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About a month ago I blogged on the German Constitutional Courts decision not to block the European Stability Mechanism (ESM), and since then investors and the markets have responded positively. However, as has so often happened in this euro crisis, clearing one hurdle doesnt always remove others. As things stand, there are some uncertainties about the real power of the ESM, including how and when it will be called into action.
Concerns about Spain
To start with, the main creditor countries led by Germany dont want the ESM to channel funds directly into troubled banks, notably in Spain. This was broadly agreed to at the EU June summit, because it would raise the debt burden on their governments. As such, the ESM could probably start lending money to the Spanish government so it can recapitalize its banks on its own account. The EU lent Spain up to ?100 billion back in June, but another ?40 billion or so will be needed to fix its banking sector, or about 4% of its GDP, according to a recently released independent audit.
The so-called “hawks” may be trying to unwind what is probably the most remarkable point agreed upon at the June summit the creation of a banking union. This would require a euro-wide resolution system to restructure or wind up failed banks, as well as a euro-zone deposit guarantee scheme. However, the German government is raising several objections and the other members may use the next summit to push it back to the outcome of the June summit.
A More Flexible Decision-Making System
There are questions about the ESMs ability to provide an enhanced firewall against market turbulence. However, it provides more operating room than the earlier-enacted European Financial Stability Facility (EFSF) program. Its decision-making system is more flexible. Action can be taken in an emergency with a qualified majority rather than unanimity (but the largest euro members Germany, France and Italy could block any decision). Moreover, doubts about the quantity of “ammunition” available, most notably to protect large countries such as Spain and Italy, may have been allayed insofar as ECBs latest bond-buying plan, the Outright Monetary Transaction (OMT), will buy up the debt of troubled countries for those that ask.
There are a lot of politics and elections to go before the ESM starts operations
Spains application should come first in our view. We expect its government to apply by the end of November once local elections in the Prime Ministers home region are held on October 21. It is getting ready for that occurrence, as it brought the 2013 budget to Parliament, which aims to cut the deficit from 6.3% to 4.5% of GDP. Italys technocratic government has taken several steps to impose fiscal austerity and pursue long-overdue economic reforms in spite of a few setbacks in the process. We believe that a formal request by Italy for aid is not needed, although we still hold the view that drafting a memorandum of understanding with the EU may meet a favorable response in financial markets, as it would put constraints on future governments electoral manifestos and policy actions.
We maintain that the latest central bank actions may keep markets relatively quiet up to a point. A worsening scenario outside the EMU should not be ruled out, notably renewed concerns over a hard landing in China making the outlook for Europe fragile again.