For once it wasn’t the same old, same old. Instead of a set of somewhat banal generalities that markets had come to expect from European policy powwows, the European Union (EU) summit on June 28 and 29 actually took the first steps towards resolving some of the long-term structural problems bogging the region down. Some commentators claim that it was Italian Prime Minister Mario Monti’s assertiveness that effectively countered Germany’s hard line. Whatever it was that did the trick, it certainly improved risk appetite across global markets and triggered rallies across asset classes.
There are a number of things that emerged from the summit, though the operational details remain to be seen. European leaders proposed a growth pact worth a good euro 120 billion that would be spent partly on boosting the European Investment Bank’s capital and also in funding “project bonds” that would finance infrastructure projects in peripheral economies. This growth pact was incidentally newly-elected French Prime Minister Francois Hollande’s brainchild. Its adoption would mean that the narrow obsession with fiscal rectitude or “austerity” (that Germany has championed) would give way to some good old-fashioned Keynesian pump-priming. This could, one hopes at least, stoke the growth engines of euro zone’s battered periphery.
But two sets of measures announced in the summit really stand out. First, the European bail-out facility, the European Stability Mechanism (ESM) can directly recapitalise banks whose balance sheets are overstretched. This would effectively break the vicious cycle between a sovereign and a banking crisis in which the troubles of the banking sector would invariably spill over to the sovereign government that bailed it out. The immediate beneficiary could be Spain whose banks have been recently sanctioned a hefty euro 100-billion bail-out package. As of now, this has increased the Spanish sovereign’s debt burden but under the new dispensation it could be a direct deal between its banks and the ESM. Ireland’s government could also get a reprieve from a banking bail-out that it received back in 2010. This could also be the first move towards a European banking union.
The second step is to allow the ESM to directly purchase sovereign debt in case the need arises, although a memorandum with the EU will need to be signed that will focus on monitoring the current reforms. This is an important step since sovereign bond purchases will no longer be a purely monetary policy decision taken by the European Central Bank (ECB) but could be driven by the EU itself, depending on its assessment of the fiscal situation and market borrowing costs of sovereign nations. This could help in reducing sovereign yields allowing nations such as Italy and Spain to fund their deficit via the market more easily.
It will also act as de-facto monetary easing by injecting EUR liquidity into the financial system that could feed risk appetite.
A key area of concern in the context of the Spanish bank bail-out was whether the funding provided as a loan from the ESM would have “senior” debt status. Were it to have this status, it would lead to the subordination of the existing debt of Spanish banks. Thus, private holders of these bonds were concerned that in the event of a debt restructuring they would move down in the pecking order of claims and the risk of not getting paid would increase. The summit announced that funds provided from the ESM would not have senior status and, hence, private debt-holders can breathe easy.
But before one gets carried away with all this, some caveats need to be kept in mind. First, there can potentially be many a slips between the cup and the lip and the fine print of the implementation of these policies need to be read carefully in order to assess how well they will work. European finance ministers are scheduled to meet on the 9th of this month and this could give us an initial sense of how things are likely to progress. Second, there are concerns over the size of the ESM that is currently euro 500 billion and whether it would be adequate to play the myriad roles that it is expected to play. Finally, Germany still seems opposed to some of the other critical measures needed for effective fiscal integration in Europe such as the issue of common eurobonds. Unless there is consensus on these critical issues, a comprehensive solution to Europe’s problems will remain elusive.
The post-summit high lasted for less than a week and took the rupee from levels over 57 to sub 54. The “downer”, ironically, came from Europe again. The ECB cut the region’s benchmark interest rate on June 6 by a quarter of a percentage point as was expected. However, its prognosis for the region’s growth prospects seemed to somber for the market’s comfort; besides, it gave no indication that it was interested in, unilaterally, infusing more liquidity in the system. As risk-appetite waned, the rupee slipped again.
Going forward, the ebb and flow of risk appetite will determine where the rupee finds itself on a particular day. For it to break out of this trading range and settle at a higher (appreciated level), it will need concrete policy measures on the domestic front to counter global uncertainty.
The writer is with HDFC Bank. These views are personal
