Dutch contortions on budget highlight potential limits of eurozone rules

Jeroen Dijsselbloem (L) and Olli Rehn (R)

The Netherlands, Germany's most prominent triple A ally, has been through a bout of political upheaval in recent weeks, which could have brought down the government. The troubled coalition of the centre-right VVD and centre-left PvdA was struggling to find a majority in the Dutch Senate for its 2014 budget, which aims to comply with the EU's deficit rules.

After several months of discussions with opposition parties the government narrowly managed to convince three opposition parties last Friday to support measures for the 2014 budget: the left-liberal D66 and two small Christian parties: the Christian Union and the SGP.

European Commissioner Olli Rehn's conflicting statements on the issue illustrate how the Commission now must attempt to cajole the member states into line. He suggested in June that the Netherlands should ideally aim for a 2.8% deficit, with Finance Minister (and Eurogroup Chairman) Jeroen Dijsselbloem responding that the 3% EU deficit target was already difficult enough. This week Rehn praised the Netherlands for reaching a deal on a 3.3% deficit in 2014, even saying that the US should follow the example and "go Dutch". By the way, the government's own economic advisory agency, the CPB, thinks the real deficit will be 3.5%.

Martin Visser, the finance editor of the Netherlands' most-read daily De Telegraaf commented that:

"Even before all the calculations are made, Rehn provides a political judgment instead of a purely economic one."

When push comes to shove, the European Commission is always liable to grant a bit more wiggle room to national governments - illustrating the difficult in enforcing the EU's souped-up budget rules. This week German Finance Minister Wolfgang Schäuble criticised Rehn’s decision to exempt large scale public investments from calculations of member states’ structural deficits, describing it as a “re-interpretation of criteria”. What constitutes a 'structural deficit' is, of course, always open to debate and therefore finessing.

On a side note, Dijsselbloem's role as Eurogruop chair is undoubtedly getting tougher. Telling other eurozone member states to get their house in order when your own country has been in the EU's "excessive deficit procedure" since 2009 must be increasingly difficult.

So, after a whole range of eurozone reforms (think Fiscal Pact, six-pack, two-pack etc) the lesson seems to be that legal rules just won't trump politics.

Plus ça change...

Athens strikes another bargain in Brussels, but how long will this one last?

As we noted last week on CNBC, a deal was always likely this time round in Greece:

"We've got German elections coming up in September and no one wants to have that talk of how we're going to fund Greece for the next three or four years. So they just want to kick the can down the road until after the elections…They will come to some agreement but it's clear that Greece is well behind track on its programme once again and it's only a matter of time before a new funding gap opens there."

One was eventually reached yesterday morning with details filtering out overnight.

How much will be disbursed and when?

• The eurozone will provide €2.5bn this month and €500m in October, while eurozone central banks will provide €1.5bn and €500m at the same time by releasing profits from their holdings of Greek government bonds. This should give Greece enough cash to cover costs and payoff the €2.2bn of government debt maturing in August.
• The IMF will hold a meeting later this month where it is expected to agree to release its next €1.8bn share of the bailout.
• The staggered pay-out of this €6.8bn will allow the eurozone to enforce more conditionality, meaning it could delay the future tranches if Greece does not stick to its reform programme.
• Once this round of funding is complete, Greece will have received around €208bn out of a total €246bn committed.

What does Greece need to do?

• The bargain comes with strict conditions on Greece (as always), particularly in terms of civil servant cuts on which Greece seems to have fallen far behind. Greece must put 12,500 civil servants in the labour mobility scheme within the next few weeks (where they receive reduced pay and are sacked within a year if they do not find a new position).
• This must be doubled by the end of the year, while 15,000 must be laid off by the end of 2014.
• Greece must also work to step up reform of the tax system, tackling evasion and improving collection of back taxes. This is obviously easier said than done and has been a target from the beginning, no details yet as to how this time round will be any different.
• Must close the funding gap in the healthcare provider EOPYY which totals around €1bn. Again no details as to how and when exactly this will be closed.

