MacroScope

By Robert-Jan Bartunek and Robin Emmott

French statesman Charles De Gaulle once famously said “Treaties are like roses and young girls — they last while they last.” Germany seems to have decided that the European Union’s Lisbon Treaty, which only entered into force after a fair amount of upheaval in December 2009, has lost its perfumes and must be reworked to ensure the euro zone’s debt crisis can never be repeated.

European Council President Herman Van Rompuy’s proposal to modify the treaty via a little-known section called protocol 12 has so far been unable to convince German government officials, who warned against a “bad compromise” of small steps or “little tricks.”

Van Rompuy’s sense is that changes to the protocol, which would strengthen legislation to prevent countries running up big budget deficits, could be agreed quickly and send a message to investors that the euro zone is embarking along a path to bring back confidence and resolve its crisis.

But given the critical hour, has anyone in Berlin really considered all the treaty changes and protocol adjustments the EU would really have to implement if there’s to be full fiscal union? It’s a daunting prospect. Andrew Duff, a member of the European Parliament, has identified 29 articles and protocols that would need to be overhauled – and that’s assuming the European Parliament, eurosceptic Britain and others don’t come forward with a host of other demands.

But even if that all went smoothly, there’s the ratification process. In Belgium alone, a treaty change of the magnitude of the Lisbon treaty would need to be approved by nine parliamentary bodies, for example the Flemish and Walloon parliaments, the parliament of the German community and the parliament of the capital, Brussels, which is itself subdivided into a French and bilingual assembly.

Any lingering illusion that the European crisis could be contained to so-called peripheral countries with high debt levels was shattered on Wednesday. German government bonds, which had thus far been seen as a safe-haven, slumped sharply after investors shunned the country’s auction of new 10-year debt.

Germany drew significantly less bids than the amount on offer for its Bunds, with investors deterred by very low yields. There is a growing view the euro zone powerhouse will pay a high price whatever the outcome of the regional debt crisis. If the crisis spirals out of control, some fear that it could reach a magnitude that would hit Germany as well by sending it into a deep recession. On the other hand, any solution to the crisis is likely to involve a higher fiscal bill for Germany.

Marc Ostwald at Monument Securities in London describe the auction as “a complete and utter disaster.” He continued:

One of the more bizarre aspects of the euro zone crisis is that the currency in question -- the euro -- has actually not had that bad a year, certainly against the dollar. Even with Greece on the brink and Italy sending ripples of fear across financial markets, the single currency is still up  1.4 percent against the greenback for the year to date.

There are lots of reasons for this. The dollar is subject to its country's own debt crisis, negligible interest rates and various forms of quantitative easing money printing -- all of which weaken FX demand. There is also some evidence that euro investors are bring their money home, as the super-low yields on 10-year German bonds attest.

Finally -- and this is a bit of a stretch -- some investors reckon that if a hard core euro emerges from the current debacle, it could be a buy. Thanos Papasavvas, head of currency management at Investec Asset Management, says:

No longer an idle "what if" game, investors are actively debating the chance of a breakup of the euro as a creditor strike  in the zone's largest government bond market sends  Italian debt yields into the stratosphere -- or at least beyond the circa 7% levels where government funding is seen as sustainable over time.  Emergency funding for Italy, along the lines of bailouts for Greece, Ireland and Portugal over the past two years, may now be needed but no one's sure there's enough money available -- in large part due to Germany's refusal to contemplate either a bigger bailout fund or open-ended debt purchases from the European Central Bank as a lender of last resort.

So, if Germany doesn't move significantly on any of those issues (or at least not without protracted, soul-searching domestic debates and/or tortuous EU Treaty changes), creditor strikes can reasonably be expected to spread elsewhere in the zone until some clarity is restored. The fog surrounding the functioning and makeup of the EFSF rescue fund and now Italian and Greek elections early next year  -- not to mention the precise role of the ECB in all this going forward -- just thickens. Why invest/lend to these countries now with all those imponderables.

Where it all pans out is now anyone's guess, but an eventual collapse of the single currency can't be ruled out now as at least one possible if not likely outcome. The global consequences, according to many economists, are almost incalculable. HSBC, for example, said in September that a euro break-up would lead to a shocking global depression.

The reigning narrative of Europe’s financial turmoil is that profligate European states, agglomerated all too offensively by a swine-referenced acronym, are forcing the continent’s wealthy, prudent northern countries to come to their rescue. Not so, according to two policy experts who spoke this week at a conference on the euro zone crisis at the University of Austin’s Lyndon B. Johnson School of Public Affairs.

