This step is insufficient to relieve markets.

Europe was in a vibrant mood for the last two days. First, the European Banking Authority (EBA) and then the European Central Bank (ECB) have declared policy decisions. Then on Thursday evening, European leaders met and hold a summit that lasted until Friday morning. First problems handled, and then the decisions taken:

The key problem is that the Union has a single monetary policy whereas countries implement fiscal policies independently. This, coupled with loose fiscal policy and banking sector problems dragged Greece, Portugal, Ireland, Spain, and Italy to a default. States of Italy and Spain have extremely high finance requirements. Due to the recognition that this requirement cannot be fulfilled under the given circumstances and thus the debt will have to be restructured, they could access borrowing only at high interest rates. This furthers the finance requirement and interest rates.

The absolute precondition to break this loop is to sharply improve fiscal discipline. However, this might lower growth rates steeply and increase public debt to national income ratio, which implies the furthering of interest rates. Therefore, a bridge finance mechanism that will rebuild confidence and reduce borrowing costs is needed. The problem is that, additional finance requirement is extremely high in Italy and Spain. There was no mechanism available to provide the entire amount of resources. In addition, countries including Germany were not willing to strengthen the existing mechanisms without introducing a new legal arrangement that will eliminate the key problem and making countries to take steps towards fiscal discipline.

Another linked problem is the capital gap of European banks I have mentioned last Thursday. Yesterday, the EBA has revised up the gap by €9 billion to €15 billion.  There is unrest due to the risk that banks, instead of obtaining fresh capital, might substantially lower credit supply in order to achieve the minimum capital/credit supply ratio target the EBA has set to be met by June 2012.

So, which of the expected decisions did the European leaders take? To begin with, a decision towards fiscal consolidation was made. A new fiscal rule on balanced budgets will be secured by law. Sanctions will be imposed on countries which record fiscal deficit above a certain threshold. This is a positive step that will contribute to the easing of the key problem. Still, there are two challenges: first, Sweden and UK has opposed to this proposal, dividing the Union. Second, the decision has to be approved by national parliaments, which means the decision becoming operational will take time. 

Fresh capital for the ESM
European Financial Stability Fund (EFSF) was to be replaced with European Stability Mechanism (ESM) by 2013. The ESM will have a total capital of €500 billion; €60 billion higher than the capital of the EFSF. Moreover, EFSF functions via bilateral guarantees and does not have a source of fresh capital, which the ESM will have. European leaders decided to put the ESM into operation by 2012. This also is a positive step. The problem is that the exact date it will become operable is not decided.

It was decided that member states will raise €200 billion in addition to the fund the IMF will provide. This way, the IMF will lend to troubled countries, instead of direct lending by member states which brings about the risk of a downgrading of sovereign ratings. In addition, this arrangement is expected to facilitate lending by non-European countries. This also is a positive step. Moreover, articles calling the private sector to take on responsibility during debt restructuring process have been loosened.

There is a high risk that the amount provided will prove insufficient. Below are the measures which could have filled the gap but declined in the summit: issuing a common euro zone bond; giving the ESM banking license to authorize it to purchase bonds via borrowing from the ECB leveraging its capital. The ECB also declined the proposal for furthering the bond purchasing threshold of the Bank.

Conclusion: European leaders took positive steps, but these are not sufficient to relieve markets. It appears that we will continue discussing which measures Europe has to take.

This commentary was published in Radikal daily on 10.12.2011