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Today’s meeting of eurozone finance ministers in Brussels has a very full agenda to consider. There is the latest draft of the fiscal compact to discuss (see below), a review of the progress made in the Greek debt talks, and a conversation on a draft for the European Stability Mechanism (ESM).

The latter apparently includes collective action clauses, although any debt write-offs will need to comply with IMF standards. Germany and France are both keen to wrap up the ESM issue as soon as possible, although it can only take effect once it has been ratified by those countries representing 90% of its capital. It is unlikely that any of these issues will be fully resolved at this meeting, although some progress will be made. Interestingly, these days the single currency is setting less store in meetings such as these, in sharp contrast to those held in the final quarter of last year. After threatening 1.30 at one stage early on Friday, the euro drifted back to near 1.29.

Guest post by FxPro

Commentary

ECB objections to fiscal compact draft bear fruit. According to a Bloomberg story, European lawmakers have strengthened the latest draft of the fiscal compact to reflect many of the criticisms made earlier last week by the ECB. EU finance ministers will discuss this latest draft at their next meeting later today. Should the structural budget deficit deviate ‘significantly’ from the target of 0.5%, then there is a centralised corrective mechanism which is triggered automatically. Although an improvement on the first draft which attracted a great deal of ire from the European Central Bank, there are still some important questions to be answered, such as what constitutes ‘significant’, and how the automatic centralised corrective mechanism is to work. Apparently the European Commission will also gain the power to implement a timetable for fiscal convergence. It remains to be seen how binding any instructions from the European Commission prove to be. That said the new Belgian government recently attracted the ire of the Commission because its growth forecasts were too optimistic. The Commission demanded urgent spending cuts from the Belgians in order to avoid substantial fines. The real test of these powers will be whether the Commission is brave enough to tackle one of Europe’s larger economies for their fiscal transgressions. The latest draft also gives the European Court of Justice (ECJ) the ability to impose fines of up to 0.1% of GDP on those countries that do not pass sufficiently binding balanced-budget laws. This sounds more promising, although the ECJ will not be able to enforce fiscal rules as the ECB had hoped. Unfortunately, it appears that the draft still allows a wide range of excuses for missing fiscal targets, such as “exceptional circumstances” (economic downturns) or “unusual events”. The ECB had asked for this to be tightened as well. This is arguably the most troubling aspect of the whole draft. It appears that it is still too easy to miss budget targets. Also, those countries that sign up to the treaty will have up to five years to implement it. Although progress on a decent fiscal compact is being made, on the surface at least it still appears too soft on fiscal miscreants. Any sense that this pact is just Stability and Growth Pact without bite will weigh on the single currency.

MPC will welcome news of falling inflation. Arguably the most interesting aspect of the latest retail sales figures is that the pace of growth in retail prices is definitely slowing. Although the measure extracted from this series is narrower than the official inflation numbers and is calculated on a different basis, nevertheless it confirms that high street inflation at least has decelerated significantly. Non-fuel sales inflation in December slowed to 1.8%. It is more than likely that, with the VAT increase dropping out of the calculation in the January numbers, we will move into a period of high-street deflation, at least on the retail sales measure. Indeed, looking at non-store retailing (catalogue but also internet sales), we are already there, with the deflator in this area now at -0.6%. Naturally, this is good news for those who have seen real incomes squeezed over the past couple of years, but it’s also a result of pretty tough trading conditions which have seen several high-street names go into administration this month. Therefore, the better inflation picture on the retailing side is not without costs in terms of jobs and also margins on the part of those remaining.

Portugal’s slow motion train crash. S&P’s announcement over a week ago that it was lowering Portugal’s credit rating to below investment grade was another nail in the coffin of the embattled nation. For those that had not already done so, the downgrade forced money managers who still had exposure to Portugal to offload. The ten-year bond yield rose to 14.40% on Thursday, 1250bp above comparable Bunds. Although the Portuguese Prime Minister has been praised by other EU leaders for his austerity measures, it is clearly weighing heavily on the economy. In 2012, it is entirely plausible that GDP will decline by at least 5%, with further falls in prospect next year. In the year to September 2011, GDP fell by 1.7%. Portugal is on a path of deeply painful internal devaluation, as it does not have control of monetary levers such as interest rates or an exchange rate. Private sector deleveraging is proceeding very quickly and bank balance sheets are under enormous strain which is accelerating the economic misery. Because of the financial lifeline supplied by both the EU and the IMF last year, there is no imminent trigger for a debt-restructuring. However, bondholders must surely realise that Portugal has very little realistic prospect of paying back its debts in full. As we move through 2012, discussions will commence regarding the size of haircuts that Portuguese bondholders might need to take. Some suggest it could be up to one-third. Right now, that seems like the best case for this struggling country.