Markets look for more action, less talk on the eurozone

As European leaders prepare for Thursday's summit, Julian Knight assesses the complexity of the economic tests ahead
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The Independent Online

Say it very quietly, but there is just a little optimism surrounding the single currency as EU leaders prepare to meet in Brussels on Thursday.

The European Central Bank's recent promise to stand as a "fully effective backstop" to member states through a bond-buying programme has brought some confidence to markets and done the trick of reducing the borrowing costs of the likes of Spain and Italy. But analysts warn this confidence is tissue thin and the leaders in Brussels cannot afford for the shindig to turn into a talking shop.

The markets want at least a sense of action, according to Victoria Clarke, the UK economist at Investec: "The warm glow from the ECB's recent decision to stand as backstop behind member states' debt has began to fade and is being replaced by renewed uncertainty," she says.

The question of when Spain will request help from the ECB seems to be the focus of market jitters: "Most expect Spain to ask the ECB for help but the government of Mariano Rajoy is facing crucial elections in Catalonia on 25 November and doesn't want to be seen to be going to the ECB cap in hand before then. That would be a massive blow to the Rajoy government's prestige," adds Ms Clarke.

The positive reaction from markets to the ECB's bailout scheme is benefiting Spain as it has helped supress borrowing costs.

"The ECB hasn't bought a single bond, but the potential of the scheme and the power of the ECB is helping prop up the debts of Spain and Italy, this is encouraging Rajoy to try to wait it out," says John Zhu, an economist at HSBC.

But playing chicken with the markets as Spain is doing is not a strategy with any hopes of long-term success and if the mood music emanating from the leaders' meeting this week is anything but conciliatory and forward looking then a general sell off of Spanish debt could force Rajoy's hand, earlier than he'd hope.

"An acrimonious or disappointing summit could well lead to a spike in bond prices at just the wrong time for Spain, the official language will be very important as will what is said by the likes of Germany on the side lines," says Andy Scott, a premier account manager at currency dealing firm HiFX.

Markets will also be watching the latest twist in the Greek economic tragedy. Officials in Athens are still short of reaching agreement with the troika, representatives from the European Commission, the ECB and the International Monetary Fund (IMF), over whether the country is doing enough to qualify for the next tranche of bailout cash.

In recent weeks, the Greeks have been talking tough saying they want the ECB to buy its bonds too, if necessary, as part of any deal – an unpalatable concept to the hawks in the bank and many politicians in Germany.

And, according to Ms Clarke, Chancellor Angela Merkel's visit to Athens last week seemed to do little to ease the current impasse.

"Basically, the Greeks and the troika are around ¤2.5bn apart on spending cuts and I can't see any signs of a move this side of the leaders' summit, particularly as the Athens government is supposed to have enough money to take it through to November. The Greek government will no doubt come under pressure at the summit," Ms Clarke says.

But what about the other G word: growth? With official Greek unemployment breaching 25 per cent for the first time last week and Christine Lagarde, the IMF's managing director, calling on the eurozone to give the likes of Spain and Greece more time to get their debts under control, there is pressure on the leaders to do more on growth.

The IMF supported its change of tune – to the anger of the Germans and discomfort of George Osborne – with research showing that the austerity was having a more detrimental effect on growth than first thought.

"It's becoming clear that we need a plan for growth. Demand is the most crucial commodity in the world at the moment. We have plenty of plans for austerity and meetings about that but nothing for growth," says Mr Zhu.

However, a concrete plan for eurozone growth is going to need more funds and more co-operation than is likely to be mustered at the leaders' summit.

"There is no silver bullet to the crisis – no one measure. It's a case, at best, of two steps forward one step back. It probably won't be apparent for a while after the crisis has passed what actually caused the shift in sentiment that is needed," Mr Zhu adds.

This could come with further progress on plans which started in June for a banking union, which would give the ECB oversight of European banking and enable direct bailouts of banks, most notably those in Spain.

But there seems to be a north-south divide developing over the pace of banking union with most observers reckoning that an early 2013 start date is looking unlikely.

"It's not clear if there is any real agreement on this – Spain and France want it implemented sooner but they face resistance from Germany which wants more caution. A major challenge for the summit is to come up with a more coherent plan for the implementation of the banking union," Mr Scott says.

But non-eurozone members – most notably Britain – will want to ensure any union doesn't affect their domestic banking industry.

EU heads' to-do list

Shore up Spain Gauge when and if the government of Mariano Rajoy plans to call on the aid of the ECB to buy its bonds.

Prevent a Gr-exit Break the deadlock between the Athens government and the troika over the next tranche of spending cuts, to free up further bailout cash.

Get growth going The EU may well fall into recession in this quarter and some parts are in a seemingly never-ending depression.

Banking union Overcoming the caution of the northern European states to push ahead with plans to draw the eurozone's banking system together.