Recent decisions of the ECB and the German Constitutional Court have prohibited things from getting worse.

The German Constitutional Court has dismissed the rejections against the European Stability Mechanism (ESM), but stipulated two conditions for the ESM to be signed into a law: before the signing by the president, Germany’s relevant liabilities will be capped (that is €190 billion which is the countries share in the ESM capital). The ESM will not have the mandate to change this limit, though it will otherwise operate independently. Second, ESM will have to share all information, even if confidential, with relevant officials at the German parliament. The ESM therefore can become operable by the end of the year (originally, the ESM was planned to be launched by the end of 2013 but later a backdate was decided).

Costs will diminish

Under these circumstances, if crisis countries including Spain and Italy apply to the ESM, which has a total capital of €500 billion, and agree with its terms, their bonds will be purchased by the ESM at primary and by the European Central Bank (ECB) at secondary markets. This way, borrowing costs for these countries will be lowered to reasonable levels. In fact, following the latest decisions of the ECB, interests on bonds started to decrease in secondary markets. This movement will help crisis countries breathe a sigh of relief until the stability measures in effect start to deliver results. More importantly, doubts on the sustainability of stability programs as well as on their potential to generate positive outcomes will not escalate, but ease to some extent.

But what if the crisis countries, Spain in particular, choose not to apply to the ESM? Consequentially, the markets might interpret this in two different directions. First, they might conclude “Spain is actually doing well.” This, of course, would be a naïve interpretation that does not fit markets. A second interpretation might be “Spain was not able to convince its people to accept the ESM terms.” In that case, borrowing costs increase and tension across the markets escalates. The same applies also for Italy, with a certain lag.

Therefore, recent decisions of the ECB and the German Constitutional Court have prohibited things from getting worse. If Spain and Italy apply to the ESM and agree the terms, we will most probably not be seeing an adverse development that will disturb or shock the markets. At least, not one as strong as the ECB announcing that it will not purchase bonds of crisis countries or the German Constitutional Court judging against the ESM.

We can be at ease till the end of 2012

Issues to focus on in the short term are: Will the Fed meeting that started yesterday and will end tomorrow bring a new quantitative easing? The markets will not be shaken if not; but the decision for quantitative easing will create a positive atmosphere and improve the risk appetite for Turkey and its peer countries. Second, we will wait and see if Europe will take steps to establish a strong authority to regulate and supervise financial institutions.

Later, we will focus on other issues that might raise tension in markets. The first item to watch is the developments about the debt ceiling of the US. As you might remember, in the mid-2011 the US Treasury came across the risk of not being able to borrow from markets because of the profound dissensus between Democrats and Republicans. The issue was settled after a long debate. But it will rise back on the agenda during 2013. Second, general elections will be held in Italy in 2013 spring. Election of a government with a leader alike Berlusconi poses a risk for the markets.

Adding these together, we can conclude that Turkey and its peer countries can be at ease at least until the end of 2012, unless Spain surprisingly decides not to apply to the ESM. Under these circumstances, what can Turkey do to boost growth that is significantly below the potential for the time being? I will continue.

This commentary was published in Radikal daily on 13.09.2012