What sparked yesterday's renewed concerns around the eurozone?

Over on his Forbes blog Open Europe's Raoul Ruparel provides a comprehensive analysis of the renewed concerns around European banks, centred around Banco Espirito Santo (BES), which saw stocks falling across Europe yesterday. The full post is here and reproduced below.

Firstly, there’s no doubt there are some valid concerns surrounding BES, the key ones of which are:

• The ownership structure is a mess. BES is 25% owned by Espirito Santo Financial Group, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito Santo International (last two are based in Luxembourg).
• The exposure between these level is equally opaque, with the WSJ highlighting back in December that ESI was utilising different branches of its structure, including BES, to fund itself up to the tune of €6bn. Currently, BES has admitted it has the following exposure: €980m debt from Rioforte, but it also helped place €651m of debt issued by Rioforte and ESI to retail customers and €1.9bn to institutional clients.
• This debt could essentially be worthless or massively written down. It’s not clear how open BES was about its conflicts of interest and if it mislead buyers. There is a serious risk of lawsuits here. Citi has put potential total losses at €4.3bn, this could wipe out BES capital buffer and force it to raise a similar amount again.
• BES also has a worrying exposure to its subsidiary in Angola which is draining €2bn worth of funding. This is substantial for a bank with a €6bn loan book. The bank has also required a 70% guarantee from the Angolan state, which itself has a poor credit rating meaning the usefulness of such guarantee may be limited (the fact it was needed at all says a lot). This has also been weighing on the share price.

All this culminates into some very real concerns. While there are plenty of unfounded rumours flying around, the fact is they are hard to disprove because the structure of the bank and its affiliates is so maddeningly complicated. The exposure has also been continuously underestimated and hidden so it’s only right to ask, what else might they be hiding?

But all of these are very specific BES problems, why has this suddenly sparked Europe-wide contagion. I believe there are a few factors behind this:

• The market has pulled too far ahead and was looking for an excuse to pull back. The market is also in a bit of a price discovery phase, still trying to figure out how to balance the issues of low inflation, search for yield, remaining eurozone risks and future ECB action, so it can be prone to sharp moves. The lower volumes and liquidity in certain markets may also exacerbate the move. Lastly, with the recent market convergence, there is bound to be more spill over between and within markets. All to say, part of this may be the confluence of market factors and circumstances – such a situation can last but is more likely to be temporary.

• More importantly though, investors are realising that, if the bank got into trouble it would have to rely on its sovereign for help. The bank cannot afford to recapitalise to the tune of €4bn. Equally though, Portugal (in the midst of trying to find further budget savings) would struggle to stump up the cash – hence the sovereign spill over. Talk of the sovereign-bank loop being broken are seemingly premature (as I have said before). 

• On top of this, investors are also looking at a lot of uncertainty about how a bailout/bail-in might work and what the exact rules would be. The eurozone’s rules on bank bail-ins and the single bank resolution mechanism don’t kick in for some time and while the state aid rules make it clear investors will take losses the exact format is very uncertain. These two points should once again peak investors’ concerns about how such bank resolutions might be handled. Throw the political obstacles in the mix surround a national flagship bank such as BES and one might wonder how much has really changed since such questions were asked at the peak of the crisis.

• More generally, BES’s problems show some elements indicative to periphery banks (particularly in Portugal and Italy). It has a very old, complex and opaque structure and its exposures are still not well known. Too little attention has been paid to this in the past year. The loan books are also weighed down by investments and lending to zombie firms. Let’s not forget, these two countries did not suffer from bubbles but chronic low growth and high corporate debt levels – neither of which has been tackled.

There are clearly some lessons in this situation for eurozone investors and they would do well to remember the short comings in the eurozone architecture, particularly when it comes to the banking sector which is yet to be cleaned up even after six years of crisis. That said, given the specific nature of the problems it is unlikely to mark a huge turnaround in market sentiment. Sure, the market will pull back a bit but we still have the injection of the new ECB lending operations (TLTRO) to come and the hope of some positive data on the GDP and inflation front.

One final point out of all of this is to watch how BES does in the upcoming ECB Asset Quality Review (AQR) and bank stress test. If it is not seen to have been rigorously assessed and problems highlighted then serious questions will begin to be asked about the credibility of an exercise. Now, the failure of the AQR would really be the start of bigger problems for the eurozone. 

The ECB gives Portugal a helping hand with its return to the markets

Portugal this morning followed the lead set by Ireland and Greece and issued new debt for the first time since its bailout in 2011.

Portugal managed to sell €750m of 10 year bonds at an average borrowing cost of 3.58% and with demand totalling €2.6bn (3.47 times the desired amount). This is a successful return, albeit not quite as large as Greece’s or Ireland’s issuance.

Again, many people will be asking why a country with uncertain funding conditions over the coming years saw such solid demand for its debt, even before it exited its bailout. As with Greece, we would say many of the factors are more to do with the state of the broader market than specific to Portugal:

• The issue remains small with a decent yield – there will always be demand for this kind of risk and return.
• This is particularly true in the current market where interest rates are at record lows and there is a dearth of safe assets which still yield a decent profit.
• The ECB and the eurozone have shown their commitment to keeping the eurozone together and have shown a renewed aversion to private sector write downs on sovereign debt. This combination provides insurance to investors that, even if the Portuguese economy struggles, the rest of the eurozone will ensure that it continues to pay its debts.
• Of course, all that said, the reforms which Portugal have instituted and which have helped boost exports will play some role in encouraging investors.

One specific point to note though is that, on top of the general support given by the ECB mentioned above, it also gave Portugal a more direct helping hand.

Die Welt reported on this issue today, terming it a “trick”. In reality, the ECB has altered its collateral rules so that, when Portugal exits its bailout, its government bonds will still be eligible as collateral for its lending operations. The change was snuck through as part of a package of changes in ECB/2014/10 ‘amending guidelines for ECB/2011/10’ last month.

The ECB’s line seems to be that this was simply a move to bring all the ratings from different agencies into line for collateral, so they correspond to the correct level in the other agencies. This is a fair point, but the timing seems more than coincidental, especially since these rules have been in place since 2011.

The thinking is that, without this change, demand for Portuguese debt would have been limited since it couldn’t be used to gain liquidity from the ECB (we explained here why ratings are still important for just this reason). As such, the ECB looks to have given Portugal a helping hand.

