Margaret Thatcher secured the UK rebate in its current form.

European Constitution/Lisbon Treaty – 8 years 
The drafting for European Constitution was initiated by a declaration annexed to the Treaty of Nice in 2001, and the draft Constitution was signed on 29 October 2004 by representatives of the then 25 member states. Following the ‘no’ votes in the French and Dutch referendums, negotiations over the Lisbon Treaty began in 2007 and the new Treaty was ratified in 2009.

...but those who say that, given the enormous stakes, Cameron actually achieve something substantial, could point to:

Limited treaty change to establish new eurozone bailout fund – 5 months 
On October 29 2010, following pressure from German Chancellor Angela Merkel, EU prime ministers and presidents backed "a limited treaty change" to deliver tighter fiscal discipline and allow for the creation of a permanent bail-out fund for members of the eurozone. On March 25 2011, the European Council agreed to amend Article 136 of the Treaty on the Functioning of the European Union with regard to a stability mechanism for Member States whose currency is the euro.

Setting up a new €440bn eurozone bailout fund - 12 hours
On May 9 2010, following 12 hours of talks in Brussels, EU financed ministers agreed to establish the EFSF, a temporary bailout fund composed of government-backed loan guarantees and bilateral loans worth up to €440bn provided by eurozone members.

In EU politics, when you hear someone giving you an easy answer, it's probably the wrong answer...

A big leap towards banking union - and a victory for the UK?

Leaving aside whether David Cameron actually is right to actively back and call for an EU banking union (and our views on that should be well known), Britain did just score a diplomatic victory in Europe, securing safeguards similar to those we have previously proposed. It has also established a very important principle in the battle against "not in the euro but run by the euro" scenario.

In the early hours of this morning, EU finance ministers reached a technical agreement on the plans for a single financial supervisor under the ECB.

This deal is pretty big, as it links to a number of key questions surrounding the future of the eurozone, including whether the permanent bailout fund (the ESM) can directly recapitalise banks. It was always going to have important implications for the UK, given the threat of eurozone caucusing - the 17 writing the rules for the 27 - in the European Banking Authority (EBA) and changes to EU financial regulation (as we discussed here).

The details on the deal are still emerging and we'll look at the ECB-side later (our assessment from last night still stands). But the Chancellor George Osborne stressed that the UK (along with Sweden and the Czech Republic who also decided not to join) got a “very good deal” and that the “single market was protected”. He would, wouldn't he, so what deal did the UK actually secure and how good is it?

Double simple majority within QMV – This means technical rules at the EBA will (as before) need to be approved under QMV. Additionally, within this vote, there must be a simple majority of ‘ins’ and a majority of ‘outs’. So say that no non-eurozone country will join the banking union (which is very unlikely), this means the UK along with 4 other ‘outs’ can block any regulations which they do not support.

Revised voting rules once there are only four countries left: For the UK, there's one potential weakness, if the number of 'outs' gets below 4 then the rules will need to be reviewed - and could be completely rewritten. Currently only three countries have explicitly said they won't join: the UK, Sweden and the Czech Republic. If all remaining countries decide to join, then these rules could need to be changed almost immediately. Here's a concern: the EBA regulation is decided by QMV, the ECB regulation by unanimity. Once the UK has agreed to the ECB regulation, it loses much of its leverage. The concern is that at a later date, the double majority principle is watered down using QMV, meaning that the UK gets stuffed anyway. Also, remember, MEPs must also approve this deal. Any changes made by the EP would also be subject to QMV approval. However, as a further guarantee, there seems to a provision making clear that the revised voting modalities will need political approval at the European Council (where unanimity applies). This is not a legal protection but a political one, so not completely watertight but clearly a useful addition.

Non-discriminatory clause – The separate proposal giving the ECB supervisory powers (see Article 1 here) also includes a provision meant to commit the ECB to not discriminate within financial regulation against a single or a group of countries. 

 So a big question remains:

Who are the ‘ins’ and who are the ‘outs’? Currently the UK, Sweden and the Czech Republic have said they definitely will not join the single supervisor, while all eurozone countries are obliged to. The other non-euro countries have suggested they will have a ‘close cooperation’ deal with the single supervisor (expect for Denmark) – this basically makes them count as ‘in’. For the UK point of view, 5 non-participants seem the ideal number as it will be much easier to block unwanted regulations, while 4 could trigger the review referred to above.

Will Croatia be an ‘in’ or ‘out’? This could alter the necessary majorities in EBA. 

