E U R Ooc 26811

Europe

26 August 2011

Data Flash (Euroland) Eurostress Update

Deutsche Bank AG/London

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.

Economics

Research Team

Mark Wall Economist (+44) 20 754-52087 [email protected]

Marco Stringa, CFA Economist (+44) 20 754-74900 [email protected]

Gilles Moec Economist (+44) 20 754-52088 [email protected]

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Last week’s key concern was growth. It was not far from being the key issue again this week. The flash PMI was more resilient than expected, but it was the wrong kind of resilience: production was boosting inventories and this cannot persist. IFO more obviously suffered a “shock”, such is the seriousness with which the crisis is now impacting on sentiment. The risk of a contraction in euro area GDP in Q3 is rising.

Nervousness around Greece has increased, internally because of even weaker-than-expected growth and externally because of the challenges of getting the new loan in place, including now resolving the Finnish collateral problem. Markets should anticipate lots of debate and noise but ultimately we expect the Finnish collateral condition to be satisfied, the PSI to complete (the formal offer was released this week), the EFSF reforms to be agreed and the new Greek loan to be established. That won’t take Greece off the agenda completely, however. It will continue to be judged against tough criteria every quarter. We expect risk will remain high.

With markets skeptical, many clients are asking “what next” in terms of the European policy response. Eurobonds are ruled out. The EU is due to approve amendments to the EFSF, the core strategy for dealing with the crisis. The EU is unlikely to switch strategy before those reforms are delivered and tested. Nevertheless, there are some ways in which the EU could reach out to engender market confidence, including amongst other ideas, greater transparency on the EFSF approval timeline, clarification of IMF commitments to EU rescues and an EFSF funding strategy.

We also update the Schedule of Events to watch over the next several weeks.

Growth: Recession risk increases Last week’s key concern was growth. It was not far from being the key issue again this week. Last week Q2 GDP surprised to the downside, in particular in Germany where economic activity grew just 0.1% qoq. The greater loss of momentum has sparked a flurry of growth downgrades. For example, we have cut our 2012 euro area GDP growth forecast to 0.8% from 1.5% (see our Dataflash Euroland, 19 August 2011, for our new economic forecasts). This week’s data validated the concerns and revisions, and especially so in Germany.

The euro area composite output PMI was unchanged in August at 51.1, outperforming expectations for a drop to 50.0, effective stagnation. For sure, the level remains a disappointment, down over 7 points from the February peak and remaining at the lowest since September 2009. However, the result still flatters to deceive. The composite would have been worse were it not for a remarkable rise

26 August 2011 Data Flash (Euroland)


in German manufacturing output. Near guaranteeing its transitory nature was the fact that all the production appeared to go into finished goods stocks. Orders, including Germany’s critical export orders, fell further beneath 50. Unwanted inventories will now weigh on production in the coming months. As Figure 1 demonstrates, rising final inventories and a rising inventories-to-orders ratio is not just a German phenomenon. The euro area’s near-term activity outlook is increasingly in the shadow of an inventory overhang.

Figure 1: In the shadow of an inventory overhang

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Euro area PMI stock of finished goods (lhs)

Ratio of PMI finished goods stocks-to-orders (rhs)

Source: Deutsche Bank, Markit

The German IFO index for August had no redeeming features. The report was more obviously weak than the PMI. The headline index and the two subcomponents (current conditions and expectations) both fell more than expected. All industry sectors are down, including the separately surveyed service sector. The level of the main indices remain high compared to history. The level tends to correlate well with German year-on-year GDP growth, which we still expect to be high at 2.8% in 2011. The concern is the pace of decline. This is in 'shock' territory.

Figure 2: IFO suffered a “shock” in August

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German IFO businesss climate index

Source: Deutsche Bank, Ifo Institute

The headline index fell 4.2 points in August, a 3 standard deviation fall. The largest monthly decline since the Pan-German survey began in 1991 was 4.9 points, recorded in November 2008, shortly after Lehman Brothers collapsed. In short, IFO is reacting as if there has been an equivalent ‘shock’, such is the seriousness with which the crisis is now impacting on sentiment. The difference then was IFO sustained falls as markets tightened and then froze after Lehman's collapse creating the economic collapse and worst recession since WWII.