We have written before about concerns over the ECB’s independence during the crisis, particularly in relation to adjusting its technical rules to aid struggling countries. This seems pretty close to falling into that category and highlights that, even though the crisis has eased somewhat, the ECB still finds itself treading some difficult boundaries with regards to its independence.

All that said, this remains a positive, if small, first step for Portugal. Questions remain about whether it will be able to fully fund itself without a credit line from the EU/IMF and whether export growth will be enough to offset the collapse in domestic demand and investment.

Can the real Super Mario please stand up?

Former Italian Prime Minister Mario Monti may be out of Italian politics, but it's fair to say he still likes to talk - especially when travelling abroad.

In an interview with Belgian daily De Morgen and Dutch daily De Volkskrant, Monti seems to hint at what many Bundesbank-fearing Germans already suspected: that the ECB's pledge to do "whatever it takes" (i.e. the OMT, the new bond-buying scheme) was de facto grounded in a political decision - contrary to what the ECB's mandate dictates.

Here is what Monti said in the interview:

[At the June 2012 European Council], I have used my full negotiating position in order to get a line approved that looks boring at first glance. At 4 am, the signatures of all leaders had been provided, including the ones of [German Chancellor Angela] Merkel, of my good friend the Dutch Prime Minister Mark Rutte, and of Finnish Prime Minister Jyrki Katainen, you can say the monetary firepower from the North [...] The line established, in short, that eurozone countries who did their homework, like Italy, were guaranteed ECB support. That statement – at the highest political level – didn’t impress the markets, because the leaders did have the authority, but no money. One month later, ECB President Mario Draghi came out with his famous statement: the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. That did calm the markets, because Draghi did have the money. 

Monti is clearly trying to claim some credit - and the headline of the interview in De Volkskrant is actually "Mario Monti: the man who saved Europe". However, if Monti is right, it clearly means that the ECB's political independence was seriously compromised, since, strictly speaking, there should be no link whatsoever between a political agreement and ECB action..

Draghi's statement is one of the main reasons behind the fall in borrowing costs for countries in the eurozone periphery - some of which have yet to deliver on real economic reform. Monti may have given Draghi some of the credit - but he has also given fuel to those Germans who fear the ECB's independence is a thing of the past.

European Commission forecasts fragile recovery in the eurozone

The European Commission today released its autumn 2013 economic forecast. The EC broadly sees a

recovery in the eurozone, but does highlight that it remains fragile and that unemployment is expected to increase while further austerity also seems likely. The key figures have been widely covered so we won’t rehash them here. Below we pick out a few key points from some key countries which caught our eye.

CYPRUS
Not much new in what remains a dire forecast for Cyprus. In an otherwise sea of declining figures, net exports remains the one hope as a source of positive growth. Ultimately, any success in this area will be determined by the removal of capital controls. Until this is cleared up, significant uncertainty will remain.

FRANCE
France is facing low growth for this and next year (0.2% and 0.9% respectively). In the meantime, unemployment is going to increase slightly, as “the positive effects of the recent labour market reform are only expected to be visible from 2015.” Unsurprisingly, the Commission notes that most of the adjustment in France has so far come from tax hikes – and warns that “GDP growth significantly below potential and revenue shortfalls, which may be due to unusually low tax elasticity with respect to GDP, are having a negative impact on the nominal deficit.” Actually, the Commission already believes that, absent new measures, France will miss its deficit targets for 2014 and 2015.

GREECE
Despite a positive tone, the figures still make for difficult reading. The forecast recovery is reliant on jumps in exports and in particular tourism, something which is far from guaranteed particularly if the euro remains strong. Also, investment is expected to go from a 5.9% contraction in 2013 to 5.3% growth in 2014. Even from a low base, this looks like a heroic turnaround. Unemployment is also expected to begin dropping next year, over the course of the crisis forecasts on this front have proven misguided. The signs suggest it could still increase slightly or at least remain elevated.

IRELAND
Importantly, the adjustment in Ireland will become increasingly reliant on domestic consumption and investment, the outlook of which remains uncertain. Exports will continue to contribute but significantly less so than recently, while public spending will continue to be a drag on GDP.

ITALY
In line with the IMF, the Commission sees the Italian economy shrinking by a further 1.8% this year and then go back to limited growth next year. The Commission admits that its prediction “does not incorporate the benefits from the full implementation of the adopted structural reforms, as they could take more time to materialise.” Interestingly, the report seems to suggest that the potential benefits of “projected moderate wage growth” in terms of price competitiveness could be offset by the appreciation of the euro vis-à-vis other currencies. As regards Italy’s gigantic public debt, the Commission believes it will begin to fall only in 2015.

PORTUGAL
Again a familiar story, with a tentative turnaround off the back of increasing investment and exports. However, the Commission highlights an important downside risk from the interventions of the Portuguese Constitutional Court, which have already threatened to derail Portugal’s bailout programme. EU Economic and Monetary Affairs Commissioner Olli Rehn reiterated this point in his press conference.

SPAIN
Despite some positive signs, the Commission is quite clear that “still large adjustment needs will constrain the strength of the recovery” in Spain. Furthermore, “financing conditions for households and companies remain relatively tight, in particular for smaller borrowers.” Confirming our previous analysis (see here and here), the Commission notes that the recent decline in Spanish unemployment “was largely driven by a contraction of the labour force and some seasonal factors.” On the deficit side, the Commission has no good news for Spain. Without additional measures, the deficit is expected to increase to 6.6% of GDP in 2015. Remember, Spain has already been given two extra years to cut its deficit and bring it below 3% of GDP by 2016.  

SLOVENIA
Along with Cyprus, the only country forecast to contract next year. Reliant on exports to limit this contract as domestic demand, investment and public spending collapse. The key will be the upcoming bank recapitalisation which the Commission forecasts will cost 1.8% of GDP (as we have noted before, this cost could end up being higher). Whether the government can afford this without external help remains to be seen.

GERMANY
Unsurprisingly, Germany is in a better shape than its eurozone counterparts – with its economy projected to grow by 1.7% and 1.9% in 2014 and 2015 respectively and the unemployment rate expected to keep going down to 5.1% in two years’ time. According to the European Commission, “After a temporary deceleration in 2013, growth in wages and compensation per employee is set to reaccelerate, so Unit Labour Cost growth would remain above the euro area average” – which should help the rebalancing. Interestingly, the Commission’s own figures also show that Germany is breaching the threshold of 6% of GDP for current account surplus. Will Germany get some sort of official warning for this?

