European Union summit: 'No quick fix'

@CNNMoneyInvest June 27, 2012: 8:25 AM ET
euro area quartet

The leaders of Spain, France, Italy and Germany met last week to discuss economic reforms ahead of the latest EU summit.

NEW YORK (CNNMoney) -- European Union leaders have signaled that their latest summit will set the stage for a dramatic rethinking of the economic and political edifice that underlies the euro currency.

The European Council meeting, which brings together the leaders of all 27 EU nations for two days starting Thursday, is being billed as the first step toward deeper integration.

The euro has been badly shaken by more than two years of constant crisis. But it remains to be seen if politicians can push past previous stumbling blocks and reach consensus on thorny issues of national sovereignty and debt.

"What is at stake is not only the economic integration, it is also the overall economic confidence in the euro area, and indeed, our commitment to the European project," said European Commission president Jose Barroso, in a speech Tuesday. "This is why we need to be bold and define the way forward."

The summit comes amid high anxiety in financial markets as large euro area economies are starting to look vulnerable.

Investors are worried that Spain could be the next to seek a bailout after Madrid asked for emergency loans to shore up its banks.

Italy is in better financial shape, but investors are concerned that the government's debt load could become unsustainable if borrowing costs continue to rise and economic activity remains sluggish.

"This is the first EU summit that will take place when the bloc's fourth-largest economy is in the process of being bailed out while the third-largest continues to face a run on its debt," said Nicholas Spiro, director of London-based consultancy Spiro Sovereign Strategy. "Make no mistake, this is the 'Spain and Italy' summit."

While a surprise break-through cannot be ruled out, most investors are not holding their breath.

"The summit can only disappoint, in the sense that the markets want a quick fix," said Andreas Utermann, global chief investment officer at Allianz Global Investors. "There is no quick fix for this."

Despite the low expectations, some hope that Germany will relent on a proposal championed by Italian Prime Minister Mario Monti to allow the use of bailout funds to purchase sovereign debt.

Officially, the leaders will discuss "building blocks" to address the long-term challenges facing the euro area economy, according to a paper by European Council president Herman Van Rompuy and other top euro area officials, including European Central Bank president Mario Draghi.

Of course, this will take time.

An interim report could be done in time for the October European Council meeting, in the hope of having a final version by the December meeting, according to Van Rompuy.

Banking union: The first step is to form a so-called banking union, including increased oversight by the ECB, common deposit insurance and a mechanism to aid banks that are too big to fail.

The aim is to restore confidence in the European banking system and break the "negative feed-back loop" between euro area governments and the financial sector.

In Spain, for example, banks are among the biggest buyers of domestic sovereign debt. That means a bailout of the government would drag down the banks, and vice versa.

While it is considered one of the more achievable goals, analysts say there is significant disagreement among euro area leaders over how the banking union should be implemented.

It is also unclear whether non-euro members of the EU, such as the United Kingdom, would join the banking union.

In any event, analysts do not expect it to be up and running until 2013 at the earliest.

Fiscal union: The next building block is more controversial and will likely take years, if not decades, to become reality.

The idea is to correct fundamental flaws in the structure of the euro monetary union, in which 17 nations are bound by a common currency but have very different policies when it comes to government spending.

According to Van Rompuy's paper, the leaders will discuss "upper limits" on government budgets and debt levels. They could also give EU authorities more power to change the budget policies of euro area member states "keeping in mind the need to ensure social fairness."

In a more contentious move, Van Rompuy proposed steps toward some form of debt sharing, which could include eurobonds or euro bills, effectively creating a "Treasury office."

French president François Hollande has said eurobonds, which would combine the debts of euro area governments, should stay on the table. But the idea has been blocked by German Chancellor Angela Merkel and other more fiscally conservative euro area politicians.

Economic stimulus: The leaders of Germany, France, Italy and Spain agreed last week on a package of "growth-enhancing" policies that are worth about €130 billion, or 1% of eurozone gross domestic product.

These measures include increasing the resources of the European Investment Bank to stimulate growth and create jobs by funding public works.

Economic activity has slowed across Europe, with several EU nations falling back into recession during the first quarter. The latest reports on euro area manufacturing activity point to continued deterioration in the second quarter.

Spain: The summit comes days after Spain formally requested loans from the eurozone bailout fund to recapitalize insolvent banks.

The big question is whether the loans will be given directly to the banks or channeled through the Spanish government. The fear is that lending to the government would drive up Madrid's debt load and further undermine its credibility in the bond market.

In addition, eurozone finance ministers have yet to decide whether the bailout fund, known as the European Stability Mechanism, will be given preferred creditor status. Investors are concerned that the ESM would be repaid first in any restructuring of Spanish government debt, while private bondholders would come second.

Greece: No summit of EU leaders would be complete without some discussion of Greece, where the eurozone crisis was spawned more than two years ago.

Greek Prime Minister Antonis Samaras, who is recovering from eye surgery, is not expected to attend.

Samaras brokered a deal earlier this month to form a coalition government with two other political parties. While the coalition has pledged to honor Greece's financial obligations, it is also expected to renegotiate the terms of the nation's bailout package. To top of page

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