With migration and trade exacerbating the existential reform questions that will drive European Union (EU) members together or apart, we think this week’s summit should be measured in binary terms: does it further EU cohesion (and help to withstand future shocks) or does it advance the forces of fragmentation?
In this context, it is important to understand that all the different points of tension are intertwined at the EU level, e.g. Eurozone reform, migration and Brexit negotiations. Each issue pits different countries against each other and raises the possibility of finding EU-wide solutions or encouraging nation states to pursue individual solutions, something that is bound to weaken the EU further. Below we set out the agenda points and which stakeholders to watch on each issue.
Eurozone Architecture: Upside and Downside Risks to Reform
First up for discussion is making the monetary union more resilient to financial crises by transforming the European Stability Mechanism (ESM) into a European International Monetary Fund (IMF) that could provide funding for any sovereign borrower before, during or after a crisis. The range of financial instruments available to the ESM will need to be broadened to make this credible. Given the centrality of the ESM, there is still a large gap between views on governance (can it loan independently or will it still require member state approval?) and on conditionality (will countries need to undergo debt restructuring prior to accessing the ESM?). While fudging is probable, we see failing to agree on such a key improvement as a downside risk.
Another weakness laid bare by the euro sovereign debt crisis needs to be addressed at this summit: the feedback loop between sovereigns and banks. The ESM is likely to be approved as the backstop for the Single Resolution Fund1. While this will be an anchor for the long-awaited European banking union, the union itself is far from accomplished. One of the key unresolved issues is a banking deposit insurance program. This is highly contentious given the varying health of member countries’ banking systems, notably Italy’s high volume of non-performing loans. Tangible steps toward agreeing on deposit insurance would be a positive surprise for markets and could be supportive for European bank stocks in the medium term.
Third, any agreement on creating a new Eurozone-wide budget would be a strong signal toward greater cohesion. There is a range of proposals over whether these funds would be dedicated to bolstering the ESM, raising public investment, providing countercyclical budgetary support or supplementing national benefits. Yet the exact size, mandate and terms of such a budget are less relevant, as any new institution could easily evolve over time, as the ESM has done. At this stage, markets would probably see failure to design some form of common budget as a disappointment.
Migration: Chance for Acrimony
The 2015 refugee crisis introduced another wedge between European states. It continues to be acutely important, as Italy is both the weakest Eurozone member and also a frontline state for migration flows. This transforms the politics of the summit, with the new Italian government able to ally with other political forces in Europe, including German Chancellor Angela Merkel’s domestic coalition partners. Therefore, what matters is whether there is a genuine EU-wide solution. Some EU-wide measures appear consensual, such as the boosting of the EU border force by another 10,000 officers or the creation of migrant absorption centres in non-EU states. More controversial are proposals to reform existing EU mechanisms such as the Dublin agreement on returning migrants to their country of arrival. In the absence of a deal, some EU states may pursue national solutions. That would undermine core pillars of the EU’s architecture, notably the Schengen agreement on freedom of travel within the EU. However, any acrimonious conclusion to the summit on migration would eclipse any other progress on Eurozone structural issues as it would make other reforms less credible. We believe markets would react badly to that outcome.
Brexit: Not the Focus, But Tone Could Be Revealing
Finally, Brexit is unlikely to be a central topic of conversation at this summit, but the summit should still be read as a barometer of economic prospects for the UK. While the British government has still not outlined a clear view of its desired post-Brexit relationship with the EU, the contours of a British proposal are becoming visible. For example, the UK may suggest remaining a member of the single market for goods, but with restrictions on immigration. Such cherry-picking goes firmly against EU principles. Still, it might be attractive for the EU, given the union’s large goods surplus and services deficit that would benefit from continued trade with the UK. If summit leaders signal even a modicum of flexibility, including on arrangements to mitigate the return of a border in Ireland, the chance of a smooth Brexit and stable UK-EU relationship rises greatly and should be supportive of sterling.
 The Single Resolution Fund (SRF) is the designated resolution fund to help wind-down failing banks. The SRF is composed of contributions from credit institutions and certain investment firms in the 19 participating Member States within the Banking Union.
The views expressed in this material are the views of Elliot Hentov and Esther Baroudy through the period ended June 25, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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