A few interesting points then, but as is often the case with these forecasts, they raise as many questions as they answer. Next week’s assessment of the macroeconomic imbalances may provide a bit more meat to the European Commission’s analysis and given the recent political uproar, its view of current accounts could make for interesting reading. In any case, it’s clear that the EC continues to see this as a very fragile recovery.

'Budget Deadline Day' in Europe

As you may have noticed, yesterday saw numerous governments across Europe unveiling their latest budgets for the coming year. Rather than just being a coincidence, this is down to the fact that yesterday was the deadline for eurozone governments to submit their budget plans to the European Commission – 'Budget Deadline Day', if you will.

As part of the ‘Six-pack’ set of rules, eurozone governments must have their budgets endorsed by the Commission, although the ability to actually force changes to the budget plans is limited for those countries which are not missing their targets already (except for significant peer pressure).

As with football’s transfer deadline day, there were some frantic negotiations, albeit without the minute to minute media coverage. Below, we take a look at the budgets of the Italian, Irish and Portuguese governments.

Italy
Italy yesterday unveiled its new ‘Stability Law’ – the budget guidelines for 2014-16. There’s some encouraging stuff in there, notably a package of tax cuts for businesses and workers worth €10.6bn over three years (of which €2.5bn to be cut in 2014). Nothing massive, but it's a start. The money to cover for these cuts is due to come from a number of public spending cuts. However, the draft budget will now have to be adopted by the Italian parliament, and some of the measures may change.

Prime Minister Enrico Letta has confirmed Italy aims to bring its deficit down to 2.5% of GDP by the end of next year. That said, the problem for Italy remains its weak growth – which in turn threatens its fiscal targets. Last week, for instance, the Italian government had to adopt a set of urgent measures to find a further €1.6bn and make sure the deficit stays below 3% of GDP this year. Unlike other countries, the budget may hold less importance for Italy’s economic future with the focus now on much needed political reform and improvement in the business environment.

Ireland
Debate over the Irish budget has been going on for some time, and the government managed to secure a lower level of headline cuts than expected ahead of time - €2.5bn compared to €3.1bn. However, the budget remains controversial with the Irish Independent running the front page headline, "Unkindest cuts", because they fall on pensions, healthcare and unemployment benefits for young people.

For the most part, although this budget was about tinkering around the edges rather than making the huge cuts we have seen before, the government focused on adjusting lesser known taxes to reap numerous small savings. Interestingly, the government also committed to reducing tax evasion and tackling the view of the country as a ‘corporate tax haven’. It will be key to see if this impacts the number of multinationals locating in Ireland and if it has any knock-on impact on economic growth.

Portugal
Of the three, this is probably the most concerning budget. Following a difficult summer for Portugal, politically at least, the government has once again been forced to find a further €3.2bn in cuts. However, the government has once again taken the same approach by heaping the cuts of public sector workers pay (up to 12% in parts) and on pensions. Action on these areas is needed. However, it has also been repeatedly struck down by the Constitutional Court. This might be setting the scene for another showdown.

This has evoked concerns from within the Commission, and it will be interesting to see whether a full endorsement is forthcoming. Portugal also confirmed it will miss this year’s deficit target and the continuing push to ease next year’s target suggests little confidence that it will meet that one either. The good news is that Portugal’s borrowing costs remain well below their peak, and some market access once it exits its bailout next year seems likely. That said, unless it can get a hold of the public sector reform needed, some additional aid still looks likely.

Overall then, a bit of a mixed bag. Few marquee measures, but some positive moves in terms of focusing cuts on spending rather than tax hikes.

The EU budget is a disaster that cannot save Greece

Our Director Mats Persson argues on his Telegraph blog:

Ever driven on a motorway in Spain or Portugal? You’ll notice it’s not exactly the M25 – often, cars are few and far in between (some pretty heavy congestion around Gibraltar not included).

According to some estimates, 25 per cent of the EU’s so-called regional funds in Portugal has been invested in roads, heavily contributing to a ridiculous situation where the country has 60 per cent more kilometres of motorway per inhabitant than Germany and four times more than Britain (H/T FT). Meanwhile, around one third of EU structural funds in Spain has been invested in infrastructure, further inflating an already critical construction bubble, while, like in Portugal, creating a whole host of ghost roads, airports and harbours. The EU’s own auditors have hammered EU spending on roads, noting that 74 per cent of the project they monitored in a recent investigation recorded less traffic than expected.

Welcome to the folly of the EU budget. This economic anomaly is at best irrelevant for the Eurozone crisis – at worst outright damaging.

Consider Greece. In the last week, there has been some talk of the EU budget being used in a third bailout for Greece. Although it’s not entirely clear how this could work – or how even how credible this speculation is – one way could be to reduce the amount of its own cash the Greek government needs to put up in order to unlock EU funds, known as co-financing. Depending on the circumstances, this usually ranges between 25% and 60% of a total grant. Greece currently has special permission to put up only five percent, and it wants this extended to the next EU budget period, to run between 2014 and 2020.

This is politically convenient since it draws from a cash allocation that has already been agreed (easier to sell to German taxpayers) while not coming with new, tough bailout conditions (easier to sell to Greek citizens). However, such an arrangement will also do absolutely nothing to save Greece:

• Most fundamentally, a quick look at the records shows that Greece has been allocated over €64bn in structural funds over the last two decades (to which the UK has contributed around 12%). Per capita, this is amongst the highest in the EU, yet the country is still bust and uncompetitive. 

• It follows therefore that it’s the wrong type of funding for Greece. It can’t be used for health spending, education or to recapitalise banks, for example, areas where the fiscal shortfall in Greece is / has been the most critical. It can, however, be spent on roads. 

• Like the structural funds in general, it risks creating an opportunity cost by diverting limited public investment away from where it can have the greatest impact. 

• Reducing the co-financing rate gets us away from the structural funds actually being a fiscal burden – Greece can’t afford putting up the matching cash (the structural funds tend to be oddly pro-cyclical). However, the trade-off is that it eliminates any form conditionality attached to the money. Is this really the way forward? 

• It’s a bureaucratic nightmare to get to the actual cash – exactly what Greece doesn't need. 

This also illustrates why (almost) the entire EU budget is pretty much a running disaster, in desperate need of root-and-branch reform.

Beyond appearances, the recent political crisis has changed things in Portugal

Political stability seems to have returned to Portugal - at least for now. The country's ruling coalition and the opposition Socialist Party have failed to agree on the 'national salvation pact' demanded by President Aníbal Cavaco Silva to help the country successfully complete its EU/IMF bailout programme.

