Franco-German meeting

October 20, 2014

German Finance Minister Schaeuble and his French counterpart Sapin attend news briefing after talks in Berlin

The big question of the week is whether financial market gyrations continue, worsen or calm. European stocks are being called higher at the open.

Greece has been effectively shut out of the bond market. If it and others on the euro zone’s southern flank come under persistent market pressure, in a way that hasn’t happened for two years, the onus on the European Central Bank to act will grow and grow.

None of the countries likely to be in the firing line appear to qualify for the conditions attached to the ECB’s still-unused OMT bond-buying programme, the legality of which is under review by the European Court of Justice.

So full-on QE might be the only option to restore calm if the turmoil persists or worsens. We’re a long way from that yet and internal divisions within the ECB may rule it out altogether. Maybe that dawning realization, as the Federal Reserve prepares to turn the money taps off, has contributed to the unnerving of investors.

It is possible that if European bank stress tests – to be unveiled next Sunday – give a cleanish bill of health, credit and lending will start to flow again. But that will only happen if the demand for funds is there, and that is questionable, particularly at the rates banks are prepared to lend.

In the meantime, Germany continues to rebuff suggestions from much of the rest of the world that it should use a little of its current account surplus to increase public spending to give its own economy, and that of the wider euro zone, a lift.

Berlin insists it will balance its budget next year for the first time since 1969 despite the fact it is flirting with recession. The Bundesbank’s monthly report is due today. Latest data suggest the economy will be lucky to post any growth in the third quarter, having contracted in the second.

Germany and France have asked experts in Berlin and Paris to come up with reform recommendations in an apparent attempt to avert a full-blown clash over economic policy. The economy and finance ministers of both countries meet in Berlin today.

France and Italy are pressing for more leeway on debt targets to buy time to push through much-needed structural economic reforms but are likely to have their 2015 budgets rejected by Brussels.

The hope is that a renewed French and Italian commitment to economic reforms will persuade Germany to loosen its purse strings and the ECB to act more forcefully. But the ECB has denied there is any “grand bargain” in the offing and officials admit that whatever transpires – the aim is for a deal to be done in time for a December summit – may fall short of what is required.

German weekly Spiegel reported that Berlin and Paris are secretly discussing a deal to enable the European Commission to approve Paris’s draft 2015 budget whereby France will provide Brussels with a detailed roadmap for deficit reduction and structural reform. French Economy Minister Emmanuel Macron said on Sunday he was sure the European Commission would not reject the budget.

The Italian Treasury will start offering a new BTP Italia retail bond aimed at small investors. Previous such issues have romped away but the market backdrop looks very different now.

Ukraine and Russia have reached a preliminary agreement on a price for gas supplies this winter but Kiev may need international help to pay, Ukrainian President Petro Poroshenko said on Saturday. Russia cut off gas supply to Ukraine in mid-June, saying Kiev had to pay off large debts for previously-supplied gas before it would resume supply.

Any interruption to flows to western Europe, via Ukraine from Russia, would deal another blow to already struggling EU economies. Putin has threatened to cut gas supplies to Europe if Ukraine steals from the transit pipeline to cover its own needs this winter. Poroshenko said the next round of gas talks was likely to take place on Tuesday in Brussels.

With Moscow having blown billions of its reserves in short order trying and largely failing to defend the rouble, and the economy probably heading into recession as the oil price tumbles, there are obvious checks to piling into Ukraine more aggressively. Moody’s cut Russia’s credit rating late on Friday to just two notches above junk status.

New echoes of the Cold War. Sweden released a grainy photo of a mysterious vessel in Stockholm’s archipelago, as the military hunted for a foreign submarine or divers. Reported sightings of one man dressed in black wading through waters led to speculation of Russian special forces in the archipelago.

Sweden’s new prime minister, Stefan Loven, is in Finland to meet counterpart Alexander Stubb. Finland last week accused the Russian navy of interfering with a Finnish environmental research vessel in international waters.

The Syrian/Turkish border town of Kobani saw a resumption of fierce fighting over the weekend as Islamic State fighters attacked Kurdish defenders with mortars and car bombs. A week ago, Kurds said the town would soon fall.
The United States and its coalition partners then stepped up air strikes on Islamic State and on Sunday the U.S. military said it had air-dropped weapons, ammunition and medical supplies arms in what appeared to be the Pentagon’s first public acknowledgment it has delivered lethal aid to Kurdish forces.

The fate of the town is seen as a critical test for U.S. President Barack Obama’s campaign against the Islamists.

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