Between June and December 2008 the IFO headline index fell 23 points, from broadly 107 to 84.

After the August 2011 fall, the IFO headline index still stands at a still lofty 108.7. The question is, why would the IFO stop falling, at least in the relative near-term? The breadth of declines through the survey speaks of both internal and external drivers. There is nothing obvious that is going to “catch” this falling knife, at least not yet. Hence, the risk of a contraction in GDP by year-end does open up more clearly as a possibility. Indeed, looking across our range of simple regression models, the better quality models are starting to more clearly indicate a GDP contraction in the euro area in Q3 (Figure 3). Rather than forcing German Chancellor Merkel into a more introspective stance, the ‘shock’ IFO could be a basis for arguing the Germany economy needs a more extroverted stance, one that does more to fight the crisis to re-achieve stability even if it costs Germany.

Figure 3: Models point to increased “recession” risk

in Q3 2011 Q3'10 Q4'10 Q1'11 Q2'11 Q3'11

Euro Area GDP, % qoq (and DB forecast for Q3'11)0.40 0.30 0.80 0.20 0.00

R-square

PMI level0.74 0.64 0.56 0.87 0.64 0.11

PMI level, crisis dummy0.75 0.49 0.41 0.70 0.48 -0.02

PMI level, PMI chg, crisis dummy0.82 0.31 0.25 0.72 0.25 -0.36

ESI (EC economic sentiment index)0.56 0.47 0.64 0.73 0.64 0.51

ESI level, crisis dummy0.56 0.44 0.61 0.70 0.61 0.49

ESI level, ESI chg, crisis dummy0.80 0.42 0.57 0.49 0.14 -0.02

IP ex construction0.79 0.63 0.86 0.60 0.40 0.22

IP ex construction, crisis dummy0.84 0.26 0.48 0.23 0.05 -0.12

Real indicators*, crisis dummy0.92 0.26 0.30 0.65 0.01 0.02

Real & survey indicators**, crisis dummy0.87 0.31 0.50 0.58 0.32 -0.10

* euro area IP ex construction, German/French construction output,

euro area car registrations and euro area retail sales ex autos

** euro area IP including construction, euro area services PM I

All regression based on quarterly data since 1999; crisis dummy

imposed since Q4 2008 (Lehman co llapse); Q2 and Q3'11

estimates based on data available to date and/or carryover effectsSource: Deutsche Bank, Markit, Eurostat, EC



Figure 4: Contraction warning for Q3 GDP

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Source: Deutsche Bank, Eurostat

Greece: Situation remains tense Nervousness around Greece has increased, internally because of even weaker-than-expected growth and externally because of the challenges of getting the new loan in place, including now resolving the Finnish collateral problem.

The worsening sentiment towards Greece is reflected in the recent increase in the Government yields, which nearly wiped out the July fall. For example, the 10-year Government yield was just 21 below the June peak on 25 July (Figure 5). However, in this gloomy summer there are some positive developments. The market seems to be increasingly appreciating the prospects of Ireland, both in absolute terms and when compared to Portugal. For example, on 25 August the Ireland 10-year Government yield was 559bps below the peak on mid July. True, some of the fall may be due to the re-activation of the SMP. But, over roughly the same period, Portugal 10-year yields fell by 203bps and the spread between Irish and Portuguese 10-year yields has reached minus 228 basis points – the lowest spread since the onset of the monetary union. This development appears in line with our long-held view that Ireland has a better chance than the other two small peripheral to successfully complete its adjustment process.

Figure 5: Ireland slowly differentiating itself?

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Ireland 10-Yr %

Portugal 10-Yr %

Greece 10 -Yr %

Source: Deutsche Bank, Haver



However, we think that the above increase in yields for Greece reflects a too pessimistic view on the new loan. Indeed, we continue to believe a new loan will be approved. Growing skepticism about Greece’s capability to deliver on the terms of the loans will on balance be overcome by EU and IMF concerns about the financial shock that would occur if Greece went unfinanced. Credibility depends on Athens capacity to keep reaching for fiscal adjustments and economic reforms.

