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On the surface, last night’s speech by French President Sarkozy appeared to suggest that he was endorsing Angela Merkel’s vision of how fiscal union in Europe will look. Sarkozy stated that eurozone countries must prepare their national budgets in a common fashion, face stringent automatic penalties for breaking fiscal rules and undertake measures to narrow competitive gaps. He also supported EU treaty change and the proposal for Europe to shift to qualified majority voting in order to facilitate more rapid decision-making.

More critical, however, was what Sarkozy did not say on fiscal union. As made clear by his Budget Minister yesterday (see below), France is deeply troubled by the idea that the EC will have the power both to review national budgets and have veto power over them. Always the master of nuance, France supposedly supports tougher automatic sanctions for fiscal rule-breakers, but at the same time wants national discretion over implementation. On some level, this last debate is rendered superfluous because most Eurozone members will not get anywhere near satisfying the fiscal rules for some considerable time and so the imposition of financial penalties in the interim would make their plight even more tenuous.

Merkel is apparently in Paris on Monday to thrash this issue out with Sarkozy, just four days ahead of the next EU Summit but Merkel is extremely unlikely to relent. For Sarkozy, there are huge political hurdles to accepting Merkel’s vision. The outcome of Monday’s meeting will tell us a great deal about the single currency’s near-term future.

Guest post by FxPro
Commentary

King’s candour to be applauded. It is so refreshing to hear a central bank governor speak frankly and honestly about the enormous financial challenges in front of us. Delivering yesterday’s Financial Stability Report, BOE Governor Mervyn King suggested that: 1) The spiral facing banks looks like a systemic crisis; 2) The euro crisis is one of solvency, not liquidity; 3) The outlook for financial stability in the UK has worsened materially; 4) The Bank and the UK government are making contingency plans; 5) UK banks are better capitalised than European banks; 6) UK banks should raise efforts to boost capital, limit dividends and bonuses; 7) UK banks should declare gross loans to capital by 2013. A more concise summary of the situation here in the UK would be difficult to find. Although UK banks are in a better place than their European counterparts, if Europe’s crisis descended into chaos then this would clearly not be an especially robust defence, hence the suggestion that capital ratios be raised. Also, King is making it that much harder for the major UK banks to pay dividends or bonuses by stating explicitly that it is so much more important to rebuild capital buffers. Finally, given his assertion that Europe’s crisis is a solvency issue and not one of liquidity, Mervyn should not expect too many seasonal greetings cards from Europe’s leaders this Christmas.

Parisian resistance to Berlin’s fiscal union push. The seemingly unstoppable momentum towards a German-style fiscal union complete with judicial sanctions and EC reviews of national budget drafts has been dealt a blow by France. Yesterday, Budget Minister Pécresse declared after a cabinet meeting that France wanted “more budgetary discipline, but a budgetary discipline exercised by the states, with a real participation by national parliaments”. France continues to argue that Brussels should not have the power to force individual members of the eurozone to adopt budgetary discipline and/or to impose automatic penalties for breaking agreed rules, arguing that elected governments should retain this responsibility. France is especially sensitive to the suggestion that these features should be embedded in a new EU treaty. On this critical issue, one which Germany regards as imperative for the preservation of the euro, there are obviously still very significant differences between Paris and Berlin. Germany has got its way on a number of major issues recently but on this however, one which threatens to undermine national sovereignty which the French guard incredibly closely, it will be extremely difficult for Sarkozy to give in.

A double blow for the Aussie. Two developments yesterday had a negative impact on the Aussie. Firstly, it is becoming much clearer that China’s economy, on which Australia greatly depends, is slowing. The manufacturing purchasing managers’ index produced by the China Federation of Logistics and Purchasing fell to 49 last month, well below expectations and the worst reading since early 2009. A separate purchasing managers’ report released by HSBC and Markit Economics similarly recorded its lowest reading since March 2009. Chinese house prices also appear to be declining, a trend likely to intensify in coming months – a report from SouFun, the largest real estate website owner, claimed that the average price for a home had fallen for a third straight month in November. Unsurprisingly, Beijing recognises that the economy is more vulnerable. Wednesday’s 50bp reduction in bank reserve requirements is likely the first of many policy measures to be taken in coming months, including interest rate cuts and fiscal easing. Secondly, it is equally clear that the slowdown in the Australian economy is greater than expected. A survey conducted by PWC and the Australian Industry Group showed that manufacturing down under contracted for a fifth straight month in November. Retail sales for October were lower than expected and housing approvals are plummeting (down another 10.7% in October after a 14% decline in the previous month). There is a growing sense that the RBA is likely to follow up last month’s cut in the cash rate with a further 25bp reduction when it meets next week. Finally, some speculation is mounting that S&P could downgrade the credit ratings of the big four local banks as part of its global review of international bank ratings. Against this challenging domestic and international backdrop, it would not be surprising if the Aussie gave back some further gains in the near term.