Euro gang of four – or three versus one?

June 22, 2012

The euro zone’s big four meet in Rome with Germany’s Angela Merkel likely to come under pressure from Italy’s Mario Monti, Spain’s Mariano Rajoy and France’s Francois Hollande to loosen her purse strings and principles.

Monti, with Hollande’s backing, has suggested using the euro zone rescue funds to buy Spanish and Italian bonds but Berlin is not keen and there are good reasons why it might not work, not least the ESM’s preferred creditor status which means that if it piled in, private investors may flee knowing they would be paid back last in the event of a default.

The Eurogroup may have skirted the same problem with regard to the Spanish banking bailout last night by deciding to start the loans via the existing EFSF, which does not have seniority, before switching to the ESM. The EFSF’s rules will persist throughout.

It’s possible that Rajoy will announce the formal request for bank aid in Rome. Last night, Eurogroup chairman Juncker said it would be done by Monday. An independent audit said up to 62 billion euros was needed. Officials hinted they would take more to cover any margin for error.

Monti got his retaliation in first overnight, giving an interview to a number of European newspapers to say if next week’s EU summit does not deliver, Spain and Italy would come under ever greater market “harassment” which would ruin any growth strategy put forward by the bloc’s leaders. He said euro zone leaders were working on a plan designed to halt the spread of debt contagion while satisfying Germany’s refusal to sanction financial irresponsibility. But details there were none.

Today in Luxembourg, the full Ecofin of 27 EU finance ministers will look at how to construct a banking union. There is a consensus that that should be a long-term goal but Germany will only countenance its most telling parts – a deposit guarantee scheme and cross-border structure to deal with failing banks – when the drive to fiscal union is set in stone, although it’s happy for overarching supervision to be introduced faster. Today’s groundwork will go to the full EU summit next week.

IMF chief Christine Lagarde, attending the Eurogroup last night, demanded rapid progress on this and a number of other fronts, upping the pressure on Merkel. Lagarde said the three main elements of a banking union were a top priority, alongside fiscal union and the principle of mutualising debt. Germany refuses to consider common bond issuance and will not soften until economic union is complete.

Much of next week’s summit will be devoted to mapping out a long-term roadmap to a fiscal and banking union. Growth measures will be discussed too but there is little on the agenda to tackle the crisis right now, even though it has returned to an acute state. However, a strong statement of intent by the leaders could encourage the European Central Bamnk to fill the breach in the short-term.

The big questions are what the ECB has in its locker, how prepared it is to use it and whether it would be effective for anything more than a few weeks. In essence, an interest rate cut probably won’t make much difference, a three-year money splurge bought three months of calm last time and according to the law of diminishing returns might deliver less next time, and as for bond-buying, which the ECB really doesn’t want to do, it poses the same preferred creditor problem that the ESM does. So what to do? One thing that would work would be giving the ESM a banking licence so it could borrow from the ECB. But both the central bank and Berlin oppose that.

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