There has been some new flow this week:

• Finnish collateral: Comments from Germany through the week made it clear that the proposed Finnish collateral solution of a partial cash rebate will not be accepted. While EU leaders pledged on 21 July to satisfy the Finnish collateral condition, Germany says it will not permit preferential treatment. The debate raises unfortunate questions about the strength of EU solidarity, but we believe a solution will be found (see discussion on an option to collateralize on privatisable assets in out Dataflash 19 August 2011). Finland may only be small (EUR14bn of the EUR440bn EFSF), but it will not be permitted to withdraw from the EFSF. Not only would it be awkward and require a re-writing of the Legal Framework to extricate Finland, but in codifying a preferential treatment for Finland its exit would seriously undermine EU solidarity and the perceived durability of the EFSF. EU leader will not let this happen.

• PSI: A formal letter of inquiry has been sent by Greece to foreign governments asking their help in distributing the offer to international holders of the bonds. Holders of the relevant bonds (until 2020) have until 9 September to indicate their willingness to voluntarily participate in the bond exchange. It is said the transaction will complete in mid-October.

• EFSF reforms: It remains the case that only one of the 17 euro area member states has as yet given an indicative date for their parliamentary approval of the EFSF size and flexibility reforms, namely Germany. However, it is now claimed that Germany’s tentative decision date of 23 September could be pushed back to 29 September because of the Pope’s visit to Germany. As we said previously, newswires have reported that the Netherlands might not vote until October. The Slovak Prime Minister has also announced that her country will wait until all others have approved before voting on the EFSF, which we interpret as Slovak being unlikely to deny the reforms their unanimity unless others have done so ahead of them.

• Next tranche: On the current timeline, the new loan programme for Greece is unlikely to be in place before mid-October. Until then, the original bilateral loan programme remains in place. The next tranche – EUR8bn – is due to be disbursed in September. The Troika review mission ahead of the disbursement has already arrived in Athens. According to an IMF spokesperson, the review mission is likely to conclude on 5 September, “assuming agreements are in place” (that is, assuming any necessary corrections to the programme are agreed with the Greek authorities) and the IMF Board would then be in a position to approve its portion of the disbursement “towards the end of September”.

Next steps for Europe’s crisis response With markets skeptical, many clients are asking “what next” in terms of the European policy response. Eurobonds are ruled out (not forever, but would only make sense after fiscal union, itself a long-term idea at best). The EU is making amendments to the EFSF, the core strategy for dealing with the crisis. The EU is unlikely to switch strategy before those reforms are delivered and tested.

Nevertheless, there are some ways in which the EU could reach out to engender market confidence:



1. Rapid approval of EFSF size and flexibility reforms. The reinvigorated EFSF is the centrepiece of the EU's crisis response. There are implementation hurdles and the market is cautious. Europe must be seen as trying harder to gain the parliamentary approvals as rapidly as possible. Germany and France have asked that the process be completed within September, but there is some concern that not all countries will vote on the changes before October (see above). EU President Van Rompuy should strongly encourage the euro area member states to announce when their EFSF votes will take place. The market could take some comfort from greater transparency.

2. Clarifying extent of IMF support for Greece in particular and for euro area rescues in general. The EU has propagated a belief that the IMF will donate 50 cents for ever EU euro committed to euro financing packages. The IMF has never endorsed this view. Yet the scale of available resources is one of the key dimensions on which the market judges the credibility of the official responses to the crisis. Irrespective of Greece’s quarterly review decisions and whether or not the IMF will disburse the original Greek loan, the IMF needs to clarify (a) whether or under what conditions it intends participating in the new Greek loan, and (b) whether and under what conditions it will participate in the new EFSF policies such as precautionary lending, lending for bank recapitalisation without a general fiscal/economy adjustment programme, secondary bond market purchasing and bond buy-backs. Whether or not the IMF participates affects the market's assessment of the lending capacity of the EU rescue initiatives.

