Franco-German motor

May 30, 2013

Today’s big setpiece is a meeting of German Chancellor Angela Merkel and French President Francois Hollande ahead of a June EU summit which is supposed to lay the path for a banking union. The traditional twin motor of Europe has sputtered – not least because the French economy is so much more sickly than Germany’s – but also because of real differences of opinion.

When the Franco-German relationship was running smoothly, the two countries’ leaders routinely met before EU summits to prepare a joint position which more often than not prevailed (much to the annoyance of some of their partners). But Merkel and Hollande have conspicuously not done so on a number of occasions since the latter took power a year ago.

Hollande wanted a banking union including a structure to wind up failing banks and common deposit guarantee. The latter is already dead in the water and Germany is wary of the liabilities the former might impose upon it. The European Central Bank may have taken euro break-up risk off the table – though its pledge to save the euro is still to be tested – but banking union is still a huge issue. Without it the seeds of a future crisis, or even a revival of this one, will have been sown.

The smart money is that the June summit is long on bank regulation, short on bloc-wide measures to deal with stricken lenders. The big question is whether progress will be easier after Germany’s September elections.

There appears to be a recognition in Germany that antipathy towards its insistence on budgetary rigour (cuts and pain) is reaching uncomfortable levels. It has approached Spain and Portugal with a plan to help get money flowing to their credit-starved companies in the hope that it will bring down sky-high unemployment and German Finance Minister Wolfgang Schaeuble warned on Tuesday that failure to win the battle against youth unemployment could tear Europe apart. He also ruled out ripping up Europe’s welfare model.

In January, Merkel and Hollande promised to come up with joint proposals on greater euro zone cooperation, boosting industrial competitiveness and job creation for next month’s summit.

So something is afoot and it is more than pre-election positioning; witness Berlin’s acceptance that its euro zone partners should get more time to meet debt-cutting targets as long as the impetus for structural economic reforms is not lost (the latter message is particularly directed at France). Another one to watch is whether the two leaders can agree on whether the EU should risk a trade dispute with China by imposing punitive duties on its solar panel exports. Germany, for whom China is a vital export market, is very keen not to.

Italy holds the third of a trio of debt auctions at an interesting time. Spanish yields rose at auction for the first time in three months last week and on Wednesday, borrowing costs at a short-term Italian debt auction rose for the first time in two months. Rome will offer up to 5.75 billion euros of five- and 10-year bonds today and has cleared well over 60 percent of its 2013 funding needs in the first five months of the year, so in that respect, the pressure is off.

But there are certainly signs that the 10-month fall in peripheral euro zone borrowing costs could be drawing to a close. If it happens, it will be in large part due to markets waking up to the fact that central bank largesse will not go on forever after Federal Reserve Chairman Ben Bernanke said last week U.S. bond-buying with newly-minted money could begin to taper off in a few months. Not stop, just slow but it was enough to put stock markets into a temporary spin.

German government bond futures haves risen a quarter point in early trade, waiting to see how the Italian auction goes down. European stocks are expected to edge lower. Reuters’ monthly asset allocation polls, to be published at 1100 GMT, will show where the serious investor money is flowing and may pick up some of that nervousness. The Bank of Japan may be an exception, but the next big crunch moment for the financial world is when the top central banks say enough is enough. That’s still more likely a story for 2014 and beyond but Bernanke has certainly concentrated minds.

Even if there is a market wobble, the theme of 2013 has been the disconnect between soaring asset prices and the grim state of European economies that underpin them. Revised Spanish first quarter GDP and  May inflation figures are unlikely to alleviate the gloom. Neither will French unemployment figures (the jobless rate is already in double figures), although consumer and business sentiment for the euro zone might show glimmers of hope.

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