European leaders’ effort to save the euro hinges on support from investors, central bankers and credit-rating companies to win the months needed to put a revamped budget rulebook into practice.
“Luck is likely to be required,” said Joachim Fels, chief global economist at Morgan Stanley in London.
To have a chance of success, a deal reached after all-night talks on Dec. 9 to restore faith in the single currency requires investors to avoid dumping European debt, Standard & Poor’s to hold off on threatened downgrades, foreign countries to chip in rescue cash and the European Central Bank to soothe bond markets.
Politicians also have to avert the unforced errors that sank previous initiatives and turned a Greek deficit problem in 2009 into a threat to the international financial system.
The result of a Brussels summit that French President Nicolas Sarkozy called the last chance to rescue the euro after a two-year debt crisis ended with leaders setting themselves a March deadline to flesh out new fiscal rules.
“The better fiscal straitjacket and the pro-growth reforms can only serve to prevent future fiscal crises,” said Holger Schmieding, chief economist at Berenberg Bank in London. “The key issue is whether the summit result suffices to prevent the current crisis from spiraling ever more out of control.”
The so-called fiscal compact requires nations to virtually eliminate structural deficits, create an “automatic correction mechanism” and enshrine the new measures in national law. There will be “more intrusive control” of taxing and spending by governments that overstep the deficit limit of 3 percent of gross domestic product.
The summit also added to the war chest to protect cash-strapped economies, with an extra 200 billion euros ($268 billion) for the International Monetary Fund. Leaders will accelerate the start of a permanent rescue facility to next year and reassess its 500 billion euro cap in three months. They dropped a plan to force losses on bondholders in bailouts.
The first test may be the response of S&P after it put Germany, France and 13 other euro nations on review for a downgrade, linking the decision in part to the summit outcome. Moody’s Investors Service said today it will review the ratings of all EU countries in the first quarter because the summit failed to produce “decisive policy measures.”
The summit makes it “more likely than not that S&P will carry out its threat to downgrade most of the euro-zone states in coming days,” said Adam Cole, head of global currency strategy at RBC Europe Ltd.
AAA at Risk
Such an announcement, especially if Germany and France lose their AAA ratings, could be the spur for financial markets to revive the rout which last month drove Italy’s 10-year bond yield beyond 7 percent for the first time. European governments face maturing debt of 157 billion euros by the end of March. One-third of that is Italian, UBS AG estimates.
“The summit won’t stop investors asking: will euro area governments default on their debt,” said Karen Olney, an equity strategist at UBS. “This could be a rolling crisis where the market continues to oscillate on every half-hearted solution.”
In contrast, Julian Callow, chief European economist at Barclays Capital, said the plan’s components “add up to a substantial package of measures.”
Governments have declared victory over the turmoil before, only to be forced back to the drawing board with last week’s deal the fifth attempt at a systemic solution since May 2010. They have sometimes been their own worst enemies as with their failure to implement a July package quickly enough and then Greece’s October decision to call a referendum on the terms of its bailout package.
Juergen Michels, chief European economist at Citigroup Inc., is already warning drafting of the new framework in March “looks very ambitious” because it may not be enforceable. That’s in part because the U.K.’s opposition to a 27-nation EU-wide treaty left the other nations having to pursue a more flimsy “international agreement.”
That creates doubt over the role of pan-European institutions and opens it to attack from national constitutional courts, said Michels, who predicts the euro-area economy will contract throughout 2012. Euro-area nations have still gone it alone before as with the establishing of their 440-billion euro rescue fund.
The U.K.’s isolation means “time will now be wasted on finding legal loopholes so that the institutions can indeed be used in the better integrated Europe,” said Erik Nielsen, chief economist at UniCredit Group.
The lack of new sanctions for those who violate the fresh budgetary checks may also undermine the accord’s heft in markets, said David Mackie, chief European economist at JPMorgan Chase & Co. No previous euro rulebooks provided “cast-iron guarantees on behavior because the sanctions are not really that meaningful,” he said. “This hasn’t changed.”
Away from the summit heat, the pact could also fall prey to national politics as happened with the summer overhaul of the European Financial Stability Facility. Even when they work out the language, up to 26 capitals will have to ratify it in their own legislatures and amend their constitutions.
Finland has already said it may withdraw its support for the permanent rescue mechanism if the unanimous decision making provision is watered down as planned.
“Legal hurdles and implementation risks remain and so will keep us all watching,” said Morgan Stanley’s Fels.
Looming French elections could also prove a spoiler. Sarkozy, trailing in the polls to Socialist Francois Hollande, may blunt German-led efforts for greater intrusion into national budgets. Hollande’s Socialists have criticized adding fiscal rules to the French constitution.
“The uncertainty until after election day on May 6 will create an extra layer of anxiety,” said Gilles Moec, co-chief European economist at Deutsche Bank AG.
Another hurdle, albeit a low one, is whether governments meet their own deadline of next week to find the cash for the IMF. Even if they stump it up it will be housed in a general rather than Europe-specific account meaning any loans made will require repayment before privately held bonds.
A bigger challenge may be luring other nations to chip in too, a month after the Group of 20 failed to find common ground. The U.S., the IMF’s biggest shareholder, has said it won’t participate. Chinese, holder of the world’s largest currency reserves, may join the effort, Vice Foreign Minister Fu Ying said, without giving details.
“Getting the international community to match the Europeans’ increase in the lending to the IMF could be complicated,” said Moec at Deutsche Bank.
Leaders may be left looking to the ECB to provide a backstop in markets while they carry through their summit promises. For now, ECB President Mario Draghi has limited his response to saying the pact was a “good outcome” and the basis for a “good fiscal compact.”
While the ECB bought Spanish and Italian debt in the summit’s aftermath, ECB officials including Draghi have played down speculation they will ramp up their bond-buying program or go as far as to cap yields. They want the keep the pressure on governments to restore budget order and are instead focusing on reviving bank lending with new steps such as offering banks unlimited cash for three years.
Bundesbank President Jens Weidmann told the Frankfurter Allgemeine Sonntagszeitung that while the new accord represents progress, the onus is on governments rather than the Frankfurt-based ECB to resolve the crisis with financial backing.
“The mandate for redistributing taxpayer money among member states clearly does not lie in monetary policy,” Weidmann told the newspaper in an interview published yesterday.
Howard Archer, chief European economist at IHS Global Insight, expects the ECB will ultimately change its tune to preserve the euro.
“The ECB will ultimately need to substantially step up its bond-buying program and effectively act as a lender of last resort, to convince the markets that European policy makers really are prepared to do whatever is needed to combat the crisis,” he said.