3. EFSF must pre-emptively announce its funding strategy, probably in conjunction with or at the very least backstopped by the ECB. Once ratified by the euro area member states, the EFSF lending capacity will increase from EUR255bn to EUR440bn. If the ECB's intention is to hand responsibility for secondary bond purchasing to the EFSF as soon as it has operational authority for such interventions, the EFSF will need considerable and rapid financing. So far, the EFSF has been able to finance tranches of primary funding aid to Ireland and Portugal with intermittent EFSF bond issuance. For credible secondary market intervention, the EFSF will need a large enough pool of liquidity on hand quickly. One option is for the ECB to purchase the EFSF bonds and thus finance the EFSF. As a private financial institution rather than a “government”, the ECB is legally permitted to purchase the EFSF debt at primary issuance. The EFSF bonds would have the benefit of the explicit national guarantees, protecting the ECB's investment. Alternatively, the EFSF could be converted into a bank and on the back of a limited capital it could leverage itself and repo the purchased bonds via the normal ECB refi operations. An “EFSF bank” might not however be a means to leverage the underlying EFSF lending capacity upwards from EUR440bn. The EFSF bank will have to reside within a jurisdiction. Assuming this jurisdiction is the AAA-rated euro area member states, a "leveraged" EFSF could increase the contingent liabilities on the AAA sovereign balance sheets to such an extent that it threatens the least secure of AAAs, France. For maximum credibility, the market needs to know how the EFSF will fund itself and the extent to which the ECB will provide that finance in the absence of a market-based solution.

4. EFSF as a European TARP. The 21 July reforms already allow for the EFSF to lend to a euro area member state for the purpose of recapitalising its banks without the country having to enter a fiscal/economic adjustment programme. This is a valuable reform aimed in particular at Spain. However, there remain arguments to allow the EFSF to play the role of a European TARP, whereby it recapitalises European banks directly in extreme scenarios or provides term funding to banks (something the ECB is reluctant to do as it sees its job as providing “liquidity” rather than term finance). The current reform facilitates the shifting of bank risk onto the sovereign balance sheet if a market-based solution is unavailable. There may be scenarios where shifting the risk to the sovereign becomes self-defeating, as became the case in Ireland. For example, if an unanticipated sovereign shock occurred, Europe may require a vehicle to recapitalise and finance banks and ring-fence the shock. The EFSF as a European TARP probably requires the rapid introduction of the EU Directive on Bank Resolution.



5. EFSF could drop the AAA rating requirement. In requiring a AAA rating, the EU set an artificial constraint on the EFSF. This constraint might have been sustainable had the euro crisis been limited to smaller euro area member states like Greece, Ireland and Portugal. However, the more the crisis has spread to the larger peripherals (Italy and Spain) and potentially beyond, the less sustainable is the AAA constraint. Moving from a AAA requirement to a AA requirement increases the EFSF lending capacity from EUR440bn to EUR716bn minus the step-outs (even with intervention in Italy and Spain, as well as Greece, Portugal and Ireland, the lending capacity would be EUR483bn). More importantly, the EFSF would no longer be susceptible to France losing its AAA rating. Also bear in mind that a "eurobond" would arguably only be AA rated, not AAA rated. A large euro area crisis cannot be addressed with a solution that can be sustainably financed with AAA rated bonds. There is, however, a risk of a catch-22 scenario. First, dropping the AA would increase the cost of borrowing for the EFSF, which would then have to be passed on to the peripherals. Their adjustment process would then become more challenging, likely offsetting the decision on 21 July of lowering the borrowing rate for Greece, Ireland and Portugal in line with those of the Balance of Payments facility (currently approx. 3.5%). But this would also result from Eurobond. Second, the increase in size would be necessary to take care of Italy on top of the four peripherals. But if Italy steps out (along with the four peripherals), the remaining EFSF firepower would be EUR 484bn.

