The eurozone debt crisis has been raging for almost three years now. During that time countless meetings, plans and decisions have been made, all of which have contributed to a roller coaster ride of optimism and pessimism. In contrast, August has, thus far, been relatively quiet – the calm before the storm perhaps? Indeed, a number of crucial events are expected to take place during the next month so let us take a look at what is in store.
One of the key developments will be the unveiling of plans for a new banking authority to govern the eurozone banking system. The new body, which will fall under the control of the European Central Bank (ECB), will have oversight of the euro-zone's banking system, a function currently carried out by the European Banking Authority which oversees the banking system of the entire European Union. The plans are expected to be revealed by September 11, after which member states will have an opportunity to analyse and make recommendations before taking a final decision at a European summit carded for the end of the year.
Why is this important? The implementation of this new banking authority is a prerequisite for plans to allow the European Stability Mechanism (ESM) to provide support directly to troubled banks. In this way, the debt levels of the sovereign country would not be affected by any recapitalisation of its banks (in other words, the banks will borrow funds on their name). This problem was evident in June 2012 when Spain revealed that its banking sector would need financial support. Any borrowing would have to be done on Spain's name (and therefore add to Spain's existing debt) even though the sovereign was only facilitating the transfer of funding to its banks. Spanish yields (the cost for them to borrow) climbed as a result. If, as the new plans outline, the ESM can provide support directly to the banks themselves, the sovereign itself would not have to incur additional debt and therefore face higher borrowing costs.
Preventing this escalation in borrowing costs is the primary focus of the recovery effort in the eurozone. The fear is that rising borrowing costs would take some troubled countries, in particular Spain and Italy, to the point where they are no longer able to service their debt. If that happens, these countries, like Greece, Portugal and Ireland before them, would require external aid/or face the prospect of defaulting on their debts. Unlike Greece, Portugal and Ireland, the sheer size of the total debt holdings of Spain and Italy together, would be far beyond the reach of the current support mechanisms.
But there is a problem. If the plan to provide support to the banks were to work, it would require the ESM to be functional. The ESM was due to be launched in July 2012, however a series of lawsuits in Germany have prevented this from happening. The constitutional complaints seek to prevent the implementation of the ESM on the grounds that it undermines the sovereignty of Germany's parliament in determining its budget and is therefore not subject to democratic control. The decision on this matter is carded for 12 September 2012.
The most recent lawsuit, however, calls upon the German high court to refer the issue to the European Court of Justice (ECJ). As it happens, the ECJ also has before it a case submitted by Ireland's supreme court for a preliminary judgment on the legality of the amendment to the European Union's Lisbon Treaty allowing the ESM to be created. The German lawsuit, therefore, claims that the German court must defer its decision until the ECJ has ruled on the Irish case and, by extension, the legality of the ESM. This, as one would expect, may push the final German decision on the ESM beyond the expected September date.
Not so, according to the German constitutional court. A spokesperson for the court has stated that its decision on 12 September involves "only a ruling on a temporary injunction sought against the ESM and fiscal pact, not a final ruling on the two European mechanisms". This translates into an expectation, by the court, that the 12 September deadline will remain.
Notwithstanding the German court's position, similar challenges have also been made in Austria and Estonia. On the prospect of a longer than expected delay in the launch of the ESM, Germany has warned of "new financial-market turmoil because (the) delay would leave the eurozone without a viable firewall against financial contagion for an uncertain amount of time".
And there is still more in store for September. On 26 July 2012, the President of the ECB made the emboldening declaration that "within our mandate, the ECB is ready to do whatever it takes to preserve the euro". This was widely interpreted as a promise to restart its secondary market bond-buying program, in which the ECB purchases the bonds of troubled countries, thereby providing the demand needed to keep the yield on troubled sovereign bonds from escalating. The optimism was a bit short-lived: on 2 August 2012 the ECB announced at its monthly meeting that bond purchasing will not happen until the sovereign (in this instance Spain) has first made a formal request to the European Financial Stability Fund (EFSF) for support. Spain has thus far, refused to ask for the EFSF support, partly because of the austerity measures that this would require. But there is some expectation that Spain may soon capitulate on this position, perhaps as soon as next month. Furthermore, the decision on whether or not the ESM would be allowed to purchase sovereign debt on the primary market shall also be made in September.
Even Greece is catching the September fever. Following their meetings in Athens, the nation's creditors are expected to announce their verdict on whether or not Greece has progressed enough on its promised economic targets in order to qualify for the next tranche of its aid package. In addition to this, Greece will also enter the spotlight a bit earlier on 20 August when EUR 3.2 billion in Greek debt matures and requires repayment. To meet the repayment, Greece intends to issue EUR 4 billion in new debt.
There are other possible surprises worth mentioning. The possibility of a third round of long-term refinancing operations (LTRO) by the ECB should not be ruled out in light of the fact that the ECB recently lowered its main refinancing rate and broadened the range of collateral acceptable for the loans. There is also a possible upset in the form of parliamentary elections in the Netherlands (where the opposition Socialist Party is opposed to the ESM).
Whatever the outcome of this extraordinary alignment of events, the impact on the markets is sure to involve a great deal of volatility. Indeed, since none of the measures to be announced in September seek to address the underlying issues of low growth and high debt levels, the situation in the eurozone is likely to persist for some time. Hype and optimism cannot support the markets indefinitely.
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