On current count, this is a pretty good deal for the UK and it does establish that principle that the eurozone cannot run over none-eurozone countries.

Economic realities push Europe closer to a Greek decision

We have a piece in City AM today, which look's  at the impact of this week's crucial votes in Greece, see below for the piece in full:

One down, one to go. The Greek government has got through one crucial vote this week and looks likely to ride out the budget vote on Sunday. Although markets and eurozone leaders will breathe a sigh of relief as Greece makes it through another crucial week in its economic crisis, the government has not been left unscathed.

Pushing through the latest, and supposedly last, package of stringent economic reforms and budget cuts has exposed deep cracks within the governing coalition, as the Democratic Left and Pasok parties put up a fight to slow the process of public sector cuts led by Prime Minister Antonis Samaras’ New Democracy party. It took two days to push the package through parliament, while a reported 100,000 Greeks took to the streets in Athens to protest against austerity, once more leading to violent clashes with police.

However, a bigger problem for the government is the flurry of economic figures which have again exposed deeper flaws in the Greek economy, propelling talk of a Greek exit from the eurozone back into the headlines. The new budget projects Greek debt peaking at 192% of GDP, rather than the 167% estimated previously, but even this revision seems to be built on optimistic assumptions. Unemployment, investment and exports are all projected to stabilise, despite most indicators predicting the opposite. In fact it is now abundantly clear that Greece will need an extension to its current bailout.

The questions to ask then are: how much would such an extension cost and how could it be funded? We estimate that slowing the Greek fiscal consolidation programme by two years could cost an extra €28.5bn (rising to €39bn if Greece fails to borrow from the markets – something which looks increasingly likely). The main options being proposed include: reducing the interest rates which Greece pays on its current bailout loans (which could raise around €3bn over two years) or putting a hold on interest payments for a few years (which could raise €10bn+, but would be much trickier legally). These options would likely be combined with some further austerity and increased short term debt issuance by Greece – both of which could actually increase Greek debt levels, not exactly what is needed. The kicker is that even this is unlikely to be enough.

The question of an extension then, drives home that a larger decision on Greece’s position in the eurozone is closing in on EU leaders. Even talk of using bailout loans to buy back Greek debt at a discount and then retire it, to provide extra funding, would require a big political decision on further loans to Greece. However the funding is found, it will likely involve breaking a taboo – either by the ECB (in terms of helping to fund states) or more likely by eurozone countries in allowing permanent transfers to a country whose future funding is far from assured.

The Greek government and the eurozone will make it through this week but this short-term success is likely to belie the massive decisions ahead.

A big week for Greece - but still few answers

As we noted in our press summary today, this week is lining up to be another big one for Greece.

The Greek government faces two crucial votes in parliament – first on Wednesday to push through the latest package of structural reforms (as demanded by the EU/IMF/ECB) troika and second on Sunday to approve the latest and, according to Greek PM Antonis Samaras, the last austerity budget for next year.

Since the governing coalition was formed after the second summer elections, such votes have usually passed without much fanfare. However, this time around the Democratic Left (which holds 16 seats in parliament) has said it will not vote with the its coalition partners. Pasok (which holds 31 seats) is also facing a period of internal strife with one MP already leaving and up to five others threatening to at least vote against the government. New Democracy (127 seats) should have an easier job pulling its MPs together.

The votes should pass but the margin for error is tiny, possibly only two or three votes, notably provoking unrest amongst financial markets and other eurozone leaders. In the end, given that the end of the government would very possibly signal the end of Greece as eurozone member, the (perceived) fear factor is likely to be enough to once again push the vote through.

This clears the way for the release of the next €31.5bn tranche of bailout funds and a potential two year extension to the Greek bailout. Today’s FT notes that the extra funding for the extension is likely to come from an increase in short term debt issuance by Greece and possibly a reduction in interest rates on eurozone loans to Greece – exactly as Open Europe predicted in its recent flash analysis on the issue.

The FT article also includes a potential plan for the ECB to return profits from its purchases of Greek bonds to Greece via eurozone governments to avoid the thorny issue of the central bank directly financing a state. This sounds plausible on the surface since the returning of profits to national governments should happen naturally anyway under the ECB rules. The only issue being that this can only happen overtime as the profits accrue as the bonds are paid off, so its unlikely to be paid out in a single chunk at one time (as is needed here).