6. EU could arrange a "Constitutional Convention" to explore support and blueprint options for closer fiscal union. It was the notion of an "EU Constitution" that ultimately scuppered the outcome of the 2001-2003 Convention, replacing it with the stripped back Lisbon Treaty. Nevertheless, the market should be under no allusions -- a sustainable eurobond market requires EU constitutional reforms to ensure full legal rights to impose fiscal policy on otherwise sovereign European nations. Convening a Convention, with representatives of all EU countries, is not a promise to implement eurobonds, but it might placate markets to formally explore what is involved, assess the political will to achieve such an objective and at the very least identify politically sustainable improvements in European fiscal policy coordination and integration.

Schedule of Events • 30 August: Italy auction. Bonds. This will be a key test of the effectiveness of the

ECB’s intervention. On Friday 26 August, Italy issued short-term debt at costs materially below the peak in late July. The yield on 6-month bills fell by close to 130bps from the late July auction. The fall for the two-year zero coupon bond auction fell to 3.41% from 4.04% at the end of July auction. We think that the intervention of the ECB was the key driver of the fall in yields. On the positive side, we think this bodes well for the 30-August auction. On the negative side, the re-activation and extension of the SMP to cover Spain and Italy appears a necessary support in the current circumstances. To reach a sustainable equilibrium, we think that Spain needs to recapitalise its banking system and Italy to finalise its fiscal austerity programme and above all its structural reforms. But given market tension, in the short term the successful completion of the new-loan programme for Greece appears of crucial importance.

• September: EFSF issuance. �The EFSF is expected to be back in the market in September to raise a tranche of funds for Portugal. This issuance is independent of the EFSF reforms to make the Facility more flexible and allow it intervene in secondary bond markets. It will nevertheless be an occasion to test ongoing investor appetite for the EU’s crisis facility.

• September: Italian structural reforms. �Although there has been progress, there is still great uncertainty in terms of the concrete measures that the Italian Government will present to the Parliament in terms of structural reforms. It is of paramount importance that the Government abandons the one-leg strategy based solely on fiscal austerity, and fully embraces a two-pillar strategy of fiscal consolidation and structural reforms.



• From early September: European parliaments start to return from their summer recess. The process of ratifying the EFSF reforms can begin. All 17 euro area member states must approve the reforms (including the 78% increase in national guarantees and the right to intervene in secondary bond markets) for the changes to come into effect.

• Mid/Late-September: Greek sixth tranche of original bilateral loan programme due. This is an EUR8bn tranche and will likely be the last payment through the EU bilateral loan programme. The new Greek loan programme is expected to be in place from around mid-October and be paid through the EFSF; the EU portion of the remainder of the original programme will in future be distributed by the EFSF.

• 1 September: Spain and France auction. Bonds.

• 4 September: German State Election. Mecklenburg-Western Pomerania. Currently ruled by an SPD-Grand Coalition and polls indicate that no other party combination is likely to secure a majority. This ought to be a non-event.

• 4-5 September: Italian fiscal austerity vote. The tentative date for the parliamentary vote on the new Italian austerity measures, approving the decree signed by the government. On the evening of Friday 12 August, the Italian Cabinet approved the emergency decree aimed at balancing the budget in 2013, one year earlier than the target set in mid-July austerity package (Data Flash on 14 August). As we explained Focus Europe on 12 August, the Government adopted the measures in response to calls from the European Central Bank for it to accelerate its balanced budget target. According to the Italian constitution, the emergency decree has to be passed into law by parliament within 60 days. The upper house has started discussing the decree on 22 August, at the moment it appears that the vote may occur on 4 or 5 of September. Note that Italy's largest trade union confederation called for a one-day general strike for 6 September against the cuts to local and central government, plans to liberalise labour contracts and a lack of more severe measures to tackle tax evasion. It is possible that the Government after the vote in the upper house decides to ask for a confidence vote in the lower house to avoid debating further changes to the austerity plan. Part of the Prime Minister’s party (PDL) and of the opposition have proposed amendments that would not impact the overall size of the plan but could improve its effect on the economy. However, the ruling majority is divided over the possible changes. The disagreement appears to be (i) between the Prime Minister and the Finance Minister on an increase of the VAT in exchange for a lower increase in the income tax – a beneficial change in our opinion – and (ii) between the PDL and the Northern League. The latter opposes additional measures to discourage early retirement. As we discussed in Focus Europe on 12 August, we think that this would be a more growth-friendly measure than tax hikes. We also continue to think that an introduction of a wealth tax to partially offset some of the tax hikes – including the likely increase in local taxes – would be constructive. For example, a wealth tax could be designed to increase the likelihood to capture some of past tax evasion. Besides increasing the potential fairness of the package, it could increase social cohesion. For example, a wealth tax has been proposed by the unions (and the main opposition party). A step in the direction of the unions could then represent a useful dowry to bring to the table of the labour market reforms. Besides the debate on the amendments, we think that the decree will be converted into law without decreasing its overall size. It is however important in our opinion that the Government then presses on with more incisive and broad-based structural reforms to boost growth potentials.

