The most recent news that Germany is in the driver’s seat on Europe’s current financial crisis has direct implications for financial markets. The crux of the matter is Germany’s financial stability relative to the shakiness of other well-known Eurozone countries including Spain, Portugal and Greece. If Germany “lends” its credit rating to stabilization, then the Euro has a real future. But German Chancellor Angela Merkel has already said that terms of any deal would require more financial centralization at the European Union level and less individual country fiscal management. These changes would have real and lasting impacts for financial markets.
The specifics of a shared debt deal are to combine all national-level bad debt into one fund and pay that fund off over 25 years. There would be no issuance of Eurobonds, something that the Germans want to avoid.
The attractiveness of the deal to suffering nation-states is obvious. According to the New York Times today, “Currently, Spain’s 10-year bonds yield about 6.3 percent, compared with Germany’s 1.2 percent; thus, the risk premium stands at about 5.1 percentage points.” A central Euro deal would spare Spain at least a few percentage points on its debt however the final result turns out.
For its part, Germany’s participation in this payoff fund would give it the leverage to push for greater centralization of EU financial functions including supervision of member-state finances. The EU would become responsible for a new EU-wide deposit insurance and would take over greater supervision of member-state banks. This would be a big win for the proponents of centralization of EU financial activity. Unfortunately, it would also be a big loss for supporters of the free market. The recent French election of Francois Hollande notwithstanding, the Germans and the French have been the backbone of an interventionist EU policy in financial markets. More German influence would move the continent more fully in the French/German direction. Here are five specific impacts:
1) EU-wide Financial Transactions Tax
The French have already passed the Financial Transactions Tax that has been proposed at the EU level as well. The Germans would be happy to go along with this. The Netherlands and several other countries are strongly opposed but may be overruled for the sake of the EU.
2) More tax harmonization
EU member-states distinguish between tax harmonization, which is one tax rate for all member-states, and tax coordination, which lets individual member-states coordinate taxes bilaterally. German support of tax harmonization would help the EU move forward with its own centralizing goals. Ireland and Luxembourg would be the biggest losers in the financial services realm, as their strategy of attracting business with low tax rates would be very negatively affected. Dividend arbitrage would also suffer.
3) Less differences in bond rates from member-states
A stronger central EU would have a firmer hand on the fiscal stability of member-states and on its banks. Read another way, the EU would impose strict controls over domestic spending including retirement ages at the nation-state level. As a result, bonds issued by Greece should one day look more like Germany’s.
4) No new capital requirements on banks
While a more interventionist EU bank regulatory environment might seek stronger risk and capital controls on EU banks, this seems unlikely to happen in the short term. The EU has already shown itself more flexible than the US in allowing banks more room on some Basel III capital guidelines. Even Solvency II might get a bit looser soon. Germany’s push towards greater central bank regulation would be unlikely to change the current EU direction.
5) A strong Euro with a core group that want or need it, but others may think again
A newly invigorated Euro with a cleaned-up banking and member-state financial system will be a boon to Germany, France and the bailed out countries of Spain, Portugal, Greece and perhaps others. Middle of the road countries that neither need aid nor are likely to benefit from increased oversight or bank supervision may not be as happy with the new arrangement.
If the EU does create a new debt pool to bail out bankrupt banks and countries, Germany will emerge with a much stronger hand for creating a more centralized EU for fiscal policy and banking regulation. Our list of five impacts is just the tip of the iceberg; look for more new German-style regulation for financial markets in the future.