Judgement Week

A big week looms for the eurozone and thus the world’s stockmarkets. On 12 September, the German Constitutional Court rules on whether the German government is allowed to support the European Stability Mechanism (ESM).

The court’s 16 judges need to determine whether the bail-out fund is constitutional. If they do, the fund will become operational; if they do not, the eurozone project is thrown into doubt once again.

A lot is at stake. The first bail-out fund – the European Financial Stability Facility, which was established in 2010 – is down to its last €250bn (£200bn) or so in lending capacity, having spent much of its cash supporting Greece, Portugal and Ireland. That may sound a lot of money but it is unlikely to cover the financing needs of Spain or Italy – and certainly not both. Estimates from Citigroup put their financing needs for the next two years at more than €700bn.

The ESM would make sufficient cash available to the eurozone’s larger struggling nations and give them a chance of digging themselves out of their current hole. If the German Constitutional Court were to reject the mechanism wholesale, it would present an immediate and serious problem for eurozone policymakers and would lead, almost certainly, to a significant sell-off in equity markets.

Most analysts see this as unlikely, however – suggesting the court will allow the ESM to become operational. The devil will be in the detail. The court may require additional information before making a final ruling or it may require limits on areas such as bond purchases under the existing ESM programme. Anything but a full endorsement of the mechanism is likely to make markets extremely nervous – especially in the short term.

But will even a full endorsement quell the rising tide of scepticism? It is likely to provide – at the very least – a short-term bounce in markets. Markets prefer the imperfection of the current situation to the chaos of a break-up. Yet there are increasingly credible calls for a fundamental change.

George Soros has said Germany now needs to decide whether it is going to “lead or leave the euro”. The veteran investor believes the eurozone should target a higher rate of economic growth – which would require it to abandon German-led austerity measures – and that a new ‘European Fiscal Authority’ should be established to oversee government finances.

Investors may well be growing tired of hearing how “this is an important week for the eurozone” but, as the German Constitutional Court prepares to pronounce judgement, this time it really is the case.

September 2012