Unanswered questions

• On top of the ones hinted at above, the key unanswered question remains, how will Greece fund itself once the bailout runs out? The eurozone has already further committed to €11bn in aid (unlikely to be in the form of direct funds) in 2014 and 2015 although it is yet to identify where this will come from. Eurogroup head Jeroen Dijsselbloem dismissed such concerns saying, "If there is a financing gap it will be at the end of 2014, which will allow us plenty of time to deal with it," which provides little comfort given the delays in dealing with other eurozone problems.
• Can the government actually push through all these measures with its slim majority? We expect it will probably be able to (just), but it will be the first real test for the new coalition and will provide a good bellwether of how it will fair in the coming months.
• What is happening to the closed state broadcaster ERT? This remains unclear. This is important not just for political reasons (still has the potential to expose divisions in the coalition) but also since the 2,600 employees could provide a big boost towards meeting the targets for civil servant cuts (the real reason behind the closure in the first place we suspect).
• Another key aspect of the recent funding gap was the reluctance of national central banks to rollover their holdings of Greek bonds (thereby reducing the amount Greece has to pay off). It’s not clear whether this has been done or will be done, although comments from officials this morning suggest it may not yet be finalised.

Another bargain very much along the usual lines of cash-for-reforms. Questions over Greece still loom large, it is not clear that they will be able to push through these public sector reforms having failed many times before. Given the lukewarm comments from the Troika it seems that even they expect another funding gap to open soon. Meanwhile as the end of the bailout approaches the fundamental issue which the eurozone has been avoiding for some time – how to fund Greece for the next decade – will need to be dealt with.

Coalition row over public broadcaster gets nastier by the day in Greece

Ten days ago, we wrote a blog asking, "Will the closure of the public broadcaster set the scene for a coalition showdown in Greece?" Yes, it has. And it's looking nastier by the day.

Greek coalition leaders met for the third time this week yesterday, but failed once again to strike a deal on the future of the country's public broadcaster ERT. This despite Prime Minister Antonis Samaras offering to re-hire as many as 2,000 old employees to resume broadcasting. Democratic Left, one of Samaras's junior coalition partners, could pull out of government as early as today.

This would leave the government with a wafer-thin majority of 153 seats out of 300 in the Greek parliament, although Samaras could try to win support from some of the 14 non-attached MPs on a case-by-case basis. Not ideal only one year after the coalition was formed, although it could avoid the prospect of snap elections.

Democratic Left MPs are currently in talks with the party's leader, Fotis Kouvelis, to make a decision. An announcement is expected shortly.

How did the problems escalate to this point?

Although the closure of ERT instantly flared up coalition tensions, it does seem surprising that the Prime Minister's party New Democracy (ND) has allowed it to get to this point - where a coalition split is a real possibility. On the surface, it seems it would be simpler for ND to give in and re-open ERT at least temporarily (that is after all what even the Greek Council of State suggested). However, this misses the confluence of problems which the Greek government is currently facing:

• The government is falling well behind on the sacking of civil servants and the necessary savings this delivers. It has agreed to dismiss 4,000 public sector workers by the end of this year and put a further 25,000 into the labour reserve (where they receive a reduced salary). Closing ERT instantly delivers up to 2,600 layoffs - though part of old ERT employees would presumably be hired once the revamped broadcaster is created. The EU/IMF/ECB Troika is ramping up the pressure for clear evidence that these promises will be fulfilled.

• The privatisations programme, due to raise €2.6bn this year, is clearly off track. This is mostly due to the failure to sell the natural gas monopoly DEPA. This funding gap must be filled from within the government's existing budget - and no concrete plans have been put forward so far.

• A further €1bn financing gap has opened up in the National Healthcare Provision Organisation (EOPYY), while the Troika remains unconvinced of plans for a new property tax which was forecast by Greece to boost revenue.

• Furthermore, the IMF could suspend the payout of the next tranche of Greek bailout funds due next month unless eurozone leaders plug a €3bn-€4bn shortfall in the country's rescue package. Compared to the internal funding gaps above, this is an external one which has arisen due to euro area national central banks refusing to roll over their holdings of Greek bonds as had been agreed under the last revision of the Greek bailout (as we reported in yesterday's press summary). Eurogroup Chairman Jeroen Dijsselbloem moved quickly to deny the reports, adding that "the [Greek] programme is fully financed for at least another year."

Therefore, the sum of these factors has escalated the ERT issue into one which could potentially undermine the coalition. The opening up of a new financing gap is hardly surprising, and is actually something we predicted at the start of this year.

As noted above, if the Democratic Left exited the coalition, the Greek government would still hold a majority in parliament, albeit a wafer thin one. Support from the Democratic Left on certain issues could be expected, but would of course no longer be guaranteed.

The Greek government is likely to face some very tough decisions in the near future. An erosion of its power now could make pushing these decisions through significantly more difficult.