One final point on the cost of the extension. We put it at around €28.5bn, although estimates range from €15bn to €40bn. We didn’t include a delay in Greece’s return to borrowing from the markets, which is looking increasingly likely. If Greece doesn’t return to borrowing until after 2016 it could add a further €10.6bn to the cost of an extension.

So although this is a big week for Greece, even a clear government win in both votes will do little to answer questions over Greece’s future in the eurozone.

Another disastrous budget for Greece

This week saw the release of the Greek budget plan for 2013-2016 and it did not make for happy reading. The English version is yet to be released but below we reproduce some of the key facts and figures from the Greek report. The table below essentially sums up the report and the crushing blow it delivers to hopes of a Greek recovery:

Debt peaking at a 192% of GDP in 2014! Astonishing given that less than six months ago the EU/IMF/ECB Troika seemed supremely confident that Greek GDP could stabilise at 120% of GDP by 2020 and would peak in 2013 at only 167% of GDP. (It’s also worth checking out this FT Alphaville post which highlights just how wrong some of the previous estimates were).

It’s easy to say that Greece failed to fully implement reforms and adhere to the bailout conditions (which it did) but at some point the failure of policies themselves and the fudging of the numbers must be admitted.

To many of us all of this was already abundantly clear but the release of the official figures confirming it at least ensures that the political debate will need to be moved on – expect ‘Grexit’ discussions to return to the headlines with a vengeance.

There are also a few interesting nuggets in the budget which suggest to us that further revisions may be likely:

• Firstly, unemployment is expected to go from 22.4% this year to 22.8% next year and then decline to 17.1% in 2016. It’s hard to see how this can happen with both government and private spending expected to fall over this period, while there will also be plenty of labour market reforms which tend to increase unemployment, at least in the short term. 
• Despite dropping by 15% this year, investments are expected to fall by only 3.7% next year and then return to growth. Again this seems massively optimistic without a permanent fiscal transfer supporting Greece and remove the cloud of a Grexit which continues to deter investors. 
• Exports are expected to grow at an increasing rate over the next five years, despite the eurozone and the global economy potentially posting low levels of growth. 
• Private consumption is expected to fall by 7% next year (after 7.7% this year), and yet this is expected to be consistent with a 4.5% contraction in GDP rather than a 6.5% one seen this year. Combined with falling government spending and structural reform this is again hard to imagine. 
• Table 2.5 highlights what could happen if Greece does not implement its medium term fiscal strategy (aka. its austerity packages and structural reforms), putting debt at 220% of GDP in 2016. This highlights how easily the levels could once again veer off track if many of these unrealistic targets are not met. 

As we mentioned in our recent note, a two year extension will be far from enough for Greece and this budget further reinforces that fact. With it now out in the open, discussions over the next few weeks should focus on more than just Greece’s next two years, but the fundamental decision of whether Greece belongs in the euro.

About that Spanish bad bank...

The Bank of Spain has just made an announcement regarding the country’s bad bank plan which fleshes out more details of the proposals following the recent consultation period. The press release and presentation are here and here, respectively.

Key points:

• The bad bank (known as Sareb) will be a for profit company (expecting a 'conservative' return on equity of 15%), majority owned by private investors (read other Spanish financial institutions) with a minority government stake. It will have 8% capital. 
• Its duration will be up to 15 years. 
• A transfer of up to €90bn of assets will take place in two stages. Stage 1 will see around €45bn in assets transferred from the most troubled (already nationalised) banks. Other banks will transfer assets in a secondary stage. (See picture below for the timetable). 

•  The valuation of assets will work from the baseline scenario of the Oliver Wyman stress tests (which we analysed here). It will be adjusted for the ‘costs’ of transferring the assets to Sareb. (See below for a breakdown of rough valuations). 

More details are still to come but here are some of our initial thoughts:

- One phrase that caught our eye was this: “The transfer price is not a reference for the valuation of non-transferred bank assets.” According to whom? Surely just asserting that this is not reference for the valuation of assets means nothing unless the market agrees? As we saw with NAMA, the market will still price broader assets of the prices used in the transfer, hence long standing market distortions in Ireland.

- The delayed/staggered nature of the transfer of assets could create a two tier market for similar assets, since the ones valued in the bad bank will be valued much lower than those kept on by the viable banks. This could hamper the viable banks attempts to sell off assets at reasonable values.

- The write downs, although substantial, still seem lacking in areas (not least due to the flaws in the OW baseline stress test scenario). For example, assuming foreclosed land will be worth 20% of previous value may seem substantial, but when there is an real estate oversupply which could take a decade to unwind the prospect of this land being worth anything soon seems unlikely.