Nonetheless, Cavaco Silva said in a speech yesterday that the continuation of the existing centre-right coalition was "the best [alternative] solution" - thus ruling out snap elections. The Portuguese President also stressed that the government would request a vote of confidence in parliament on its future economic and social policy plans.

So are we back to square one in Portugal? Not entirely.

First of all, there will soon be a cabinet reshuffle - as agreed by the two ruling parties before President Cavaco Silva stepped in. In particular, Paulo Portas - the leader of junior coalition member, the People's Party (CDS-PP) - should become Deputy Prime Minister and be in charge of dealing with the EU/IMF/ECB Troika from now on.

This could be an important change. Let's not forget Portas tendered his resignation from the government because he disagreed with Prime Minister Pedro Passos Coelho over the appointment of Maria Luís Albuquerque as new Finance Minister. On that occasion, Portas made clear that he was hoping for a change in the country's economic policy approach (in substance, less austerity).

This leads to a more general point, which we already made in the past (see here and here). Political consensus around EU-mandated austerity is shrinking in Portugal, and although the turmoil seems to have passed for now, tensions within the ruling coalition will remain - with Prime Minister Passos Coelho's Social Democratic Party (PSD) clearly more in favour of sticking to the current economic policy course than its junior coalition partner.

Furthermore, as Prime Minister Passos Coelho himself admitted this morning, the recent political crisis has "undermined" confidence in Portugal's determination to push ahead with the implementation of its bailout programme - something which could make it more difficult to obtain concessions from the European Commission and its eurozone partners in future.

As we noted in our flash analysis on this issue, these tensions have come at an inopportune moment for the country given that it still needs to enforce significant austerity to meet its targets and that its economic reforms to improve competitiveness now look off track. As political consensus wanes and protests increase, these tasks will become ever more challenging. 

Needless to say, Portugal's return to the markets - currently scheduled for June 2014 - is already looking quite complicated. Further delays or disagreements within the ruling coalition could make things even worse.

Portugal's coalition fights to keep its head above water

UPDATE (17:15) - First reports of an agreement to keep the coalition alive. Stay tuned for more details.

UPDATE (16:40) - Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas have just come out of another (swift) round of talks.

The outcomes of their third meeting in less than 24 hours are still unclear. Passos Coelho is now heading to the Belém Palace - where Portuguese President Aníbal Cavaco Silva is waiting for him.

UPDATE (14:45) - The second meeting between Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas is over. It was "very positive" - according to the Prime Minister's office - but inconclusive. Negotiations over a new coalition agreement will therefore continue.

According to the Portuguese media, Portas may backtrack on his resignation. If he did so, he would reportedly be appointed Deputy Prime Minister (the post is now vacant after former Finance Minister Vítor Gaspar quit) and Economy Minister (which in Portugal is a separate portfolio from Finance Minister).

More interestingly, a source quoted by Diário Económico suggests that a revamped coalition agreement would involve discussing "a new compromise with the [EU/IMF/ECB] Troika" - so potentially a relaxation of Portugal's deficit and reform targets.

ORIGINAL BLOG POST (11:25) 

As we noted in yesterday’s flash analysis, tensions in the Portuguese coalition reached critical levels over the past few days. They have eased off somewhat overnight, but there is still plenty of uncertainty around.

Key developments:

• Despite tendering his resignation from his post as Foreign Minister, the leader of junior coalition member CDS-PP, Paulo Portas, now seems to be backtracking somewhat. This is down to both internal pressure from his party, which is clearly not keen to be seen as bringing down the government, and external pressure from markets and eurozone partners over fears of snap elections which would delay the implementation of key reforms in Portugal.

• Portas already met Prime Minister Pedro Passos Coelho, with another meeting due later this morning. The two will also meet Portuguese President Aníbal Cavaco Silva this afternoon.

What are the potential outcomes?

• Portas is reportedly seeking a renegotiation of the coalition agreement. At the moment, it's not entirely clear whether his desire is more power for his party or less focus on austerity - or both. The former seems possible, although his party is significantly smaller (Passos Coelho's Social Democratic party controls 108 seats compared to 24 for CDS-PP). The latter seems less likely. The government has very little scope to adjust its economic policy due to the bailout requirements, while, as we noted yesterday, austerity and structural reforms need to continue with the country already falling behind in terms of implementing its programme.

• It is, of course, still possible that no agreement is reached and the CDS-PP confirms its withdrawal from government. However, the Portuguese media seem to agree that, even in that case, CDS-PP would keep granting parliamentary support to the government (an arrangement the Portuguese call incidência parlamentar).

• No matter the outcome, the divisions within the coalition are clear and present. There are likely to be some tough votes to come, particularly on labour market reform and further budget cuts. Whenever these take place, the spotlight will be on the coalition to see if it holds up under pressure.

We will continue to update this blog throughout the day with developments and news as we get them.

Governo em risco: Portuguese government at risk of collapsing after Foreign Minister resigns

UPDATE (18:15) - We thought it would be useful to explain quickly how things work in Portugal when a government crisis occurs. If the Prime Minister resigns, the Portuguese President is the one who decides when and if parliament has to be dissolved.

Under Portugal's electoral law, new elections must be held at least 55 days after parliament is dissolved. This would mean almost two months with a caretaker government at a rather unfortunate time for Portugal. 

ORIGINAL BLOG POST (17:45)

One day after the resignation of Finance Minister Vítor Gaspar, the Portuguese government has just lost another one of its key players. But the impact could be a lot bigger this time.

Paulo Portas, the country's Foreign Minister (see picture), has resigned because he disagreed with the appointment of Maria Luís Albuquerque as new Finance Minister.

Portas is also the leader of the People's Party (CDS-PP), the junior coalition partner of Prime Minister Pedro Passos Coelho. If the party pulls out of the coalition (which looks likely in light of Portas's resignation) Passos Coelho will lose his majority in parliament. So this is critical as it can potentially trigger new elections. 

Passos Coelho will make a TV statement tonight. We'll keep you posted. In the meantime, it's worth keeping in mind the economic and social challenges Portugal faces - which we outlined here.

Portugal's Finance Minister quits: A bolt out of the blue? Not really...

A surprise development in Portugal this afternoon, as Finance Minister Vítor Gaspar has announced his resignation. The office of Portuguese President Aníbal Cavaco Silva has said in a note that Gaspar will be replaced by Maria Luís Albuquerque - one of his deputies, with a long career in the Portuguese Treasury.  

