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The Eurozone crisis continued to unnerve investors during June in the run up to an EU leaders’ summit at the end of the month. Despite a positive market reaction to the summit, underlying issues remain and are likely to lead to a re-emergence of tensions, according to a report from QNB Group, prompting EU leaders to take more focused and concrete action.

During June, in Greece, anti-austerity parties threatened to derail Greece’s bailout programme, but elections returned a majority for the pro-bailout parties. Following these elections, the focus of concerns shifted to Spain and Italy.

After months of speculation, the Spanish government was finally forced to call for a bailout for its banks, which are suffering from large exposure to a worsening real estate market. These stresses and a generally worsening outlook for the European economy, led to concern about Italian sovereign debt, driving up bond yields. During June, the yield on Spanish and Italian sovereign debt reached levels that are generally regarded as unsustainable in the long term, breaching the 6% mark in Italy and 7% in Spain.


Prior to the summit, European leaders were able to pledge up to €100bn for the bailout of Spanish banks, considerably more than the initial estimated requirements of €40bn.

However, this was insufficient to allay market concerns, according to QNB Group, as the money would initially be lent to the banks via the Spanish government, leading to an increase in public debt. Worries about higher debt levels drove up sovereign bond yields.

Also prior to the EU summit, European leaders appeared to be divided on how to tackle rising bond yields for Spain and Italy. Germany was insisting on a focus on fundamental long-term issues, such as giving more control to EU institutions over national budgets and economic policies. This led to little optimism that agreement on short-term crisis measures for Spain and Italy would be reached at the EU summit on June 28th-29th.

However, in fact, leaders at the EU summit did succeed in reaching an agreement on a short-term fix. Spain and Italy were able to force action by refusing to discuss anything else until crisis measures were agreed.

Consequently, at the summit it was agreed that Spanish banks could be recapitalised directly, reducing projected government debt levels by 6%-10% of GDP. It was also agreed that the European Stability Mechanism (ESM) could purchase sovereign bonds without an accompanying monitoring programme. This cleared the way for the Italian government to request assistance in its bond market.

The surprise positive result led to the largest daily drop in Spanish and Italian ten-year bond yields this year, from 6.95% to 6.33% for Spain and from 6.20% to 5.84% for Italy. It wasn’t just bond markets that reacted positively, the Euro Stoxx 50, an index of leading European companies, gained 4.96% for the day and the Euro rallied 1.77% against the dollar to €1:US$1.2662, also the largest daily gains this year.

Despite the positive reception in financial markets, it is likely that tensions will re-emerge in the near future. While the summit was successful in making some key decisions, the agreement did not outline the details of implementation, making it potentially problematic with potential treaty changes and parliamentary approvals. More details should be revealed around a meeting of EU finance ministers on July 9th.

The recapitalisation of Spanish banks was agreed on the basis that a Eurozone-wide banking supervisor, run by the European Central Bank (ECB), would also be created, consolidating 17 different organisations into a “banking union”. This is complex and will take some time to implement (the intention is to have it in place by the end of this year), possibly leading to delays and doubts about when recapitalisation loans will be transferred from sovereigns to banks. The change in mandate for the ESM to be able to recapitalise banks directly may also require a change in EU treaties, potentially creating complications.

Furthermore, the summit has not changed the resources available to EU institutions to tackle the region’s debt issues, according to QNB Group. The combined Eurozone bailout funds have about €500bn of new lending available to them, or €400bn with the Spanish bailout deducted. With around €600bn of refinancing needs falling due for Spain and Italy in 2013, should these countries lose access to debt markets, the bailout funds would soon be exhausted. Current rescue funds are therefore insufficient to protect the Eurozone system in the event that the crisis worsens, and this alone is likely to be sufficient to lead to investor concerns re-emerging.

Additionally, little progress was made at the EU summit on addressing the fundamental issues to resolve the crisis in the long term. Germany gained a commitment for the European Council President to develop a time-bound roadmap for the achievement of a genuine economic and monetary union, which would include EU institutional oversight of budgets as well as economic and monetary policies. However, a roadmap to stronger union does not bode well for swift action on the controversial issue of sovereign powers.

A “growth pact” was also agreed to use €120bn of potentially available funds for investment to provide an economic boost to EU countries. However, according to QNB Group, this involves tackling the symptoms of a weak Eurozone economy, not the structural debt issues that are driving the crisis.

The ongoing debt crisis is having a harsh impact on the real economy, according to QNB Group. Data released on July 2nd indicated that Eurozone unemployment had risen to a record high in May of 11.1% and a manufacturing activity survey was close to 2009 lows. Manufacturing surveys last week pointed to weakening economies around the world, suggesting the Eurozone crisis is having a wide ranging impact.

Should the European and global economies weaken further, this would be likely to lead to greater stress in the EU banking system and sovereign debt markets and would necessitate more drastic actions from the authorities.

The key measures that could be taken are further long-term refinancing operations (the provision of cheap loans to banks),  increasing the size of the rescue funds (the ESM), a Eurozone bank deposit guarantee scheme that also protects against the risk of redenomination into new currencies and making the ECB and European Commission more democratically accountable as tighter union will strengthen their authority. An alternative means of bringing down borrowing costs in the Eurozone periphery, issuing jointly guaranteed debt, or Eurobonds, has been firmly rejected by Germany.

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