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

You want contagion…I’ll show you contagion…

Everyone, including us, has commented at some point this week about how calmly markets have reacted to the situation in Cyprus.

Cue Dutch Finance Minister Jeroen Dijsselbloem.

From his interview with Reuters:

"What we've done last night is what I call pushing back the risks…If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'… If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

"If we want to have a healthy, sound financial sector, the only way is to say, 'Look, there where you take on the risks, you must deal with them, and if you can't deal with them, then you shouldn't have taken them on’”.

"The consequences may be that it's the end of story, and that is an approach that I think, now that we are out of the heat of the crisis, we should take."

"We should aim at a situation where we will never need to even consider direct recapitalisation…If we have even more instruments in terms of bail-in and how far we can go on bail-in, the need for direct recap will become smaller and smaller.”

"Now we're going down the bail-in track and I'm pretty confident that the markets will see this as a sensible, very concentrated and direct approach instead of a more general approach".

We’ve bolded the key quote. Essentially, he saying the Cyprus deal might be a template for other bank restructurings across the eurozone (although he seems to be trying to row back from this a bit).

Now, we’re not saying we disagree with his points and we certainly agree with the sentiment of his comments – banks should be able to shoulder their own risks and if they can’t they should have plans for winding down and deleveraging. This is why we’ve long argued for things such as living wills for banks.

Let’s be clear, banks should be responsible for their own risks. That said, if you go round telling markets all week that Cyprus is unique and specific and all year that a banking union is on its way with an ESM backed recap fund, they aren’t going to take kindly to abruptly finding out otherwise.

It all just seems a bit strange and a bit clumsy - to put it mildly. Sometimes for better or worse, markets need to be handled with kid gloves.

Contrary to his expectation that markets would see it as “sensible”, they have reacted wildly. Spanish and Italian stock markets have swung into negative territory after being up for the day, led by their banks taking a hammering, figures via @suanzes:

Ibex35: -2,68%. BBVA (3.97%), Bankinter (-4%), CaixaBank (-2,44%), Banco Popular (-4.147%), Sabadell (-3,83), Santander (-3,27%)

As we have said before, we never quite bought that Greece, Cyprus or anyone was entirely unique, though with Greece eurozone leaders definitely could have got away with it.

Where does this leave plans for banking union and eurozone integration? We’re hesitant to say tatters, but it’s not looking great.

What next on the EU bank bonus cap?

Today has been billed as the final chance for UK Chancellor George Osborne to secure a change in the proposal to limit bank bonuses across the EU.

It is true that any change to the broad political agreement (including the level of the ratio limiting bonuses) would probably need to be secured today – a move which looks unlikely. However, as we note in today's press summary, the technical discussions over the specifics will continue for some months, presenting the opportunity to water down the proposal behind the scenes. Numerous issues remain unresolved such as: whether the cap will apply to all staff or just the highest paid, whether it will apply to all banks or only larger ones and, most importantly, whether the EU will stick with the plans to apply it to subsidiaries (both EU ones located elsewhere and foreign ones located in the EU).

So there could yet be room for some improvements to the proposal. There are also two other issues which have cropped up in this discussion: the possibility of the UK invoking the Luxembourg compromise and potential legal challenges against the proposal.

What is the Luxembourg compromise?

See below for a box from p.31 of our ‘Continental Shift’ report (really a worth a read by the way to understand the context of this and related debates) which explains the premise (click to enlarge):

It has been muted that Osborne could trigger this at today’s meeting. This is a last resort and seems unlikely – besides it is not clear how effective it would be in this case, as it is only a gentleman's agreement.

Is the proposal open to legal challenges?

According to the FT, banks have been receiving legal advice and believe they may have a case based on Article 153.5 of the Lisbon Treaty, which says:

“The provisions of this Article shall not apply to pay, the right of association, the right to strike or the right to impose lock-outs.”

Article 153 is in the social policy chapter of the treaties. Currently, the legal base for the rule is as part of CRD IV, i.e. under financial regulation and looking to address financial risk taking. 

The Commission and MEPs have also dismissed claims of illegality, on the grounds that the rules do not limit total pay, but simply set a ratio on variable pay in an attempt to reduce risk taking, and it is not therefore social policy.

It looks likely that there will be some legal challenges, although from the private sector rather than the UK Government.

Buying back Greece: another ad hoc deal or a step towards a solution?