Initially, the news sounded very much as a bolt out of the blue. That was until Jornal de Negócios published Gaspar's letter of resignation on its website. The letter reveals the following:

• Gaspar had already written to Portuguese Prime Minister Pedro Passos-Coelho in October 2012, stressing "the urgency of [his] replacement as Finance Minister."

• At the time, Gaspar had decided to quit over "a series of important events". In particular, he mentions the Constitutional Court ruling that struck down the government's plan to limit extra holiday and Christmas pay for public sector workers as unconstitutional in July 2012, and "the significant erosion of public support" for the austerity measures attached to the Portuguese bailout.

• However, Gaspar was asked to stick around a bit more - at least until the 7th review of the Portuguese bailout by the EU/IMF/ECB Troika was finalised and an extension of the bailout loan maturities was secured. Incidentally, the fact he has now been allowed to leave could be seen as a vote of confidence from the government in the strength of the Portuguese economy (although Gaspar may simply have been stepping up the pressure to be allowed to exit).

• Gaspar also points out that Portugal's consistent failure to meet its deficit and debt targets under the EU/IMF bailout agreement had "undermined [his] credibility as Finance Minister." On this point, it is probably worth reminding that, on Friday, it came out that Portugal's public deficit in the first quarter of 2013 had reached 10.6% of GDP - with the target for this year set at 5.5% of GDP.

• Interestingly, Gaspar concludes his letter by saying, "It's my firm conviction that my exit will contribute to reinforce your [Prime Minister Passos-Coelho's] leadership and the cohesion of the cabinet". This seems to suggest Gaspar may have lost faith in the reform approach taken in Portugal, and may not have been willing to push ahead with it (not least for the reasons mentioned above).

In any case, the news of Gaspar's resignation hardly comes at a great time for Portugal. As we noted in a recent briefing, the country faces some tough challenges this year:

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 

• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated. 

How much impact this will have remains to be seen, although in a country where the economic future remains uncertain, suprises such as this are hardly ever welcome. In practice, though, the approach is likely to continue in much the same vein, firstly because the EU/IMF/ECB Troika has shown little willingness to be flexible with Portugal, and secondly because Maria Luís Albuquerque has often voiced her support for the approach taken so far.

That said, it is an interesting reminder of the strains the bailout programme is putting on the Portuguese government, as it begins the difficult task of finding a way to smoothly exit from its reliance on external funding.

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

Yet again the eurozone crisis is butting heads with national democracy

After a lengthy absence Portugal returned to the headlines over the weekend with the Constitutional Court ruling that some of the government austerity measures were unconstitutional. Here are the key details:

• The court found that four out of nine key savings measures included in the government’s latest budget were unconstitutional. These measures focused on cuts to public sector wages and pensions – the court deemed these unconstitutional since they hit public sector workers disproportionately hard. They also ruled against cuts to unemployment and sickness benefits.
• The measures amount to savings of €1.3bn (0.8% of GDP) which will now need to be found elsewhere. If they are not found, then Portugal’s deficit this year could reach 6.4% rather than the 5.5% currently targeted.

What does this mean for Portugal and the eurozone?

• The ruling was the cherry on top of a bad week for the government after a close ally of Prime Minister Pedro Passos Coelho resigned and the government faced a no-confidence vote in the parliament. Fortunately, it has so far survived these problems (new elections would bring huge uncertainty) but its support continues to be eroded.
• The previous political consensus in favour of the bailout and the accompanying austerity has now vanished, the opposition is likely to become increasingly vocal in its anti-austerity approach.
• The Commission has warned that the extension of the bailout loans agreed recently will be under threat if the government does not meet its targets.
• The cuts are likely to be found elsewhere but they may have more of a negative impact on growth, although this remains uncertain. One thing that is clear is that the public sector wage and pensions do need to be adjusted if Portugal is to become competitive and particularly if it is to recover through export led growth as the bailout programme currently targets. The inability to adjust these areas could harm Portugal in the long run.
• That said, this is not the first time this has happened. Last July, the court made a similar ruling on public sector wage cuts. The fact that this has happened again suggests the government may be struggling to find savings elsewhere (why else push on with cuts it knows stand a good risk of being blocked), and doing so may take longer than some expect.
• Legal points aside, experience (particularly in the Baltics) suggests that wage cuts in the private sector often follow or go hand in hand with public sector ones – at the very least, buy-in is needed across the economy and the private sector is unlikely to lead such an adjustment unless prompted to (wages are sticky on the downside). In this sense, although the cuts may have disproportionately hit public sector workers initially it may be necessary part of the internal devaluation approach taken (whether this approach is correct or not is another question).
• And of course, this adds further delays and uncertainty in the eurozone – along with lack of government in Italy and capital controls/bailout in Cyprus.

This is likely to rumble on for a while yet as the Portuguese government searches for savings elsewhere which will meet the requirements of the troika. Yet again, the eurozone crisis is butting heads with national democracy, in this case specifically constitutionality. Plenty more of that to come we expect.

Celebrating the end of the eurozone affair ignores the heart of the matter

In today's Telegraph, Mats Persson seeks to answer this simple - and yet brutally complex - question: is the eurozone crisis over?

'We are in the middle of the beginning of the end. The crisis has really hit its peak”, former French economy minister and current IMF chief Christine Lagarde told a broadcaster when asked about the eurozone crisis. The only problem: that was in July 2010. Time and again, EU leaders have declared the crisis over – and been proven wrong. So with markets remaining cautiously optimistic about the euro, is the worst finally behind us?

There are well-rehearsed reasons to be cheerful. Borrowing costs are down for all crisis-stricken countries, exports are picking up in some and EU leaders have actually agreed on a forward-looking measure by turning the ECB into a single supervisor for eurozone banks. Just as eurozone leaders have celebrated prematurely, Anglo-Saxon analysts have consistently tended to overstate the immediate risk of a eurozone break-up. Famously, one major US bank last year assigned an 80pc-90pc risk of Greece leaving the euro – an assessment that Open Europe cautioned strongly against. In Europe, the safest money is always on another fudge. Germany and the ECB were likely to take a political decision to keep Greece inside the eurozone for now, given the fragile situation elsewhere.

