EU summit: Some good progress, but any game changers?

When EU leaders met in Brussels on 28-29 June for their 19th summit since the eurozone crisis began two years ago, there were, understandably, low expectations. But while they surprised the world by taking some significant decisions, as Megan Greene explains in this analysis, the measures taken may not be sufficient to quell the financial storm.

THIS EU summit marked many firsts for eurozone crisis-era EU summits: it was the first time Greece hasn't been discussed in years, it was the first time Italy and Spain bonded together and it was the first time French President Francois Hollande attended an EU summit.

By dinner time on 28 June, the summit seemed a colossal failure, with Spain and Italy refusing to sign off on a growth initiative without some short-term measures to alleviate pressure on those two countries in the bond markets. Eurozone leaders went back to the negotiating chambers and emerged around 4am on 29 June with a deal. The measures agreed exceeded market expectations, though based on German Chancellor Angela Merkel's pre-summit assertion that Germany would not be signing up to anything significant, expectations were not difficult to beat.

The markets rallied, but was investor euphoria justified, or was this just another EU summit fudge? Some important steps were taken at this summit, but none of them game changers and a number of details have yet to be hashed out.

Short-term measures to benefit Spain, Ireland and Italy

While Italy's Prime Minister Mario Monti left the EU summit grinning and declaring a victory (both in football and at the heads-of-government powwow), the short-term measures stand to benefit Spain and Ireland much more than Italy. Most of these measures were to do with the Spanish bank bailout.

The EU bailout funds will now provide a direct capital injection to the banks, contingent on the European Central Bank (ECB) becoming the joint eurozone bank supervisor (see below) on 1 January 2013. The European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM) loans will go through the state up until then, but Spain's public finances will be adjusted come 1 January so that the bank bailout circumvents the sovereign. A second measure was agreed for the Spanish bank bailout: the EFSF loans for Spanish banks will not gain preferred creditor status when they are rolled into the ESM.

Will either of these changes be a game changer for Spain? I doubt it. Spanish public debt will reach around 100% of GDP by the end of this year if all of the off-balance-sheet liabilities are included. Given Spain's primary deficit and growth outlook over the next few years as the country implements austerity measures and structural reforms, this debt burden is unsustainable. This is the case whether the 100-billion-euro bank bailout is routed through the state or not. The change in seniority of the ESM loans, in my view, is a complete fudge. Seniority is only really an issue for sovereign bond markets if the loans are going through the sovereign, which will only be the case before 1 January. If there is a sovereign debt restructuring before 1 January - highly unlikely - it is doubtful the ESM will accept a loss on its loans. Just as the EFSF and ECB did not have preferred creditor status yet were de facto senior in the Greek PSI deal, so would the ESM be in a PSI deal for Spain.

In the official communique, eurozone policymakers indicated that the direct EFSF/ESM capital injection for Spanish banks may be applied retroactively to the Irish case. The Irish government immediately hailed this as a seismic shift, and Irish long-term bond yields fell sharply. Is this a game changer for Ireland? It is hard to say, given that we have virtually no details on how they plan to parse out bank and sovereign debt in Ireland. We can expect that it is going to be extremely difficult to take the model applied to the Spanish bank bailout and transfer it over to Ireland, where the bank bailout for zombie and solvent banks was funded by the national pension reserve, promissory notes/Exceptional Liquidity Assistance (ELA) and bailout cash. Separating bank and sovereign debt in Ireland is a bit like trying to unscramble an omelette.

While the reduction in public debt as a result of this may mean Ireland can return to the markets on time in early 2014, I expect those who bought the government's rhetoric on this being a colossal victory for Ireland will be underwhelmed. Furthermore, it is rumoured Germany will only allow direct capital injections to banks from EU bailout funds in those countries that have signed up to a financial transactions tax (FTT). With the UK rejecting an FTT, Ireland is keen to also avoid it in order to protect its financial services industry; if Ireland is subject to an FTT and the UK is not, business could easily move to London. If this German-supported piece of conditionality is imposed, Ireland will potentially have to choose between getting immediate relief from the ESM to reduce its public debt burden or supporting one of its biggest industries.

The measure announced that might be most useful to Italy is a vague commitment to using the EFSF and ESM more flexibly in the bond markets to reduce borrowing costs for weaker countries without full troika reviews. The idea that there will not be troika reviews is hardly a victory, given that both Spain and Italy are already subject to the excessive deficit procedure with built-in fiscal targets and to IMF visits. Could EFSF/ESM bond buying help Spain or Italy? Whether in the secondary or the primary markets, I'm sceptical.

Long-term measures

Two long-term measures were also agreed at the summit. First, eurozone leaders agreed a growth initiative, which will see around 130 billion euros used for job creation and investment in the region. This might help on the margins, but is more likely to slightly mitigate the recession than actually stimulate growth. Second, the leaders agreed that the ECB will serve as a eurozone bank supervisor. This is potentially the first of many steps towards a banking union in the eurozone and was the easiest step to agree. The other two steps necessary for a full banking union are a deposit guarantee scheme and a bank resolution scheme. They will be much more contentious and will surely be discussed at future summits.

While most analysts expected eurozone leaders to discuss the long-term vision of the eurozone at this summit - including a banking and fiscal union - policymakers focused more on immediate crisis-fighting mechanisms. All of the measures agreed will likely help on the margins, which has not always been the case at previous EU summits, and some of the measures could be important first steps towards a fiscal and banking union. However, next steps towards a banking and fiscal union will be extremely difficult - and in some cases impossible - to agree, so expect the eurozone rollercoaster to continue this summer.            

Megan Greene is the Director of European Economics at Roubini Global Economics, specialising in the eurozone crisis. She provides political and macroeconomic analysis and forecasting for Greece, Ireland, Portugal, Spain, Italy and Germany. This article is reproduced from her 'Euro area debt crisis' blog (economistmeg.com). The opinions expressed here are her own and do not reflect those of any employers.

*Third World Resurgence No. 261, May 2012, pp 20-21