EU Leaders Set to Focus on Debt Crisis Facility as ECB Grapples With Banks

European Union leaders will this week discuss the creation of a permanent mechanism to shore up over-indebted countries as the European Central Bank tries to hammer out plans to aid the region’s weakest lenders.

At a summit in Brussels on Dec. 16 and 17, the group will confront investor skepticism about its readiness to stem a sovereign-debt crisis that led to bailouts for Greece and Ireland and threatens to spread. Spain’s 10-year bonds fell for a sixth day today as the government prepares to sell debt on this week.

“I don’t think there’s anything they can come up with to settle things down right away,” said David Owen, chief European economist at Jefferies International Ltd. in London. “The problems will continue. Markets are very much focusing on the first few weeks of next year when not only sovereigns but banks need to go to the market for a lot of financing.”

A draft summit statement sets a Jan. 1, 2013, deadline for all 27 EU countries to ratify a treaty amendment foreseeing a “stability mechanism to safeguard the stability of the euro area as a whole,” with financial aid for distressed governments “subject to strict conditionality.”

The mechanism would take over from the 440 billion-euro ($585 billion) European Financial Stability Facility, set up in May and due to expire in mid-2013. Aid from the central EU budget and International Monetary Fund make up the rest of the current 750 billion-euro rescue package.

ECB-Addicted Banks

Meanwhile, ECB officials are focusing on how to reduce banks’ reliance on emergency liquidity measures, according to comments last week by Governing Council members Mario Draghi and Yves Mersch.

German and French leaders have pledged to do whatever is necessary to defend the currency. The euro’s survival is “non- negotiable,” requiring budget vigilance and closer economic cooperation to overcome “structural weaknesses” within the region, German Chancellor Angel Merkel and French President Nicolas Sarkozy said on Dec. 10 after a meeting in the German town of Freiburg.

EU officials are considering measures that would allow the region’s rescue fund to buy bonds of distressed governments, the Financial Times reported today, citing people involved in the meetings. They are also considering allowing short-term credit lines to nations struggling to borrow but not in need of bailouts, the paper said.

Berlusconi Confidence

Investors may also focus on Italy, where Prime Minister Silvio Berlusconi faces a no-confidence vote. Lawmakers in Rome began debating a no-confidence motion today and the voting, scheduled for tomorrow, will determine whether Italy’s richest man can sustain his government, whose term still has two years.

The yield premium on Italy’s 10-year debt over comparable German bunds, Europe’s benchmark, more than doubled this year, reaching a euro-era high of 212 basis points Nov. 30. It was at 162 basis points today.

“Italy needs to be looked at carefully,” said Owen, who noted debt equivalent to 116 percent of output as a concern. The reality is that “if the markets perceive that Italy has a problem, then Italy has a problem.”

A sovereign default in Europe could throw the entire region back into recession, Ernst & Young said in a report released today. “The euro zone’s political leadership is confronted with an existential challenge to the well-being” of the region, Ernst & Young Partner Mark Otty wrote.

‘Very Reluctant’

Any further spreading of the debt crisis may increase pressure on the ECB to step up its bond-purchase program.

“The problem is that that various parties with the ECB are very reluctant to do that,” Owen said. “The question is whether events will overtake them.”

ECB officials are discussing measures to deal with banks overly reliant on central-bank funding, Governing Council member Mario Draghi said last week. The ECB is debating “concrete proposals” for such banks, Draghi said, according to the Financial Times. Such steps would be part of the ECB’s exit strategy, he told the paper.

“We clearly have the phenomenon that some banks are dependent on ECB refinancing,” Governing Council member Yves Mersch told Neue Zuercher Zeitung in an interview published Dec. 11. “This is being worked on at the moment and we will probably present a solution at one of our next meetings.”

To contact the reporter on this story: Mark Deen in Paris at markdeen@bloomberg.net

To contact the editor responsible for this story: John Fraher at jfraher@bloomberg.net

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