The schizophrenia continues, this time as Goldman lays out the "Failure Frday" hypothesis in an attempt to incite some waterfalling risk off-taking, leading to escalating interventions by domestic governments (all of which captured just for this eventuality) and culmiating with the unleashing of the puppet head of the ECB, but not before GS has had the opportunity to sequester some assets on the cheap. We have rehashed this outlook so many times we won't repeat it again, suffice to say: those who want to know what happens, need merely to look at what happened in 2008, and who ended up gaining the most. In the meantime, this is what Goldman expects of the "summit to end all summits" - "Our bottom line is the following: the ‘clean’ solutions that would have seen clear resolution of that impasse appear to have been ruled out following Monday’s German/French meeting. That makes something altogether fuzzier likely to emerge from Friday, and this risks falling short of market expectations. The sequencing that we believe is being followed will be delayed further into the new year." Said otherwise - yet another failure. Which confirms that the Christmas rally over the past week has been nothing but. And all such "career risk" mitigation exercises in lemmingry, end in the same way: with someone defecting first.
From Goldman's Andrew Benito and Huw Pil
Raised expectations risk disappointment on Friday
Markets have advanced in recent days, seemingly in anticipation of significant progress from this week’s EU Summit. In this piece we set out our expectations for what will emerge from Friday’s Summit.
There has been tangible progress made in addressing the Euro area’s policy-making challenges in recent weeks. A framework for where agreement needs be found and in what order has emerged. Ultimately, that sequence of actions, involving national governments, Euro-area fiscal governance and the ECB, maps out a path to resolving the Euro area’s key policy challenges. But this week, culminating in Friday’s Summit, sees a return to the core ‘impasse’ between the French and German visions of Euro area fiscal governance. Repeating the experience of previous summits, above all we expect high-level statements to emerge from Friday. Lacking an ‘encompassing’ solution, the specifics are likely to take time for politicians to clarify and those details may become the focus of markets, after the meeting.
Our bottom line is the following: the ‘clean’ solutions that would have seen clear resolution of that impasse appear to have been ruled out following Monday’s German/French meeting. That makes something altogether fuzzier likely to emerge from Friday, and this risks falling short of market expectations. The sequencing that we believe is being followed will be delayed further into the new year.
Stock and flow problems are being addressed through ‘sequencing’
As ECB President Draghi highlighted in a speech last week, policy-making is following a path of ‘sequencing’. The sequence is a play in three Acts. And the ECB plays its role – which we believe will consist of purchasing sovereign debt on a much larger scale - in the third Act. We consider that role for the ECB an important aspect of ‘mutualising’ some of the debt overhang, as we have described it in the past. But crucially, this comes after the two prior Acts: 1) national governments’ commitments to additional fiscal adjustment, such as Italy’s announcements at the weekend and 2) a ‘fiscal compact’ that agrees on the future fiscal governance in the Euro area.
The fiscal compact (‘Act II’) needs to agree on what the future form of fiscal union will look like. There are many potential options. But a key development on Monday was that two options that would have resolved the past impasse most cleanly have been ruled out. Chancellor Merkel has ruled out the Eurobond – that would have directly ‘mutualised’ excessive debt in the peripheral economies (the ‘stock problem’). President Sarkozy, meanwhile, has ruled out the fiscal intrusion that would have given a formal veto against national budgets (addressing the risk of a future ‘flow problem’ of high deficits).
Having seen these two clean ‘corner solutions’ ruled out, puts us in the realm of somewhat messier ‘grey areas’ for what to expect from Friday and whether what emerges will satisfy market expectations. We also believe that the areas where agreement is likely are less substantial and less cleanly directed at the underlying stock and flow problems facing the Euro area. Focusing on where agreement is more likely, even if it is less substantial, would repeat the pattern of the October Summit.
Market expectations appear high that the agreement will prove sufficient for the ECB to intervene on a much larger scale. Trying to second-guess what is the necessary threshold for the ECB adds a further layer of complexity to the assessment.
Within this realm of ‘shades of grey’ what we can expect to emerge on Friday includes:
- Further details on ‘automatic sanctions’ against countries that fail to comply with budget deficit rules. The Sarkozy/Merkel meeting on Monday agreed to change the burden of proof that prompts a sanction, compared to excessive deficit procedure rules. Under the likely proposals, sanctions can be blocked only when a qualified majority oppose the sanction (15 from 17 states).But based on Monday’s meeting, it is unclear whether any new sanctions are likely to emerge. These additional sanctions may still follow. They might include financial penalties and/or involve a loss of voting rights.
- Balanced budget rules and debt ceilings - Although it seems the European Court of Justice will not be able to declare national budgets invalid, it is likely to be able to state whether national legislation (eg, constitutional debt ceilings) guarantee compliance with required debt ceilings.
- Private sector involvement – Further clarity on the conditions under which private sector involvement (PSI) could be expected in any future debt restructuring. That includes clarifying what PSI being “in accordance with IMF rules” means. Article 12 of the ESM states that financial assistance requires adequate and proportionate private sector involvement in any debt restructuring. It is currently unclear whether Article 12 of the ESM will be changed.
- European Stability Mechanism - the permanent successor to the European Financial Stability Facility and is likely to be brought forward by at least 6 months so that it is in place by end-2012. The ESM is significant partly because it will have some paid-in capital behind it. The ESM may also have access to the ECB, as a credit institution.
- Treaty change – this includes the option of a second treaty applying to the 17 Euro area members. This would represent a move towards the German position and would be negotiated expected by March 2012.
Significant progress along these dimensions has been made and seems likely to be announced on Friday. That progress is meaningful. Where our view differs from those views that emphasize this agreement is that we see these factors as still falling short of directly addressing the core challenges facing the Euro area.
Where the IMF fits in
The sequencing we have outlined applies to the timing of commitments being made in that order (national governments’ fiscal adjustment – Euro area agreement on fiscal governance – ECB asset purchases). But in practice each commitment will play out alongside each other. That makes monitoring and, potentially, disciplining those who do not live up to their commitments important. Indeed, the role is especially important in the period of transition as we move towards any new arrangements enshrined in Treaty changes. The IMF may have a special role to play in providing this monitoring and discipline during the transition phase. Given its experience of monitoring and imposing ‘conditionality’ through gradual disbursement of funds, the IMF can make the ‘bridge’ to those new arrangements more stable than otherwise. But this IMF role is unlikely to be clarified in the near term.
This brief overview, alongside experience from the October Summit, adds to our sense that what emerges will be another step forward, it will build on past progress but it will also involve some degree of ‘wishful thinking’. The new year will be required to clarify what is meant by ‘fiscal union’. We expect the ECB to move progressively towards more proactive purchases on a larger scale. But any such actions will fall short of attempts to ‘cap spreads’. We do not think the ECB to act more proactively soon, based on the commitments and statements of intent that emerge on Friday.