Endgame for Europe's Currency Reform Is Euro Summit First Step Toward Economic Government?

The future architecture of Europe's common currency is starting to take shape. On Friday, leaders of the 17 euro-zone countries are meeting in Brussels to hammer out details of a plan to ensure the stability of the beleaguered euro. German Chancellor Angela Merkel remains under tremendous domestic political pressure to remain tough, but concessions are expected.
Angela Merkel and Nicolas Sarkozy (in December): A taxing marathon summit is expected.

Angela Merkel and Nicolas Sarkozy (in December): A taxing marathon summit is expected.


Germany's Angela Merkel is facing two major European summit meetings on Friday. First, in the early afternoon, she will attend the European Union's special summit on Libya. Afterwards, she will remain in Brussels into the evening for the "informal meeting" of the 17 leaders of the euro-zone countries. And although it is likely that further sanctions against the regime of Libyan dictator Moammar Gadhafi will be agreed upon easily, things are expected to get a bit hairier when it comes to setting the future course of Europe's common currency, which has experienced a rollercoaster ride in the past year.

The EU leaders plan to reach an agreement about a major currency reform at the next EU summit at the end of March. Between now and then, Europe's leaders will negotiate the contents of the final plan. What will the permanent rescue fund look like starting in 2013? Which sanctions will it include for deficit offenders? Each euro-zone nation is under considerable pressure. Deficit offenders like Ireland and Greece are pushing for improvements in the conditions under which they have received loans. But countries like Finland and the Netherlands vehemently oppose those calls.

Meanwhile, Germany's Merkel also faces considerable pressure -- both at home  and abroad . The parliamentary groups of her own government coalition parties -- the conservative Christian Democratic Union (CDU), its Bavarian sister party the Christian Social Union (CSU) and the business-friendly Free Democratic Party (FDP) -- expect the chancellor to remain firm and not accept any further steps that would turn the euro zone into a transfer union in which richer countries provide financial support to the weaker ones. As the representative of Europe's leading economic power, however, the chancellor will find herself in the role of intermediary, and it is a given that she will have to make concessions. Her "pact for competitiveness" , too, which was envisioned as a more stringent version of the previous euro-zone stability pact, has already been softened considerably.

So what are the main issues at this Friday's summit? Who is pursuing which interests and what is expected to be decided on in concrete terms? And why aren't all 27 EU member states meeting?

Friday's meeting is a pre-summit in the run-up to a much larger one with all 27 member states on March 24-25. Euro-zone leaders want to reach preliminary agreements on a restructuring of the stability pact prior to the regularly scheduled event later this month, when the final reform package on Europe's common currency is expected to be approved. The fact that the club of 17 are meeting prior to that summit is already being celebrated in some quarters as the first step toward the creation of a common economic government -- a step Merkel and Germany had long resisted until the scope of the euro problems became clear.

What Decisions Are Expected?

The euro-zone leaders want to give their blessing to the "pact for competitiveness" at Friday's meeting, but final approval isn't expected for another two weeks. But by the end of the month, four major points will be decided on:

  • Possible changes to the existing bailout packages for Ireland and Greece
  • An increase in the capital and guarantees in the existing European Financial Stability Facility (EFSF) so that it can cope with cases of further countries potentially facing insolvency
  • The structure and composition of the permanent European Stability Mechanism (ESM) rescue fund
  • Structural reforms in the euro zone aimed at preventing future crises (the "pact for competitiveness").

Merkel has stated that the package must be accepted in its entirety -- or not at all.

What Does the German Government Want?

Above all, Merkel wants to prevent the resources of the euro rescue fund from being used too flexibly. In particular, she doesn't want EU money to be used to buy government bonds of overly indebted EU countries. Rescue actions should remain the exception to the rule and should only take place when "the euro zone as a whole" is in danger.

As accompanying measures to the rescue package, Merkel also insists that the partner countries obligate themselves to implement structural reforms related to retirement ages, wages and taxation in order to increase competitiveness within the bloc and ensure that the current debt crisis is not repeated.

Will the Temporary Euro Rescue Fund Be Increased?

It is likely that the temporary rescue system will be enlarged to give leaders more leeway. The current amount of €750 billion ($1.03 trillion) cannot currently be fully disbursed, as a cash buffer is needed in order to maintain the highest possible credit rating for the fund. Only the €250 billion from the International Monetary Fund and the €60 billion from the EU budget can be withdrawn. The remaining €440 billion comes in the form of credit guarantees provided by the euro-zone states.

Since only six euro-zone countries have a AAA rating, the fund can only lend out their share of the €250 billion at the most favorable interest rates. In order to exhaust the full coverage, the AAA states, including Germany, must increase their share.

The increase is a precautionary measure in the event that other bankruptcy candidates will soon also have to take cover under the rescue umbrella. Until now, money from the fund has only gone to Ireland. Greece had its own special package.

What Chances Does Merkel's Pact for Competitiveness Have?

In order to deflect attention from the constant stream of new impositions on the pocketbooks of German taxpayers, Merkel has been trying for some time to shift the focus of the discussion so it concentrates more on the obligations of the weaker euro nations. With that in mind, she and French President Nicolas Sarkozy presented a pact for competitiveness at last month's EU summit.

The six-point plan foresees, among other things, further harmonizing wages, taxes and retirement ages in the euro zone so that the economically weaker countries are better aligned to the stronger countries. The recommendations were too concrete -- and too German -- for many partner states, however.

After angry protests, Herman Van Rompuy, president of the European Council, the powerful EU institution that comprises the 27 leaders of the bloc and has the final say on many issues, prepared a compromise paper that still includes only vague wording about how the euro-zone countries should, as a whole, practice wage moderation while keeping an eye on demographic developments. This paper is the starting point for further talks.

It is only a voluntary commitment by EU leaders, not a binding change in EU law. The summit participants declare that they will do their best to reach the desired common goals, but it does not contain any mention of sanctions.

Will Ireland and Greece Get Their Wishes?

The new Irish government under Prime Minister Enda Kenny is calling for a reduction in the interest rate associated with the EU rescue package that was adopted in November. Many Irish feel that the rate of 5.8 percent is too high, especially given that the EU can borrow money for a rate of 2.9 percent on capital markets. The EU is expected to make a concession in this regard.

Greece would like to extend the timeframe for paying back its EU loans and also use them to buy back the country's own bonds at favorable rates. The German chancellor recently expressed her support for the Greeks on this point.

What Does the ECB Want?

Meanwhile, the European Central Bank (ECB) wants to offload  the Greek, Irish and Portuguese government bonds it has acquired since the start of the euro crisis, and it envisions the euro rescue fund taking the debt -- worth about €77 billion -- off its hands. The ECB will continue to push behind the scenes to get its balance sheet cleaned up. The central bankers are unhappy about the bond purchases they made as part of the emergency assistance -- considered a massive breach of an ECB taboo -- and want to clean up their act again.

Nevertheless, several EU countries, including Germany, reject the idea of financing the purchase of government bonds from the euro rescue fund.

How Do the Markets Perceive the EU's Plans?

After the last year's uncertainty, a certain calm appears to have returned to the markets. Clearly the realization has spread that the EU has the will and the means to prop up the euro. This does not mean that all the market's doubts are gone, however.

Just this week, Greece and Spain's credit ratings were downgraded  again -- and that is unlikely to be the end of the story. The risk premiums on Portuguese and Greek bonds have also hit record levels at times.

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