- The timeline looks positive with significant progress expected in the near future, however, the full transfer of all assets to Sareb could run well into middle 2013. This delay could drag out the issue and further distort the price discovery in the Spanish real estate market. Also as Zerohedge points out, this timeline may be fine in a vacuum but with everything else going on in Greece, problems could escalate quicker than expected.

- As we’ve noted before, although the private investment is positive, it looks likely to come from mostly other Spanish institutions. This furthers the ‘nationalisation’ of banking sectors and intertwines the problem banks with the healthy banks. 

- The plan seems to be, since the institution is not a majority owned by the government, that it will not appear in general government liabilities. It's not clear whether this will pass muster with Eurostat, or how any losses/transfers from the public sector will impact government finances.

Overall then, a bit of a mixed bag. Some positive plans and it’s good that the plan is progressing (if a bit later than desired) but still plenty of potential pitfalls.

Revising the Greek bailout: Two more years of extend and pretend?

Open Europe published a new flash analysis on Friday, which looks at the prospects of a revision to the Greek bailout. It now looks almost certain that Greece will receive a two year extension to its fiscal consolidation and reform programme. However, questions remain over how much it will cost and how it will be funded. Open Europe estimates that the extension would cost a minimum of €28.5bn, if Greece meets all its targets. Meanwhile, none of the options for providing the funding looks politically or economically palatable.

The €28.5bn comes from: an extra €14bn due to slower deficit reduction, an extra €12bn from reducded privatisation receipts and an further €2.5bn from increased government arrears (unpaid bills).

We examine six key options for filling this gap:

1. A reduction in interest rates - which looks very likely but could only deliver €2bn - €3bn.

2. Increased short term debt issuance and more austerity - this looks possible and could deliver anywhere between €15bn - €20bn.

3. Extending length of loans to Greece - unlikely, it could raise €9.1bn in the short term, but on net it would give zero reduction.

4. ECB forgoing interest and/or profit on its Greek bonds - looks very unlikely, but could yield €1.15bn - €2.3bn (interest rate cut) and/or €14.25bn (forgoing profit).

5. Bond buybacks - again very unlikely, but it would mark a much larger step than simply covering the funding gap, as it could deliver €45.65bn overall and €17.15bn after the two year extension is paid for.

6. Write-down original eurozone bilateral loans -  this would be a huge step and could provide €26bn to €52bn but looks very unlikely to be approved, especially as it would support in national parliaments. 

Overall then, its hard to see how the gap will be filled without some larger decision being taken over the future of Greece in the eurozone. To read the full note, click here.

Banking union: moving forward or standing still?

Media reports on the outcome of eurozone summit discussions last night are mixed, but there is general theme that eurozone leaders have taken ‘a step closer to banking union’. Looking at the latest conclusions  (see here),we wouldn't quite describe it as a step closer - at least not a big step.

·         The timetable (which everyone admittedly knew was unrealistic) has been delayed. Previously the eurozone was insistent on the single supervisor being up and running by the start of 2013, now it is some point during 2013 (with strong suggestions that this will be after the autumn German elections).

·         There is discussion on including / accommodating non-euro members but no detail on how this will be done (particularly in reference to Sweden, Poland but also the UK) or how the recently publicised legal concerns within the Commission will be dealt with. There is expected to be a substantial amount of progress on tricky legal and political issues before the end of the year.

·         The one point of agreement was that the ECB will supervise all 6,000 eurozone banks, seemingly a positive step on the surface. However, in a concession to Germany, it was also established that much of the day to day running of the supervision of smaller regional banks would still be conducted by national financial supervisors. This raises further difficult questions about the already poorly defined relationship between the ECB and national supervisors.

·         The leaders simply reaffirmed that the ESM, the eurozone’s bailout fund, would be able to recapitalise banks directly once the single supervisor is in place – but this was never in doubt. The real question over whether the ESM can retrospectively take on the burden on bank recapitalisations, relieving ailing governments of the problem, was left unanswered with little discussion.

·         There was another call for the harmonisation of deposit and resolution schemes across the eurozone – an issue which has already been delayed by two years due to political posturing. More importantly, talk of a combined backstop and resolution mechanism for the banking union was kicked into the long grass. As we said before, that element of banking union is, at best, years away.