They argue that labor reforms in Germany prevented the wages of manufacturing workers from rising after monetary union had been completed, making the country more competitive at the expense of its southern peers. Joerg Bibow, a professor of economics at Skidmore College, gives his view of events:

Germany’s wage trends have been the most important cause of the euro zone crisis. Those wage trends created an asymmetric shock that destabilized Europe.

Holding your breath for instant and comprehensive European Union policies solutions has never been terribly wise.  And, as the past three months of summit-ology around the euro sovereign debt crisis attests, you'd be just a little blue in the face waiting for the 'big bazooka'. And, no doubt, there will still be elements of this latest plan knocking around a year or more from now. Yet, the history of euro decision making also shows that Europe tends to deliver some sort of solution eventually and it typically has the firepower if not the automatic will to prevent systemic collapse.
And here's where most global investors stand following the "framework" euro stabilisation agreement reached late on Wednesday. It had the basic ingredients, even if the precise recipe still needs to be nailed down. The headline, box-ticking numbers -- a 50% Greek debt writedown, agreement to leverage the euro rescue fund to more than a trillion euros and provisions for bank recapitalisation of more than 100 billion euros -- were broadly what was called for, if not the "shock and awe" some demanded.  Financial markets, who had fretted about the "tail risk" of a dysfunctional euro zone meltdown by yearend, have breathed a sigh of relief and equity and risk markets rose on Thursday. European bank stocks gained almost 6%, world equity indices and euro climbed to their highest in almost two months in an audible "Phew!".

Credit Suisse economists gave a qualified but positive spin to the deal in a note to clients this morning:

It would be clearly premature to declare the euro crisis as fully resolved. Nevertheless, it is our impression that EU leaders have made significant progress on all fronts. This suggests that the rebound in risk assets that has been underway in recent days may well continue for some time.

Covering a summit of European leaders is a bit like covering a soccer match with no ticket for the stadium and no live TV broadcast to watch. The only way you have an idea of the scoreline is from the groans and cheers from inside the ground.

With EU leaders meeting on Brussels on Sunday and again on Wednesday to try to resolve the region's debt crisis, the emergency back-to-back summits look like a game of two halves.

A European Commission spokeswoman said as much on Monday, trying to explain why there had been no major announcements so far on solving the debt crisis: leaders had gone in for half time.

Spreads between Italian and German government debt are blowing out heading into a European Union summit on Sunday that investors are hoping will come up with some action to address the continent’s sovereign debt crisis. Spreads between 10-year Italian government debt and German bonds of the same maturity widened to 398 basis points on Thursday, making for the biggest gap since at least the fourth quarter of 1996, according to Reuters data.

Andrew Wilkinson, Miller Tabak’s chief economic strategist, expands on the implications:

You have to look back to March 1996 to see the spread’s last excursion above 400 basis points. That was when Italian government was trying desperately to meet Maastricht criteria and join the euro. I’m left wondering how pleased they are with that outcome in today’s market. They never bargained for a spillover from Greece lie this. With the French/German yield spread leading the way this week it looks like pressure will continue to build in to the weekend.

So much for Germany being insulated from the euro zone’s troubled periphery. German credit default swaps are already beginning to price in the country’s worst nightmare: that it will have to pay a hefty bill for a deepening euro zone debt crisis.

The cost of insuring 5-year German debt against default rose more than 50 percent over the past month to a record high of 118 basis points.  French CDS rose  around 11 percent over the same period to 189 basis points, according to Markit data. The rise indicates investors are beginning to associate greater risk to holding German debt, even as the triple-A rated bond continues to benefit from safe-haven flows. German Bund futures saw their biggest quarterly rise between July and September since the launch of the euro.

The problem is Germany, the largest sovereign contributor to bailout funds already agreed for Greece, Portugal and Ireland, is expected to pay a high price for any solution to the debt crisis or, given its banks’ high exposure to peripheral debt, for any failure to resolve it.

Jim O'Neill, the new Goldman Sachs Asset Management chairman who is famous for coining the term BRICs for the world's new emerging economic giants, reckons he knows why Germany might not be rushing to bail out all the euro zone debt that is under pressure. Europe is not as important to Berlin as it was.

Speaking at the Reuters 2011 Investment Outlook Summit being held in London and New York, O'Neill pointed out that in the not very distant future Germany will have more trade with China than it does with France.

"It's a different global environment. That's why maybe Germany (ties)  itself to a rules-based game with the rest of Europe because economically it doesn't mean so much to them now. What goes on in China is more important than what goes on in France and that's puts a different economic (spin) on the situation for the Germans."