Eurozone Watch: Pre-Summit Jitters, ECB's Emergency Moves Rattle Markets

The big question over the last week: Can Europe’s leaders find a workable solution to the crisis in the short amount of time given to them by the recent intervention of the world’s major central banks? This week’s summit in Brussels, which starts Thursday evening with a working dinner and continues on Friday, is the make or break moment for the eurozone – this has been said about every single one of the many crisis summits since last spring, but this time it really does seem to be the case.

The most prominent items on the agenda will be Monday’s “Merkozy plan,” a call for closer fiscal union issued by the leaders of France and Germany, and the overlapping “fiscal compact,” a plan delivered by European Council president Herman Van Rompuy. The fiscal compact hopes to use an amendment of protocol 12 of the European Union treaties – a legal loophole that would allow the passage of debt and deficit limitations in the national constitutions of all eurozone countries without having to go through the long and arduous process of individual referendums and parliamentary approval in each member country.

Van Rompuy’s plan also includes a separate set of treaty changes that would be pursued alongside the protocol 12 amendments, giving the European Commission the power to scrutinize national budgets  -- before they are presented to their parliaments -- and to approve any planned economic reforms.

The plan faces at least two opposing sources of resistance. Is it tough enough for Germany, which is pushing for rigid controls backed by the ability to take disciplinary action against errant states? And is it too much for Britain, where prime minister David Cameron is threatening to veto any version of the fiscal compact unless his country gets something in return? If Cameron remains intransigent, he was warned today by Jean-Claude Juncker, prime minister of Luxembourg and chairman of the Eurogroup, the treaty changes will be passed by the 17 eurozone countries alone, leaving Britain and the other nine EU members outside the zone sidelined.

Market sentiment as leaders arrive in Brussels is apprehensive at best. The FTSE 100 closed down 1.14%, while across the water the Dow Jones Industrial Average had shaved 150 points off by midday in New York. Spanish and Italian 10-year bonds are again on the rise, Italy’s 10-years saw a jump of 450 basis points to 6.515%, while Spanish yields went up to 5.831%, up by 373 basis points.

“Pre-game jitters,” as the Guardian suggests, but also a reaction to several pieces of summit eve news. First, the package of emergency measures announced today by European Central Bank chief Mario Draghi, in which he stripped back the last of previous chief Jean-Claude Trichet’s interest rate hikes. The ECB will also “make three-year loans to cash-strapped banks; and accept a far wider range of collateral, including mortgage-backed securities and other A-rated assets, in exchange for emergency loans. Individual central banks within the eurozone will also be allowed to accept bank loans in exchange for liquidity, at their own risk.” In addition, the ECB has cut the reserve ratio European banks are required to deposit with it from 2% to 1%.

It’s all in service of averting the looming credit crunch, and should, you’d think, be greeted as good news by investors -- but the sheer scale of the ECB’s actions seems to have struck many analysts as a sign of just how desperate things must be behind the scenes. More prominently, Draghi disappointed those hoping for a bigger role for the central bank – taking on the role of lender of last resort and hovering up the sovereign debt of distressed peripherals – today declaring that such expectations were unfounded and based on a misinterpretation of his previous remarks.

Adding to the unease: the results of the latest round of stress tests on European banks, revealing a shortfall of 114.4 billion euros across the continent, up from previous estimates of 106.5 billion in October; ECB predictions of a gloomy economic outlook for the eurozone, with 1% growth at best and a 0.4% contraction at worst.

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