Early on Tuesday morning the eurozone and the IMF reached an agreement which has been widely billed as their most comprehensive package to aid Greece. Now that the dust has settled somewhat, Open Europe has published a new flash analysis assessing the key components of the deal.

For all the talk and all the figures flying around there is still only one that really matters – 124% debt to GDP ratio in 2020, clearly this is not sustainable. Further measures will be needed and the ad hoc nature of this deal, particularly the way it skirts the big decisions, suggests that fears over a ‘Grexit’ will return as soon as Greece begins missing its targets once again.

Although reaching some deal was better than nothing, there are still significant doubts over the deal. The mixture of measures do provide some short term relief but in most cases fail to solve any of Greece's real solvency problems. The policy with the most unanswered questions is probably the most important one - the debt buy back.  A key question is: who actually owns Greek debt now? Below we break down the shares of Greek debt (click to enlarge):

We expect that the only bonds actually eligible for the buyback would be those held by foreign financial institutions (€30bn). However many of these bondholders may be reluctant to take part for a multitude of reasons.

See here for the full analysis.

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.

An intense Eurogroup meeting for Spain

As expected, yesterday's was an intense Eurogroup meeting for Spain, with several key issues on the table. Here's a summary of what happened and what was (or wasn't) decided:

• Eurozone finance ministers reached a "political agreement" over the Spanish bank bailout. The final amount of the rescue package has yet to be nailed down, although Dutch Finance Minister Jan Kees de Jager has suggested that the Spanish government could eventually go for the entire €100 billion pledged by the Eurogroup (which, as we have previously noted, may not be enough);

• For the moment, it has been decided that Spain will receive a first tranche of €30bn by the end of the month. Eurogroup chairman Jean-Claude Juncker told the press that this money would be held as a "contingency in case urgent needs" arise in the near future;

• The money will initially go through Spain's national bank restructuring fund (FROB) and will therefore count as additional public debt. Once the eurozone has its single banking supervisor - not earlier than next year, according to both German Finance Minister Wolfgang Schäuble and ECB Executive Board Member Jörg Asmussen - Spanish banks will be allowed to get funds directly from the eurozone's bailout funds, and the debt will be written off the government's balance sheets;

• The loans will have a maturity of up to 15 years, and 12.5 years on average, Juncker said. Spanish Economy Minister Luis de Guindos (in the picture with Juncker) has suggested that the interest rate "could be even lower" than the 3-4% widely reported in the Spanish media during the past few weeks;

• The conditions attached to the rescue package remain unclear, as the Memorandum of Understanding will only be signed at the next meeting of eurozone finance ministers on 20 July - i.e. after the Spanish bank bailout passes parliamentary votes in Germany, the Netherlands, Finland and others. However, the Spanish press reports that the conditions will almost certainly include tougher capital requirements for Spanish banks and the creation of a big 'bad bank' to house the troubled assets held by the Spanish banking sector;

• Eurozone finance ministers also agreed to give Spain one extra year to bring its deficit below 3% of GDP. The revised deficit targets are: 6.3% of GDP (instead of 5.3%) for 2012, 4.5% of GDP (instead of 3%) for 2013 and 2.8% of GDP in 2014. In return for the extra year, Spain is expected to stick to the recommendations made by the European Commission earlier this year - which include, among other things, a VAT increase and stricter control over regional spending (the latter is much easier said than done, as we noted here);

• Despite the Spanish government consistently stating the opposite, los hombres de negro (the men in black) from the European Commission will indeed travel to Madrid every three months to assess how things are getting on.   

• On a slightly separate note, Spain came out as the big loser in yesterday's assignment of top jobs in the eurozone - possibly unsurprisingly, since it was also holding out its hand for huge amounts of aid. Luxembourg's Yves Mersch has been nominated to replace Spain's José Manuel González-Páramo on the ECB Executive Board – making Spain the only big eurozone economy not to be represented on the six-man Board. Madrid also failed to have its candidate – Treasury official Belén Romana García – appointed as chairman of the ESM, the eurozone’s permanent bailout fund. The post is to be assigned to current EFSF chairman, Germany's Klaus Regling.

Once the Memorandum of Understanding is finalised and made public, it will be possible to make a more thorough assessment. For the moment, once again, markets do not seem to have been impressed by the agreement - the interest rate on Spain's ten-year bonds remains around 6.9% this morning, very close to the 7% threshold widely seen as unsustainable.