Why the Euro summit matters to you

Australian investors can expect markets to lift if European leaders reach agreement on a rescue plan this weekend.

PORTFOLIO POINT: Expect a sharp response from sharemarkets to the European summit this weekend.

When European and US markets cracked as doubts emerged about the European package, it underlined that if the European leaders don’t please the markets at their weekend summit there will be a sharp decline in share prices on Monday.

If they get it right the markets will improve in the leadup to Christmas.

The immediate cause of last night’s problem was the decision by the European Central Bank to limit its role in the rescue. Most of the big European banks have negative capital positions if you mark-to-market their sovereign debt holdings, so the ECB was a key part of the rescue.

And for Australia, a healthy European banking sector is important because we must be able to tap that market for wholesale funds (they provide about 40% of big-bank funding) and at the moment the wholesale market is frozen. Standard & Poor’s downgraded Australian banks because of their dependence on this overseas wholesale market.

If that market stays shut or is badly impaired Australian banks will have to scramble for local deposits (which will be bad for the economy but good for retirees).

Australia might not be in the front line of the European crisis but we are not far away from it and vulnerable.

So this week let me this week provide you with a layman’s guide to what is happening in Europe. I don’t pretend to know what the outcome will be but we are seeing three possible solutions emerge and one of them will be embraced. I will look at each option and its likely consequences, but first some history.

When the concept of the euro was being considered in the 1990s (it was introduced in 1999) the technocrats actually understood that it would probably not work because you can’t have a common currency embracing a vast number of very different countries.

Accordingly, the euro founders believed that sometime in the future there would be a major crisis and they also believed that out of that major crisis would be born a European region that would be akin to the United States of America. This would require massive delegation by nation states of their rights to govern themselves in money matters.

The founders of the euro have been proved right and Europe now faces a crisis. What we are about to discover is whether it will lead to the formation of the United States of Europe, or one of the other options being adopted.

At the weekend conference German Chancellor Angela Merkel and French President Nicolas Sarkozy will promote a solution that forces severe discipline on the European nation states. The discipline has a clear German flavour to it and it is yet to be seen whether all the European countries will embrace it or something similar.

But they are discovering the other two solutions would be painful, which gives Merkel and Sarkozy at least a chance of imposing their solution. But it won’t be easy.

Opponents of their plan say it would cause years of economic stagnation or recession as governments are forced to raise taxes, cut spending and curtail pensions and other social benefits.

The opponents to the say that already Germany and other more prosperous states are near zero growth and the cuts will put almost all the European states close to recession, causing unemployment to rise, national tax bases to shrink, and sovereign debt to become an even greater problem.

Merkel and Sarkozy are hoping their plan will gain favour from the markets and restore confidence in Euro bonds like those issued in Italy.

In terms of alternative solutions, the most obvious outcome would, of course, have been for countries like Greece, Italy Spain and Portugal to leave the eurozone. They have cultures that are very different to Germany and have become hooked on social services funded by borrowings. Yet if they want to have their own currency, their banking systems will have liabilities in euro and assets in the depressed country’s currency.

The losses will be truly horrific and effectively any banks of the country leaving the euro will be bankrupt and the countries would probably be unable to pay their public servants and many services would cease.

Of course the German and French banks that have lent money to the countries leaving the eurozone would also suffer horrific losses because their assets would be decimated and their deposits would remain in euros.

Vast sums would be required to rescue European banks and the world would have to work out whether many of the banks are worth saving.

The euro without those delinquent countries would rise sharply, which would make it very difficult for German industry to survive. So you can see that there is pain in both the Merkel-Sarkozy and euro split solutions. The third solution is to print as much money as is required, which has a superficial attraction but during the second half of the 20th century all German students were educated to never allow their politicians to become hooked on the money printing presses. In the 1920s, Germany printed money and created rampant inflation, which Hitler used to gain power. The Second World War followed.

Sarkozy and Merkel are saying to all European countries that the pain from either a euro break up or printing money is so great that the United States of Europe is a far better option and they will simply have to find a way to embrace it.

Under the Merkel-Sarkozy plan, lenders to countries in the United States of Europe would have some form of guarantee that they will get their money back and that there will be no repeat of the Greek markdowns, the so-called haircuts. Merkel and Sarkozy hope this will tempt investors to buy European bonds, and bring down interest rates. They also hope other countries will come to the same view that the pain involved in a separation or money printing is too great.

The great risk is that in Merkel and Sarkozy’s anxiousness to get countries to agree, their plan may be too soft. If markets give it the thumbs down, there may not be enough time to put together a stronger plan.

The sceptics say that to really create a United States of Europe you need the kind of fiscal and monetary policy tools the US and Japanese governments have to manage recessions.

The US government has broad taxing, spending and borrowing authority and, with the states, finances social security and pensions, healthcare and other essential public services. The US can run deficits to moderate the effect of recessions.

It is likely that part of the Merkel-Sarkozy solution would involve banks selling off some of their assets and concentrating their lending on Europe. Share and bond markets believe that the consequences of the euro split or printing money would be so bad that Sarkozy and Merkel could gain agreement from the European countries to give up much of the control over their own economies.

A clear risk is that the concessions and spending cuts agreed to would not be great enough for the markets. If that happens or, in later months the agreements begin to unravel under community pressure and protests, then severe volatility would return to global sharemarkets. Meanwhile, despite what the Treasurer Wayne Swan says about the strength of Australian banks, they are not immune from Europe’s problems.

They are heavily dependent on the wholesale market for borrowings, so if the Sarkozy-Merkel package satisfies the markets and the European securities held by the big French and German banks have real value, then once again that wholesale money might become available for Australian banks.

But it is unlikely to be cheap, which is why the banks took so long to come to a decision about following the official cash rate down. The last thing Australian banks want to happen is to reduce interest rates then have to raise them again because of the difficulties in borrowing on the wholesale market.

My view is the Sarkozy-Merkel plan will be given a trial but I suspect the difficulty in gaining approval of all 17 countries and the economic impact will put the agreement under pressure. If that happens then there will be many looking to split the currency but they may find the lure of the printing press too great to resist.