The German constitutional court in Karlsruhe is set to rule on the legality of the ESM bailout fund on September 12th. While chances are high that the court will give a green light, it is important to understand the background and the significant implications for both options.
The event in itself already caused an aggravation of the situation, making the ruling extremely important.
Importance of ESM
The European Stability Mechanism (ESM) is the permanent bailout fund that is expected to replace the temporary EFSF that has been in use so far in the cases of Greece, Ireland and Portugal. 90% of funds are necessary to establish the ESM, and without Germany, who contributes over 27% of the funds, there’s no ESM.
Spain and Italy are suffering from lack of trust in the markets, each one for different reasons (details are in the next chapters). Bond yields are high, making the recycling of debt very expensive, and eventually making their debt mountain unsustainable.
The new mechanism has in initial paid-in capital of 80 billion euros and a total capital of 700 billion euros. This large sum is needed for large countries, but may not be enough – not the “firewall” needed to calm investors.
The Bigger Firepower
The European Central Bank has the authority to create euros out of the thin air, thus making its firepower unlimited. In the recent rate decision, Mario Draghi declared that the current situation in bond markets is “unacceptable“ and that it reflects the fear of “convertibility” – the breakup of the euro.
Draghi pledged to buy bonds en masse and on the September 6th rate decision he provided many details about the OMT.
However, Draghi conditioned the usage of this tool on a formal aid request from the countries who need help, mainly Spain. A formal aid request would mean that Spain would have to undertake some conditions (more austerity) and would receive aid from the ESM.
ESM Ratification
The German parliament already approved the treaty with a huge majority on June 29th in both houses of parliament. However, the final stage is signing the change into law. This usually symbolic stage is done by the president. However, President Joachim Gauck cannot sign the decision into law without a green light from the German constitutional court.
Opposition for the ESM, which indirectly provides transfers of money from Germany to other countries, comes from various citizens, members of parliament from the right and from the left. After an initial hearing in July, the court set the September 12th date for a final decision.
There are various reasons why the court will likely approve the ESM:
- A previous approval: Just one year before this decision, the German constitutional court gave its approval to the EFSF. The judges rejected the challenges but did add a warning. President Andreas Voßkuhle said that this “should not be misinterpreted as a constitutional blank check for further rescue packages.”
- Past QE: An approval of the ESM by the court will likely lead to quantitative easing by the ECB. While this sounds like blasphemy to the orthodox Bundesbank, it is actually the Bundesbank that bought bonds back in the 70s. So, this hurdle isn’t likely to stand in the way of approval.
- Politics: The ESM was ratified by the German parliament with an overwhelming majority. There was only small opposition from some right wing members in Merkel’s coalition that led the move. The main opposition party, SPD, stood behind the decision. It even went one step further and gave its support for Eurobonds (or sharing debt), something the government ruled out on any occasion. With such wide support, it’s hard to see the court stand brave against it.
- Risks at stake: The judges in Karlsruhe aren’t likely to find distinct answers in the law, but have room for analysis. So, they will not be able to ignore the implication of their decision. A decision that the ESM is unconstitutional will trigger huge market turmoil and perhaps could lead to the breakup of the euro. The German Council of experts sees a 3 trillion euro damage upon a breakup of the euro, while the costs of fixing the euro are actually much cheaper than Germans think. German exports continue enjoying the weak euro, as seen lately in Germany’s trade balance. These considerations of Germany’s interests cannot be ignored.
So, there are good chances that the Constitutional Court in Karlsruhe will approve the ESM. Some analysts see a 60% chance of approval.
What if they say no?
If the judges go with the other scenario and reject the ESM, this will likely send the euro tumbling down very sharply.
An approval is more priced in than a rejection is. Without the ESM at hand, the euro area will be in very deep trouble and the chances of euro breakup will seem quite real. An immediate drop of EUR/USD to 1.18 and later to 1.15 cannot be ruled out.
European leaders have no other mechanisms to support Spain and Italy at the moment. The options are:
- A change in Germany’s constitution: Such a move will not be too popular. Even if German politicians all unite for this cause, it will take a long time in which the situation in Spain could get out of control.
- The ECB will buy bonds anyway: Also here, it will be very hard to sell it to the bailout weary German public. A move by the ECB without the governments moving first would provide an immediate solution and could be presented as a “transmission of monetary policy” but would be a sharp U-turn from current policy and definitely opposed to the spirit of the EU Treaty – a clear monetization of governments.
So, a rejection would be a doomsday scenario.
Assuming an approval, would could the ECB do?
The presentation of the ECB’s Outright Monetary Transactions showed that the ECB is ready with all the details. The big picture that we got from Draghi is:
- It is ready to act despite Bundesbank opposition: The orthodox German central bank expressed its discontent from buying bonds. The discontent could even result in a resignation of Jens Weidmann, the president of the Bundesbank. His fellow countrymen Axel Weber and Jörgen Stark already did that in protest. Draghi noted one reservation, but the decision went through. Merkel backs it.
- It is ready to act massively: Unlimited bond buying without setting limits nor seniority showed how serious Draghi is.
The Spanish crisis and the ECB’s actions are at a critical point, and the situation should start turning around in September. This is not too optimistic, but also not too certain.
Spain is in urgent need for this fix. Draghi even gave Rajoy a small political carrot named ECCL, or simply put: a soft bailout.
This is an adapted version of this topic from the forex monthly outlook. You can download the full report by joining the mailing list below.
More on Spain’s deep issues and the implication of the court ruling for QE3 are covering widely in the report.
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