• 5 September (tbc): Conclusion of EU-IMF review of Greek loan. This will determine whether or not the Troika will disburse the next tranche of the original bilateral loan programme.

• 7 September: German Constitutional Court rules on Greek loan and EFSF 1.0. “Fears that the Federal Constitutional Court might possibly demand the “reversal” of



crisis management decisions taken at the European level are probably largely unfounded. By contrast, the focus is likely to be on the rights of the Bundestag to have a say on matters, particularly with regard to budget responsibility. Quite a few parliamentarians consider the Bundestag’s budget to be undermined by the EFSF II and/or ESM fiscal aid measures, even though the deployment of such measures may only be approved unanimously by the euro-area members. The Federal Constitutional Court will probably find that the Bundestag has to be granted greater authority to participate also in terms of content, e.g. in decisions on new aid programmes. Authorisation of individual credit tranches or market interventions could, by contrast, remain in the hands of the executive, that is, the ministries, for reasons of practicability alone” (extract from “Germany’s Euro political mindset”, Focus Germany, DB Research, 19 August 2011).

• 8 September: ECB Governing Council Meeting. This was the meeting at which the ECB Council was due to decide whether or not to extend the full allotment regime for another 3 months. In light of the prevailing market conditions, the decision was already take in August to extend the full allotment regime to the end of the year. The market will be listening for hints of further 6-month tenders. The new ECB staff forecasts will be released. Markets will review the scale of any downgrading of forecasts to help judge the risk of a policy reaction. We believe it will require an ECB belief in recession to cut interest rates. There is an increasing risk of such a view, but more likely towards year-end if it happens.

• 9 September: Date by which private Greek bondholders to indicate participation in PSI. The objective is a 90% participation rate among all private sector holders of the relevant Greek bonds until 2020. The offer is conditional on the 90% rate being achieved.

• 12 September: European Commission issues interim economic forecasts. This report will give a partial update of forecasts. The more complete set of forecasts – including a full set of fiscal projections —will be published in November.

• 12 September: Italy auction. Bills.

• 13 September: Italy auction. Bonds.

• 16-17 September: Eurogroup/ECOFIN finance ministers’ meetings. This meeting could be a good occasion to discuss the technicalities of the EFSF 2.0 (see Focus Europe on 29 July).

• 18 September: German State Election. Berlin. Currently ruled by an SPD-Left coalition which could become a SPD-led Grand Coalition. The outcome will have little impact on the Bundesrat.

• 20 September: Netherlands to present 2012 Budget.

• 23 September (tbc): German parliamentary vote on EFSF reforms (risk of delay to 29 September). The German government has suggested 23 September as the objective, although the date itself will be determined by the Bundestag, not the Government. Approval of the bill by 23 September would imply a drastically shortened consultation period in parliament. There is a risk of delay to 29 September because of the Pope’s visit.

• 23-25 September: IMF-World Bank Annual Meetings.

• 25 September: Senate elections in France. One-third of senators face re-election. This could have ramifications for the timing of the vote on amending the Constitution to embed a fiscal brake.

• 26 September: Spanish parliament to be dissolved. The general election is scheduled for 20 November, about 4 months earlier than expected

• 27 September: Italy auction. Bills and two-year zero coupon bonds.



• 28 and 29 September: Italy auction. Bonds.