But the news last week that the eurozone economy shrunk by 0.6pc in the last quarter of 2012 illustrated what was always the bloc’s greatest challenge: reversing chronic economic malaise. Most fundamentally, reconciling a supranational currency with 17 national democracies remains a challenge. The eurozone’s basic austerity-for-cash prescription continues to fuel tension within individual countries and between the hawkish north and the austerity-fatigued south, testing voters’ patience. The forthcoming Italian elections are turning into a bit of a referendum on EU-mandated austerity, just like the Greek elections last year. Five of the seven main political parties – together polling at around 50pc – have vowed to end cuts. Two parties, Lega Nord and the Five Star Movement, the latter led by comedian-cum-politician Beppe Grillo, even want a referendum on whether the country should remain in the eurozone. The everlasting Silvio Berlusconi is making last-minute gains, in part thanks to a promise to kill what he calls “austerity imposed by Europe”. Against all known principles of common sense, the man still could win. Thankfully, a broadly pro-reform, centre-left coalition led by Pier Luigi Bersani is the most likely outcome, but even then the hope of sweeping economic reforms will be tempered, not least due to those parties’ strong links to the unions.

The Italian elections show how the north and Club Med in many ways are locked into a Catch-22: one wants cash (“solidarity”) first, supervision or discipline second, the other the exact opposite. That dynamic is again evident in the ongoing difficulties in agreeing a bail-out for Cyprus: Germany is unwilling to put in cash for fear of rewarding the bloated Cypriot financial sector. Cyprus resists far-reaching privatisations or significant write-downs of its banking or sovereign debt. This north-south stalemate could become further entrenched if French president Francois Hollande continues to slide towards the Mediterranean bloc, both in terms of political temperament and growth rates (France registered zero growth in 2012). This would weaken the Franco-German axis.

And beyond politics, has the eurozone’s triple crisis – fiscal, banking and competitiveness – really been addressed in any fundamental way? Many eurozone countries are on the path to running a primary surplus – meaning income exceeds outgoings, excluding the cost of servicing a country’s debt. But the eurozone’s overall debt still stands at 90pc of GDP, compared to 70pc in early 2010. Greece, Italy, Portugal and soon probably Cyprus, have debt levels exceeding 120pc of GDP – double what is meant to be allowed under eurozone rules.

The banking sector, too, remains fragile. Thankfully, ECB action helped avoid a massive bank funding crisis last year, but there is a price: eurozone banks have become alarmingly reliant on artificial life support. Liquidity from the ECB to banks now tops €1 trillion (£860bn) – up €140bn on 2009. Even though some banks have started to pay back the cash they owed the ECB early, the eurozone is a long way off a back-stop to allow for wind-downs of bust banks or disentangling of bank and government debt. Overnight interbank lending – a key indicator of banks confidence in the system – remains only half of what it was in 2009 and a third of its peak in 2007. If the crisis were solved, this would surely not be the case.

Finally, by almost every indicator, the single currency is absolutely riddled with economic imbalances, but with no fiscal facility to compensate for them. Encouragingly, Spain, Portugal and in particular Ireland have cut unit labour costs relative to Germany – a key measure of competitiveness - but Italy and France are actually becoming less competitive in relative terms. And imbalances go far beyond labour cost. This year, Greece is expected to contract by over 4pc, Spain by 1.5pc and Cyprus by almost 2pc – while Germany, Finland and others are set for growth. Then there is unemployment. Shockingly, Greek unemployment hit 27pc towards the end of last year, with youth unemployment close to 62pc. Spain is not much better at 26pc and 55pc respectively – and all the scheduled reforms and cuts haven’t even been implemented yet. In Germany, meanwhile, unemployment is at record lows.

In a best-case scenario, the Mediterranean countries will follow the Irish example and continue to squeeze wages and cut costs at home. But in light of domestic political resistance, these imbalances could well continue to test the eurozone’s one-size-fits-all model for a very long time.

So, we have an election fought over EU austerity, political stalemate, a bail-out which no one wants to pay for, abysmal growth forecasts and massive unemployment. There may come a day when the eurozone bounces back and puts us all to shame. But to celebrate now the “end of the crisis” seems to be setting the bar exceptionally low.

The EU budget 'veto count': and then there were ten...

Here's an update of Open Europe's 'veto count': ten EU member states (UK, Denmark, Sweden, Italy, France, Portugal, Latvia, The Netherlands, Austria and Romania) have now explicitly threatened to veto the 2014-2020 EU budget. Several other countries are also unhappy with all or part of Herman Van Rompuy's compromise proposal (see our latest flash analysis for further details).

This is what changed since we made our first 'veto count':

Italy and Portugal have both used the 'V' word for the first time. Interestingly, Italy has also suggested that it could seek a UK-style rebate to avoid its net contribution to the EU budget skyrocketing.

Latvia has also threatened to wield its veto. Latvian Prime Minister Valdis Dombrovskis said his country is not happy with the cuts to agricultural subsidies and cohesion policy proposed by Van Rompuy.

In Romania, incidentally, it looks as if EU budget talks have triggered another row between President Traian Basescu and Prime Minister Victor Ponta. The latter said he was ready to veto the budget, but President Basescu said this morning that "Romania's interest is to negotiate, not to brandish the threat of using its veto right." Given that Ponta is the one who usually attends EU summits, we consider Romania to be in the veto camp.

So over one-third of EU member states has therefore threatened to veto the next long-term EU budget so far. EU leaders could be looking at a long weekend...

EU awarded its second Nobel Prize of the year

Yesterday, a delegation headed by Bernadette Ségol, Secretary General of the European Trade Union Confederation (ETUC), delivered a 'Nobel Prize for Austerity' to the EU - a boomerang with 'Austerity will come back in your face' written on it, according to Italian news agency ANSA.

Unsurprisingly, Barroso, Van Rompuy and Schulz weren't exactly elbowing their way to the front of the queue to pick up the award, which was ultimately handed to EU Social Affairs Commissioner László Andor.

This was the only (relatively) light-hearted moment of a day which saw anti-austerity protests degenerate into violent clashes between demonstrators and the police in Italy, Spain and Portugal - while marches were also staged in several other European countries. Some Spaniards even rallied in Smith Square, London, in front of the European Commission and European Parliament's offices (see the picture, which was posted on Twitter yesterday evening).

We have stressed on several occasions that these protests are the inevitable consequence of the clash between eurozone membership and national democracy.

While structural reforms and fiscal consolidation are needed for struggling eurozone countries to try to regain competitiveness within the single currency, what the European Commission should be most concerned about is the fact that citizens in the weaker eurozone countries increasingly see the EU (and certain creditor member states) as the cause of their pain.

