With Hollande supporting Italy and Spain, Germany has became isolated. "Merkozy" is no more. Worn down Merkel conceded, sending risk assets to a massive rally. Caught in a short squeeze, the euro rallied nearly 2 % this morning. But with all the hoopla, let's take a step back and see what exactly did Germany agree to in the middle of the night. Here are some highlights.
1. Spanish banks will be bailed out (€100bn) directly out of ESM/EFSF rather than going through the Spanish government. This will avoid increasing Spanish government debt.Amazingly only last week Merkel said she could never agree to direct lending to these banks because she would be unlikely to "get her money back".
2. The Spanish bank bailout will not subordinate the bond holders as was expected.
3. Perhaps the most important agreement was that the European Stability Mechanism (ESM) could buy government bonds to reduce periphery borrowing costs. The only official statement was that the ESM will be used to buy bonds in “in a flexible and efficient manner”. No further details for conditions on such purchases were provided. This is clearly a victory for Mario Monti, who's been pushing hard for this measure.
EURO AREA SUMMIT STATEMENT: - ... We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States ...4. There is an agreement to set up a single banking supervisor in 2013.
That seems to be it. A few observations:
- As expected, there is no agreement on a "banking union" that would provide deposit insurance across the euro area.
- The ESM, having already committed €100bn to Spain's bank now only has €400bn of capital. Given the amount of debt the periphery nations will need to roll in the next couple of years, this is hardly credible. And the Eurozone leaders have not agreed on the details of how capital will be released. We all know how easily the leadership gets caught up bickering over the details.
- There will be pressure on the ECB to do what the ESM may be unable to do - expand the SMP program to buy more periphery bonds (so much for central bank independence). It already bought €220bn, but Monti and company will expect far more. That basically means QE.