• 29 September (tbc): German parliamentary vote on EFSF reforms. If delayed from 23 September.

• 30 September: Spanish banks recapitalisation. The deadline for Bank of Spain announcement on Spanish banks recapitalisation and Cajas restructuring.

Conclusion: Sticking with “muddle through” One cannot be confident that the crisis has reached the bottom. There is considerable event risk within the next few months, not least all the political approvals required to get the enlarged and more flexible EFSF in place. Sustainable economic recovery has become an equally challenging hurdle for investors to cross. Many macro indicators are coming down quickly (see the latest IFO survey as a good example). There is a heightened risk of recession and in the event of recession markets are going to be even less confident of debt stabilisation, whether in the small peripherals or the large.

The good news is the ECB is intervening in the Italian and Spanish bond markets. But the ECB needs the appetite to remain in the market to absorb whatever selling pressure emerges. So far, the ECB purchasing (EUR22bn in week one and EUR14bn in week two) has been sufficient to keep Italian and Spain funding rates down (10Y around 5%). However, it has perhaps been easier for the ECB to achieve this in August given the seasonal lack of issuance. This will change from next week when supply resumes. That said, assuming bills roll, there should only be about EUR95bn of sovereign bonds redeeming and coupons in Spain and Italy between September and December. Adding primary deficits and the total figure is no higher than EUR130bn. This is absorbable by the ECB and EFSF, even more so if domestic investors roll their positions.

But the politics of this ECB intervention are not simple. Markets are hearing opposition from parts of the German establishment (e.g., Juergen Stark at the ECB, Christian Wulff the German President). A perceived lack of consensus at the ECB will affect the market perceptions of its durability and credibility of the interventions.

In terms of sustainable solutions, exiting the crisis requires two things. First, the correction of economic imbalance to such an extent that markets are willing to finance these economies again. This means correction of imbalances in public and private sector balance sheets, and current account imbalances too. Second, we need an institutional and governance infrastructure that the markets believe is economically robust and politically sustainable. This means a tough but believable framework to manage the correction of imbalances and to prevent the creation of imbalance in the future.

Fiscal union would be the logical end point of the latter, but it cannot be rushed. It took over 10 years to plan monetary union. It will take just as long to plan fiscal union (or one that is politically sustainable at least; a rushed union won't be viewed as sustainable). Eurobonds would only make sense if there were fiscal union. As Merkel says, otherwise we would have a "debt union" not a "stability union". Perhaps the EU can launch initiatives to explore support for fiscal union (e.g., reconvene the EU Constitutional Convention), but the market will have to accept it is at best a medium-term goal.

The market also needs to price correctly what the EU has already done this year in terms of toughening the Stability and Growth Pact, creating the "Euro Plus Pact" and introducing the "European Semester". More transparent and more integrated fiscal policy is coming, it just takes time to be yield visible results. Markets won't give the benefit of the doubt until the results of policies to correct imbalances and the new policy infrastructure are visible. The onus is on the ECB to buy the time until these are visible.



It is a “muddle through” and as such the markets don't like it. But markets still fail to appreciate (a) the political constraint on a union of sovereign nation states to impose rapid solutions that require political union that is a pipedream and (b) the quality of the decisions that have already been taken. The EU is not doing too badly. If global growth were better and global risk appetite was back, markets might price the fundamentals more appropriately and the EU crisis, though still challenging — not least in Greece — would be a more manageable.



Appendix 1 Important Disclosures

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The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Mark Wall/Marco Stringa/Gilles Moec



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Australia: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless “Japan” is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. New Zealand: This research is not intended for, and should not be given to, "members of the public" within the meaning of the New Zealand Securities Market Act 1988. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation.

Risks to Fixed Income Positions

Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates – these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

David Folkerts-Landau Managing Director

Global Head of Research

Stuart Parkinson Associate Director Company Research

Marcel Cassard Global Head Fixed Income Research

Europe Asia-Pacific Germany Americas

Guy Ashton Regional Head

Fergus Lynch Regional Head

Andreas Neubauer Regional Head

Steve Pollard Regional Head

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