·         Lastly, we still find it hard to see how the EU can hold a meeting and not find time to discuss Spain or Greece in detail, given that their problems are the most immediate concern.

So more standing still or treading water. Again this reinforces the fear that, as soon as the financial and economic climate looks slightly more positive, any hope of progress on the tough decisions goes out the window.To be fair though, as Swedish PM Fredrik Reinfeldt likes to say, the most important thing is to get it right.

A virtual Spanish bailout?

In case you’re wondering, we not talking about a bailout on Facebook or the like.

No, we’re referring to the quite strange comments by a Spanish finance ministry official reported in the press this morning. The official reportedly stated that Spain does not see a bailout request as imminent or immediately necessary but would be comfortable making the request for a precautionary credit line in order to potentially access the ECB’s new Outright Monetary Transaction (OMT) programme. All par for the course you would say, but the comments that really caught our eye were the following, via the FT and the WSJ:

"The credit line is not fundamental, it is circumstantial…One could say it's a virtual credit line,” adding that Spain will likely not access any of the money from the ESM, while the ECB may not even have to buy any bonds. 

Let us elaborate, because this seems to amount to a bailout without any money. Essentially, the suggestion is that Spain would sign a new Memorandum of Understanding (MoU), which wouldn’t include any new reforms or conditions, allowing it access to ESM money if it ever became necessary. This would supposedly satisfy the OMT requirements allowing the ECB to intervene in the secondary market for Spanish bonds if borrowing costs for Spain once more reach unsustainable levels.

A very neat idea in theory, as with most eurozone proposals, but we have a few concerns:

• We can’t imagine the ECB or Germany would go for it. Both would likely request stricter reforms and conditions (probably rightly, as we noted recently Spanish labour market reform has some way to go), particulary since it would need approval from the Bundestag. 
• More importantly, this may fail the ECB’s conditionality requirement. Although, details on the OMT are thin on the ground, the conditionality needs to be enforceable. The conditionality comes from a MoU which is tied to the ESM financial aid. Therefore if the ESM aid is not actually being accessed the conditionality is instantly voided since it cannot be enforced by withdrawing funding (since the funding is non-existent). 
• A strange situation could arise where the ECB is then buying bonds without the ESM lending money, while no new conditions have been enforced. We’ve warned of the moral hazard and other negative impacts of this at length before. 
• If the ESM is not lending to Spain but the ECB is buying its bonds surely the MoU and conditions essentially become a direct agreement between the ECB and Spain, putting pay to the view that these actions relate to monetary policy and maintain the independence of the ECB. 
• As the ESM guidelines on precautionary loans note, they are only available to countries where there are no “bank solvency problems that would pose systemic threats to the stability of the euro area banking system.” We’re sure this will be fudged, with the eurozone suggesting the bank bailout solves any remaining provlems, although we’d maintain that €40bn is far from enough to solve the problem.
• This is not to mention that Spain has huge funding needs and will in fact need real cash injections at some point, meaning the threat of intervention will surely not be enough to hold Spain over. 

We’ll end with an interesting, if somewhat mixed, analogy from the Spanish official:

“One does not just normally drop an atomic bomb. It has to be co-ordinated and discussed. But we [Europe] are all in the same boat.” 

Quite. As we’ve previously warned the OMT and Spanish bailout needs to be carefully structured, unfortunately a 'virtual bailout' is unlikely to do the trick.

EU Summit: Everyone is a winner... for now

As is traditional, a leaked copy of the next EU Summit Conclusions has already been making its way around the media long before the summit has even commenced (due on 17-18 October).

As it is still an early draft, little can be drawn from these 'conlcusions' but so far the officials charged with drawing them up seem to have dropped in something for everyone:

France, has received a mention of an EU Financial Transaction Tax despite, as we reported yesterday morning, it still being far short of the nine states needed for the project to get off the ground.

Germany, has received an assurance that there will remain a "clear separation" between the ECB's monetary policy and its new supervisory functions - another clear hat tip to Bundesbank demands that price stability (inflation) remains the ECB's primary focus.

The UK and other non-euro states, have recieved an assurance that there will be a "level-playing field" (an English expression) in the new supervisory structures under the proposed eurozone banking union and that the "integrity of the single market" will be preserved for financial services.

The UK has also managed to insert a phrase regarding the "voting modalities" in the European Banking Authority, which the document suggests will be looked at to ensure non-eurozone countries will not be prejudiced by a Eurozone caucus.

