The EU Summit Recap

June 29, 2012

Today marks the end of the two-day Euro Summit in which leaders of euro zone countries met to quell uncertainty over the European financial crisis. Many agreements were reached, but the world awaits further action and implementation. Here is a breakdown of the decisions:

Terms for European Stability Mechanism

As the European Stability Mechanism (ESM) replaces the European Stability Mecahnism (EFSF) there has been some disagreement amongst euro zone leaders over whether decisions on funding to aid financially distressed countries will be decided by a unanimous vote. The Wall Street Journal reports, “The original wording of the ESM’s treaty requires that ESM decisions be taken in unanimity, but allows funds to be mobilized on the basis of a qualified majority of 85% of votes cast, if there is a risk to the financial stability of the entire euro zone.” The ESM, or “bailout fund,” will continue to support euro zone countries by buying sovereign debt when needed.

Direct aid to banks

The ESM’s powers were expanded at the euro summit. The body has been granted the ability to inject capital directly into struggling banks. This is beneficial to countries like Spain whose banks do not have enough capital because the cost of borrowing is so high. For instance, instead of lending to Spain, which would add even more debt to the government’s balance sheet, the ESM will lend to the banks directly. Howeve, the ESM will not be able to directly capitalize banks until after a banking union is formed, which could take up to a year.

Spanish Debt

The financial support previously agreed upon to recapitalize Spain’s banks will no longer be senior to Spain’s existing government debt. “Senior debt” must be paid first before all other creditors receive the funds lent to the government. With this ruling, Spanish bondholders will be paid before the ESM, contrary to what was originally agreed upon. As a result, yields on Spanish and Italian debt declined as investors were reassured of repayment.

Bailout Fund Concessions

Euro countries agreed to lower the bar to receive bailout funds to aid countries struggling to finance their debt. French President Hollande won concessions for easing aid terms for Spain and Italy by threatening a delayed endorsement of ad eficit-reduction treaty, a key achievement for German Chancellor Angela Merkel. Hollande said of the agreement, “The best way to make others move is to move ahead oneself.”

Timeline

Euro leaders gave their finance ministers 10 days to adopt steps to implement the above agreements. Member countries have until the end of the year to agree on banking union terms, which means direct bank aid may not be available until 2013.

The decisions reached definitely had positive impacts on markets around the world, but will this be enough? In the short-term, investors seem more confident, but in the long-term they must be convinced that euro-zone government bonds are safe. Furthermore, governments must begin to decrease government spending so as to cut down on the amount of debt on government balance sheets rather than adding to it.

If markets get worse, the euro zone may look at pooling their debt, but euro zone countries must focus on the real problem, not just the symptoms. Euro zone countries will need to take decisive action and focus on policies that enhance economic growth and reduce their debt. Meanwhile, maybe Washington can learn to do the same.

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