Europe is likely to continue to send shockwaves through stock, currency and bond markets over the next few weeks, but its leaders are slowly heading toward agreement on sorting out the euro zone debt crisis– although this will involve having to "look into the abyss" first, according to analysts and market observers.
However, it all hinges on the single currency area's paymaster, Germany. That country’s Chancellor Angela Merkel must come to the rescue sooner rather than later, according to analysts, risking the wrath of her own electorate.
As bad news piles up for the euro zone, yields on the European periphery countries' debt continue to climb, depositors in Greek and Spanish banks ship their money abroad, and Greece's departure from the euro zone after its June 17 election is seen as increasingly likely.
On Tuesday, Spanish Treasury minister Cristobal Montoro sent the euro to a session high and caused a brief fall in European stocks when he said the country's high borrowing costs mean it is effectively shut out of the markets.
"The risk premium says Spain doesn't have the market door open," Montoro said on Onda Cero radio, quoted by Reuters. "The risk premium says that as a state, we have a problem in accessing markets, when we need to refinance our debt."
Analysts and some politicians have said that what the euro zone needs is fiscal union – a common budget like the U.S. – if it is to survive over the long term. Right now, although they have the same currency, countries' yields on sovereign debt vary wildly and there is no common, euro zone joint Eurobond to ensure that they can get cheaper funds should they need them.
Merkel met with European Commission President Jose Manuel Barroso ahead of the next European Union Council Summit, which is due to take part on June 28 and 29.
Merkel's Slow Progress
Before her meeting with Barroso, Merkel told journalists late on Monday that she favors a European supervisory authority for banks that are big enough to affect the financial system if they are in trouble, and indicated that a roadmap was underway for fiscal union.
"The world wants to know how we conceive the political union that will accompany monetary union, and we have to provide an answer to this question in the foreseeable future," she said, according to Reuters.
Thomas Harjes, a euro zone analyst at Barclays, thinks this means that for the short run, the German government will continue to insist that fiscal consolidation and structural reforms proceed, but that it is open to discussing a roadmap toward fiscal union. However, things are moving too slowly, he added.
"The creation of a European banking union will take time, and not all EU member states may be willing to join. The same holds for a fiscal union and more common joint liability," Harjes pointed out in a research note.
One way to save the euro zone would be to create a European Redemption Fund (ERF) – an idea first proposed by the German Council of Economic Experts, a group of economists advising the German government and parliament, in November last year.
The ERF would pool the excessive debt of euro zone countries and would fund itself by issuing jointly guaranteed bonds. It will assume all debt in euro countries in excess of the Maastricht-agreed 60 percent of gross domestic product limit.
Countries that would be able to take part in the ERF would be those whose debt exceeds 60 percent of GDP and which are not already in an adjustment program financed by other entities – therefore, Greece, Portugal and Ireland would be excluded.
According to the Council of Economic Experts, the countries that would take part in the fund at present would be Austria, Belgium, Cyprus, Germany, France, Italy, Malta, the Netherlands, and Spain.
Not the Same With Eurobonds
The idea of straightforward common Eurobonds for the euro zone has been slammed for breaking European law, as it would amount to the transfer of debt from lower-rated periphery states to richer, better-rated ones. The ERF, however, would ensure that countries that transfer more debt would pay proportionally more into the fund, the Council of Economic Experts explained.
"However, the joint and several liability means an alignment of the refinancing costs. Compared with the current situation there may thus be more or less of a burden placed on the individual countries," the Council explained on its web site.
The idea is attracting increasing support, with members of the European Commission and the European Parliament calling for the introduction of such a fund, according to Ralph Solveen, an analyst with Commerzbank.
Germany prefers the ERF to simply issuingjoint Eurobonds because the debt assumed by it will be limited both in time and in volume.
"With each redemption payment to the ERF, the volume of bonds guaranteed jointly and severally decreases, meaning that the fund slowly abolishes itself," according to the German Council of Economic Experts. "Unlike this, Eurobonds are permanent in character and their volume is not limited."
Italy would transfer the largest amount to the fund, around 975 billion euros ($1.2 trillion), representing about 42 percent of its volume, with Germany the second-largest debtor, according to Commerzbank's calculations, which put the total amount transferred to the fund to 2.3 trillion euros.
"The advantages of such a construction, particularly for Italy and Spain (but certainly also for some of the other participating countries), are obvious: their refinancing costs would be significantly lower," Solveen said. "On the other hand, however, Germany would certainly have to bear higher financing costs."
Looking at ECB With Little Hope
The plan includes automatic sanctions for countries that diverge from brakes on debt, and there would be a redemption plan for a substantial proportion of debts. Both measures would sweeten the pill for Germany.
"This could strengthen investors' confidence in the long-term sustainability of euro zone public finances, thus curbing the sovereign debt crisis, which would in turn benefit the economies of the core countries," Solveen wrote.
But even if such a compromise were to be reached, it would still take months to agree on a plan and clear the bureaucratic burdens, and markets are looking for a more immediate solution or at least a confidence boost.
All eyes are on the ECB monetary policy meeting on Wednesday – a day earlier than its usual Thursday meeting because of a bank holiday – to see whether the central bank will step in and provide another temporary painkiller to markets.
Economic data in the euro zone have been very weak recently and some analysts say that even strong, core countries are in recession.
"We expect the ECB to respond with a rate cut on Wednesday," said Anders Moller Lumholtz, a senior analyst at Danske Bank.” A cut is partly priced in the market although unchanged rates remain the consensus among analysts."
However, Lumholtz added that the rate cut – which he sees at 0.25 percentage points – is unlikely to be "a game changer," as the market focuses on additional non-standard measures from the central bank - unlikely to come before the Greek election and the EU summit at the end of June.
"Hence, market sentiment is likely to worsen before things improve," he said. "[ECB President Mario] Draghi will once again call for a response from the political leaders. It appears that we will have to look into the abyss before the political leaders deliver."