As we noted in a recent briefing, the average level of trust in the EU in Greece, Spain, Portugal, Ireland and Italy has reached an all-time low. Again, it is impossible to know where the tipping point lies exactly - but the recent episodes seem to confirm that the number of those who see the EU as a positive force is rapidly decreasing.        

Ave Angela, morituri te salutant

The spotlight is back on Greece today with the release of the much anticipated Troika report (read our daily press summary or follow us on Twitter for the latest updates), meaning that German Chancellor Angela Merkel's visit to Portugal has been pushed to the background.

However, clearly not everyone in Portugal is enthusiastic about Merkel's arrival. After the open letter signed by over 100 academics and intellectuals, arguing that the German Chancellor "has to be considered persona non grata in Portuguese territory", this is the front page of today's edition of Portuguese newspaper I Informação,

Another Latin expression, this one translates as, "Hail Angela, those who are going to die salute you" - a paraphrase of the famous salute made by gladiators to the Roman Emperor before the fights in the arena started. And another example that tensions can run high in Portugal too - even if the country does not usually receive the same degree of foreign media coverage as Greece or Spain.  
 

The 'forgotten man' of the euro crisis catches a break...

While everyone is gearing up for the EU's 'Super Wednesday', Portuguese Finance Minister Vítor Gaspar has made a quite important announcement. As we anticipated in our daily press summary more than two weeks ago, following its fifth monitoring mission to Lisbon, the EU-IMF-ECB Troika has decided to give Portugal one extra year to make the budget cuts agreed under its bailout programme.

The 'forgotten man' of the euro crisis will therefore be allowed to close the year with a deficit of 5% of GDP (instead of the previously agreed 4.5%). Portugal will then have to cut its deficit down to 4.5% of GDP (instead of 3%) next year and to 2.5% of GDP in 2014. No doubt the one off transfers from pension funds to push the deficit below previous targets finally caught up with them. 

The news is particularly interesting - and not only because Portugal seems to have fairly easily achieved what Greece has failed to obtain so far, despite Greek Prime Minister Antonis Samaras's recent 'diplomatic offensive'. In fact, Portugal is still expected to return to the markets in September 2013 (exactly one year from now). Given that the country has been allowed to run a larger deficit for this and next year, this suggests that it will have to borrow more money to cover for it.

For the moment, Gaspar has made clear that nothing has changed on that front, and Portugal will try to raise the money from private lenders (i.e. will not ask the EU and the IMF for more cash).

However, this brings us on to another interesting fallout from the ECB's new Outright Monetary Transactions (OMTs). Since currently bailed out countries, such as Portugal, can access support from the ECB when they are due to return to the markets, there is a good chance that the ECB could buy up some existing Portuguese debt from the secondary markets in September 2013, allowing banks to reinvest this money in the  new debt Portugal will issue. This also allows Portugal (and the eurozone) to sidestep the IMF's demand that countries be able to show clear funding streams for 12 months (which led to the second Greek bailout request).

So, despite delaying its deficit target and not being guaranteed market access within twelve months, Portugal looks able to avoid a second bailout with the help of the ECB (at least for the moment). One should now only ask whether the conditions attached to the Portuguese bailout programme will satisfy the ECB, especially after they have been eased...

While everyone is talking about Greece...

It may sound incredibly obvious, but the eurozone crisis is not only about Greece. Yes, Athens may be facing its "last chance" (Juncker dixit) to save its euro membership. And yes, the diplomatic offensive launched by Greek Prime Minister Antonis Samaras (see picture) to obtain a two-year extension to the EU-IMF adjustment programme clearly deserves attention.

However, while everyone is talking about Greece, quite important (and not necessarily good) news is coming out of other eurozone countries - of which, as usual, we also offer a comprehensive overview in our daily press summary.

In particular:

• According to sources quoted by Reuters, the Spanish government is in talks with its eurozone partners about the eurozone’s temporary bailout fund, the EFSF, buying Spanish bonds – but has made no final decision over whether to request the assistance. Unsurprisingly, the European Commission said that there are no negotiations under way, and a bailout request from Spain is not expected "any time soon". Right...

• According to a high-ranking official at the Portuguese Finance Ministry quoted by Jornal de Negócios, Portugal (the 'forgotten man' of the euro crisis) will not be able to meet the EU-mandated deficit target of 4.5% of GDP for this year unless new austerity measures are adopted. The main reason seems to be the sharp fall in tax revenue: -3.6% during the first seven months of the year, as opposed to the 2.6% increase the Portuguese government was betting on for 2012. The alternative, the Portuguese press suggests, would be asking the EU-IMF-ECB Troika to relax the target. Boa sorte with that one, especially since in September we will hit the point where Portugal is within one year of being expected to return to the markets. Remember how the IMF's requirement for a country to be funded for twelve months played out in Greece... 

• A Cypriot government spokesman told reporters yesterday that the island's public deficit at the end of the year will be around 4.5% of GDP – significantly higher than the 3.5% of GDP initially forecast. Clearly not good news, as this will almost certainly increase the EU-IMF bailout Cyprus is currently negotiating. Another headache for the Troika, which is due to visit the island again shortly (although no clear date has been specified yet).

• New figures published by the Irish Central Bank show that €30.5 billion or 27.2% of the €112 billion outstanding in owner-occupier mortgages at banks in Ireland was in arrears or had been restructured at the end of June, up from €29.5 billion (26%) in March. Furthermore, German Finance Minister Wolfgang Schäuble told the Irish Times that he will oppose any debt-relief plan for Ireland that “generates new uncertainty on the financial markets and lose trust, which Ireland is just at the point of winning back.”

Add the German Constitutional Court ruling on the ESM treaty along with the Dutch general elections (with the EU-critic Socialist Party led by Emile Roemer ahead in the polls) into the mix and it really looks like there will be little room for boredom in September.

The folly of EU structural funds illustrated

Here are a couple of illustrative examples of why the EU's structural funds so badly and desperately need reform. The list seemingly never runs dry.

First, the Sunday Telegraph had a feature on Madeira’s economy, claiming that grants from the EU structural funds – which require match funding from local governments or business – have contributed to the local Madeiran administration now owing over €6 billion, nearly double the per capita public debt of mainland Portugal. Much of the EU cash has been spent on infrastructure (not least via the Cohesion Fund, which is earmarked for that purpose) for which there is no demand. As German Chancellor Angela Merkel put it, "There are many beautiful tunnels and highways [in Madeira]. But this did not contribute to competitiveness."