The MEPs, often an obstacle when it comes to financial regulation, have been promised that the ECB will have "appropriate accountability" in its newly widened role. This is unlikely to placate their desire for new powers but might buy some peace.

Spain, has received wording designed to calm its bond market by raising the prospect of ESM direct bank recapitalisation including 'legacy assets' (i.e. bank bailouts which have already taken place being shifted onto the ESM books). The draft wording calls on the Eurogroup (read Germany, Finland and the Netherlands) to "agree on the exact operational criteria that will guide bank recapitalisation by the ESM in full respect of the 29 June Euro Area Statement". This could still go either way, but Commission President Jose Manuel Barroso has made it clear that he wants Germany to stick to the plan as was originally envisioned/interpreted.

This is, of course, all well and good, but we find it hard to imagine that the final conclusions will be able to maintain what everyone wants. There are likely to be some fights along the way (not least over the last point), lets hope the UK Government is ready to ensure its needs remain included.

Some preliminary thoughts on the stress tests for Spanish banks: lots of optimistic assumptions...

Here is the full report (and the bank-by-bank results) from the latest Spanish bank stress test exercise. Below we provide the key points and our initial thoughts on them.

The tests put the total capital needs of Spanish banks at €59.3bn, but Spanish Deputy Finance Minister Fernando Jiménez Latorre (in the picture) just told journalists during the press conference that, assuming that Spanish banks manage to raise part of the money from other sources, the Spanish government could ask the EFSF for "around €40bn" (as we anticipated here).

Key points: 

• 14 banks assessed, 7 found to be well capitalised, 7 found to need capital injection. Total needs put at €59.3bn. This falls to €53.75bn when the mergers under way and the tax effects are considered;

• €24.7bn of the total amount is earmarked for Bankia alone, with a further €10.8bn for CatalunyaCaixa and €7.2bn for NovaGalicia;

• The adverse economic scenario assessed was: 6.5% cumulative GDP drop, unemployment reaching 27.2% and additional drops in house and land price indices of 25% and 60% respectively, for the three-year period from 2012 to 2014;

• Cumulative credit losses for the in-scope domestic back book of lending assets are approximately €270bn for the adverse (stress) scenario, of which €265bn correspond to the existing book. This compares with cumulative credit losses amounting to approximately €183bn under the base scenario.

Open Europe take: 

• The base case scenario seems overly optimistic, the adverse scenario looks more realistic - although we expect a fall in house prices of around 35% rather than the 25% assumed. The prediction that unemployment will peak at 27.2% also seems optimistic given that there is plenty more austerity and internal devaluation to come while the structural labour market reforms are yet to take effect.

• Oliver Wyman's report strongly assumes that all the previous capital buffers and loan loss provisions have been well implemented with suitable quality of assets. However, this is far from assured;

• The level of non-performing mortgage loans seems incredibly low at 3.3% currently with losses only predicted to rise to 4.1% under the adverse scenario. This number could well be distorted by forbearance (delaying foreclosing on loans likely to default to avoid taking losses) by struggling banks. It will also massively increase if unemployment and economic growth turn out to be worse than predicted;

• The levels of recovery on foreclosed assets seem a bit too positive (admittedly a wide range of between 37% - 79% losses depending on type of asset) given the continuing oversupply in the real estate market in Spain. Until the market has fully adjusted, the huge mismatch between supply and demand is likely to keep resale value on foreclosed assets incredibly low;

• These tests do look to be more intense than the previous ones but ultimately the optimistic assumptions do instantly raise questions over their credibility. The structure of the bailout request is also unlikely to enamour investors, who like to see grand gestures, however, it always positive that taxpayer participation may be limited. 

 

Meanwhile, in the Far North

One of the consequences of the eurozone crisis is that media, pundits and market analysts have been forced to become experts of what previously would have been seen as the most obscure political events. Thus, the Finnish local elections now have international significance (although they are still not making any headlines) as they serve as a barometer for the extent to which "Europe" as an election issue can trickle through to the local level. The theory being that the closer the issue gets to citizens, the harder for EU leaders to sell more integration.

An opinion poll for Finnish public broadcaster Yle puts the anti-bailout (True) Finns party at 17.2% - three times higher than in local election in 2008. Compared to 2008, all parties except for the Green party and the (True) Finns party would lose voters.

With a majority of voters from all Finnish parties - apart from the small Swedish People's Party - seemingly opposing more eurozone bailouts, expect Finland to remain assertive. Starting with the rumoured leveraging of the ESM.