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Europe: Markets Await the Next Step

Europe markets closed just off lows, with big banks down in the mid-single digits. This is the week of lowering expectations going into the EU Summit on October 23. Traders are expecting clarity on three issues:

1) how the EFSFmoney will be spent, and whether leverage will be used;

2) a procedure for recapitalizing banks, either through the EFSF or through national governments;

3) an increase in the "haircut" on Greek bonds.

So where are we in this long process? I would make four observations. Under almost any scenario, we can expect:

1) a roadmap to further fiscal integration from the EU Summit. There are clear indications that the Europeans are getting closer to fiscal integration. Whether it is the "all-in" some are expecting is not clear, but some kind of roadmap that will stretch into 2013 will certainly be presented.

2) the size of funds to ultimately get bigger, whether it is the EFSF, the ESM, the ECB balance sheet, or, ultimately, the IMF. Indeed, the ECB has already expanded its balance sheet by buying government bonds.These funds, however, will likely be restrained by much tighter fiscal discipline. There was much discussion about the article that ran in the London Sunday Times that China may yet invest in European sovereign debtin exchange for more budget cuts and structural reforms. In other words: they want to know how big the hole is before they fill it.

2) almost anything will be done to prevent another Lehman. That means systemically important banks will be identified, and some kind of transnational framework will be set up to make sure banks are monitored in the same way across national borders. Central banks will work out some plan to recapitalize banks and ensure that they have sufficient funding.

3) the ultimate solution will involve a global effort. Traders believe that only the IMF has a big enough "bazooka" to adequately deal with the problem. There was noise last week that Brazil would consider investing more in the IMF to help Europe. The problem: emerging market countries would only do this in exchange for a greater say in how the organization is run and governed. It's not clear that developed countries are ready to make that trade — yet.

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