Meanwhile, the European Commission and Swedish local authorities have earmarked nearly £10m to subsidise Facebook – a company currently valued at around $100bn (£63bn) – under plans to build giant server halls in Lulea in Northern Sweden. You'd be aware that Sweden is one of the richest countries in Europe.

Now, the European Commission always has two standard responses to examples like these:

• They've been taken out of context - and then gives a series of stats of how many jobs and how much growth the structural funds allegedly have created.

• It's up to the local authorities in member states to select the projects anyway, the Commission merely facilitates the cash.

But these examples are very much symptomatic of the wider problems and flaws inherent in the structural funds (SF). As we set out in our recent report on the topic:

1) Conflicting aims: are the structural funds meant to be channelled to areas where the absolute return of capital is the greatest or where they can foster the greatest convergence between poorer and richer regions (a key stated aim of the funds)? The €10mn in EU funds earmarked for Facebook - a thriving company - surely could have come from private capital. It's probably a decent investment. So in fact, the €10mn could have served to ‘crowd out’ private investment that otherwise could have take place in Lulea, while channelling funds away from poorer regions where they can have the most comparative impact. The result is the opposite of convergence.

2) Opportunity costs: Related to this, both the Facebook and the Madeira examples illustrate the huge opportunity costs that the SF involve - spending diverted from other, more
comparatively productive economic opportunities. In the Facebook case, the funds duplicate economic activities in relatively wealthy states that would have taken place anyway, and in the Madeira case, they're spent on outright damaging projects (i.e. needless infrastructure projects that run up debt).

3) Pro-cyclical and unresponsive to changing needs: The Madeira case shows that the SF tend to be pro-cyclical as they can be sucked into areas of the economy where unsustainable growth or serious leveraging is taking place, with few ways of making adjustments (this was also the case in Spain for example). Remember, the funds are negotiated on a seven year basis, and come with fixed spending criteria (with some discretion to alter spending on a yearly basis). Co-financing also makes the funds pro-cyclical. Not wanting to forgo the potential opportunities presented by taking up structural funding, governments and local authorities feel obliged to spend the money on co-financing, even if this means running up massive debts. Again, hello Madeira.

4) No link between performance and spending: the absence of strong conditionality
and performance criteria in the allocation of funds meant that Madeira continued to receive funding despite the absence of results from the billions in funding that it has received. This also means that the focus is on getting money out of the door rather than spending the cash wisely.

And this is even before we get into the irrational distribution patterns of the funds, the added administrative costs, the absence of absorption criteria, the problem with accountability (falling in between member states and the Commission) and the fact that the Commission's models for evaluating the funds are hopelessly inadequate.

Do read our report for the full picture.

This policy simply has to undergo root-and-branch reform, starting by limiting funding to the poorest countries only, where it can have the greatest comparative impact.

Who's afraid of the big bad bailout fund?

Update - 12:10: Eurozone finance ministers have already reached an agreement and put out a statement. It's pretty much exactly as we expected, with all assigned funds being rolled into the headline lending volume to give the €800bn.

The fact remains though that, even combined, the funds will not be able to introduce more than €500bn in fresh lending. This was the aim all along. In fact, all eurozone finance ministers have done is correct a previous mistake which would have limited the combined lending capacity to €300bn (as originally the treaty essentially specified that only €500bn in loans could be outstanding at any one time). There should be no illusions that this changes almost nothing (we expect not even the markets which have been reacting to every piece of news will be moved much by this). One thing is for certain though this is a clear win for Germany.

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Eurozone finance ministers are meeting today, in what looks to be the most chilled get-together of this group in recent time. They’re set to sign off on an agreement that will see the combination of the eurozone’s temporary and permanent bailout funds, the EFSF and ESM. On paper, the funds have the potential to produce a combined firewall of €940bn. Still far too little if Italy and Spain went, but an impressive sum nonetheless. That is, on paper. In reality they won’t even come close to this.

In an interview with Bild this morning, German Finance Minister Wolfgang Schauble said he didn’t want to “unnerve markets with numbers”, but in a speech in Copenhagen he did just that, saying,

"We have 500 billion euros in fresh money available, together with the programs already agreed for Ireland, Portugal and the new program for Greece. It is about 800 billion (euros). I think it's enough."

Apparently, Schauble reached this number by adding €500bn from the ESM, €200bn from the EFSF, €56bn in bilateral loans to Greece and €60 billion from the third bailout fund, the European Financial Stability Mechanism (EFSM) – which is underwritten by all 27 member states via the EU budget. But much of this cash has already been spent, i.e. the EFSM only has €11bn left, and some of the other money can’t actually be lent out. In addition, the remaining €240bn in unused EFSF capacity will be held back for ‘exceptional circumstances’ until mid-2013.

As we’ve been reminded of time and again, the only thing that matters is effective lending capacity. The real amount of cash that is still available to back stop struggling states, should it come to that, is only around €500bn. Here’s the lending capacity math (courtesy of some excellent analysis by the WSJ):

• Mid-2012 – The ESM will be limited to €210bn (as it will only have €32bn in paid-in capital). Along with the €240bn in ‘exceptional’ funds, this gives a total potential lending of €450bn. (The money which is already out the door should be ignored)

• Mid-2013 – Following a second instalment of capital the ESM will be able to lend €420bn. The ‘exceptional’ funds will be wound down around this point.

• Mid-2014 – All ESM capital paid-in, reaches total lending capacity of €500bn.

(There is one caveat to these figures, in that the eurozone could decide to speed up the paying in of ESM capital if the funds were needed. However, this would likely face significant opposition from the likes of Germany and Finland, and is therefore most certainly a last resort).

So despite Schauble’s comment, euro finance ministers continue to throw various different numbers around, which bear few resemblances to reality. We also note that the French Finance Minister, François Baroin, yesterday floated an unfortunate analogy. He said,

"The bailout fund is a bit like the nuclear weapon in the military domain…It is not intended to be used but to act as a deterrent."

The problem here is that if it’s too big and terrible to ever be used, it’s likely that it won’t ever be used. Even jittery markets will be able to figure out that a large fund which would damage French and German credit ratings if ever extended will never be fully tapped. So clearly some circular logic at play. And let's not forget that it’s still far too small to save Italy and Spain should if worse come to worse.

But at least eurozone ministers can look forward to a quieter Friday than usual...