Today, Chancellor Merkel and President Sarkozy agreed and announced key elements of their common position for the EU Summit meeting later this week. As we expected last week in German Chancellor Merkel continues her push for the embedding of strict and enforceable fiscal rules in EU Treaty changes) and repeated earlier  today in Euro area summits preview: how the pieces could fall into place, Merkel revised the German government's position on private sector involvement (PSI) in the European Stability Mechanism's (ESM) future design.

Today, she agreed with the position long held by the French government and the ECB and dropped the condition that debt restructuring with private sector involvement could be a key complement to official aid provided under the ESM. She called the Greek case unique and insisted that public euro area debt (other than Greek debt) was as safe as public debt in the United States. This is a very important concession because Germany had previously insisted PSI was needed as an option under the permanent ESM to fight moral hazard and make the "no-bail out" threat credible. We interpret this as an important step in the direction of more joint liability.

Chancellor Merkel and President Sarkozy further agreed to accelerate the introduction of the revised ESM and have it operational before the end of next year. We believe that the ESM could offer a vehicle for representing the euro area countries jointly at the IMF and slowly evolve into a European debt management agency. Joint representation with pooled resources through the ESM would also enable the IMF to lend much larger amounts to the ESM in return than to individual countries such as Italy that may require temporary aid. Institutional changes and their legal implementation may take some time to achieve, however, and there is growing speculation that in the meantime the Eurosystem's national central banks could provide the IMF with additional resources to quickly increase available resources for possible IMF lending to euro area sovereigns should they come again under more severe market stress.

Moreover, Chancellor Merkel and President Sarkozy agreed to a compromise on fiscal rules where each euro area government will have to adopt a "debt brake or golden rule" in its constitution that, over the medium term, will force a reduction in euro area countries' public debt-to-GDP ratios to below 60 percent. These rules will be harmonised under a new treaty and the European Court of Justice (ECJ) will rule as to whether each euro area country's "golden rule" complies with the new EU treaty, or bilateral treaties if full EU27 agreement cannot be reached. Broad adoption of such an agreement at the EU Summit would make fiscal consolidation more credible and more aggressive public debt market intervention by the ECB under the SMP more likely if needed.


source: BarCap