EU Summit Surpasses Expectations with Tentative Step Towards Banking Union

For once, an EU leaders' summit delivered more than expected. This was not only due to the very low expectations coming into the event. Some very important decisions were made at the summit, held in Brussels on 28–29 June, not only aimed at easing the immediate pressures facing both Spain and Italy, but also at taking the first important steps towards creating a banking union in the Eurozone.

Measures Announced

The leaders agreed to establish a single "supervisory mechanism" for Eurozone banks, most likely to be within the European Central Bank (ECB). Once this is established, EU leaders agreed that the Eurozone's permanent bailout fund, the European Stability Mechanism (ESM), could be used to recapitalise Eurozone banks directly, rather than lending to sovereigns as is currently the case.

Eurozone leaders confirmed that a bailout for Spain's banking sector would come initially from the Eurozone's temporary bailout fund, the European Financial Stability Facility (EFSF), before being transferred to the ESM, which would not have seniority status over private creditors.

The summit statement also suggested that both Eurozone bailout facilities, the temporary EFSF and the permanent ESM, could be used to purchase Eurozone bonds in both the primary and secondary market, via the ECB. The statement suggests that this would be done provided Member States respect their various economic and budgetary commitments.

On top of this was the announcement of a "Compact for Growth and Jobs" with a growth package worth EUR120 billion (USD151 billion). While this is not to be sniffed at, it is not a game changer for the Eurozone growth outlook. This headline EUR120 billion figure puts a highly positive gloss on what has been agreed given that several of the measures and funds are not new. Moreover, the stimulus will not markedly lift Eurozone growth prospects in the near term at least, given it will take time for many of the funds to be used and for their effect to be felt.

Bank Support and Supervision

The measures announced, aimed at bringing down Spanish and Italian bond yields and helping Eurozone banks, are potentially game changers in the short term at least. In addition, making the ECB the supervisory body for Eurozone banks by 2013 is potentially the most significant move of all, if it is the precursor to much more progress on banking integration. Rapid progress on establishing Eurozone-wide deposit insurance and a centralised way of dealing with failing Eurozone banks would be an extremely positive development for the euro area.  

Markets reacted very favourably to the agreement, with the euro strengthening appreciably, Eurozone equity markets making healthy gains and, most importantly, bond yields coming down markedly in Spain and Italy. Of course, markets have reacted favourably before to measures announced at European summits to tackle the Eurozone sovereign debt crisis, only for these gains to be quickly wiped out. However, there seems to be a genuinely stronger feeling in the markets this time that European policymakers really have taken stronger and more courageous moves which hopefully will give them a lot more breathing space to build on what has been announced so far.

Potential Problems

Nevertheless, there are some uncertainties and areas of concern related to the measures announced. A possible problem with the summit plan is that the ESM could have to cover a lot of bases, namely being responsible for some of the emergency loans to Spain, any plan to buy Italian and Spanish bonds in the primary and secondary bond markets, and provide direct funds to banks once the extended ECB supervisory role is in palace. This could be asking a lot of the ESM fund given its finite resources, which could be depleted very quickly.

In addition, the very real risk of market speculation testing the boundaries of the fund could preclude any bond purchasing scheme from being extended to the secondary market. Ultimately, the ECB with its infinite resources may need to step up to the plate to reinforce any bond buying scheme in order to bring about a significant reduction in Spanish and Italian bond yields.

Another potential problem is that direct bank recapitalisation from the ESM is dependent on the ECB supervisory role being in place first. While we believe this is the correct approach, there is the danger that any significant delay to the greater banking integration roadmap increases the risk to Spain coming from any new major bank financing shocks.

It is critical that Eurozone policymakers build on these steps over the coming weeks and months, and move towards much greater banking and fiscal integration and cooperation. This will not be easy as there are ongoing significant disagreements between governments over what needs to be done and in what order, while the ceding of more power?particularly over fiscal issues?away from the sovereign states to Brussels will be a hard sell to many sceptical electorates. Nonetheless, the Eurozone has to get the proper policy architecture into place, if it is to survive let alone flourish over the longer term. This includes some form of debt mutualisation, however, this is unlikely given Germany's objections, until there is greater fiscal integration.     

Equally important is that countries make sustained progress on structural reforms that improve their underlying competitiveness and productivity.  This obviously applies particularly to Spain and Italy at the moment, but other countries including France must make progress in this area. This is needed not only so these countries can improve their underlying fiscal situations on a sustained basis but also reduce the economic imbalances within the Eurozone that are so corrosive. It would also be particularly welcome for Germany to take measures to boost its domestic demand. There are some signs that Germany is moving down this road, with a recent greater tolerance, even encouragement, of modestly higher wage settlements.

Finally, the very real risk of Greece leaving the Eurozone makes it even more critical that Eurozone policymakers build on the progress made at the 28–29 June summit. The more progress made on banking and fiscal union, the less will be the potential contagion from a Greek Eurozone exit.  

Outlook and Implications

Eurozone leaders took an important step towards a more integrated union in the early hours of Friday morning (29 June). Nonetheless, much more detail is required, and many more steps necessary, if the fiscal, budgetary, economic and political integration essential to the enduring success of the single currency is to be achieved. This will be extremely difficult to agree among EU governments, even though leaders have shown a willingness to compromise when the alternative appears to be a path to Eurozone break-up. Yet, the greater obstacle to deeper Eurozone integration is likely to be EU citizens. The press response across Europe to the summit was marked by an adversarial tone, with the meeting portrayed as a zero-sum game between member states seeking to maximise their interests. This reflects a fundamental lack of solidarity and transnational identity across the EU. Significant steps towards deeper integration will, at some point, require the direct consent of EU citizens through referenda. It is far from clear that this consent will be forthcoming.