The Eurozone saga continues to roll on.  Following a relatively quiet summer, the future of the Euro is dominating the headlines once more. While initial impressions are that Europe has responded positively to the first challenges of the autumn, there are big questions still to be answered.

Markets responded positively to the ECB’s proposal that it would embark on a potentially unlimited bond-buying programme to bring down the borrowing costs of Italy, Spain and other troubled Eurozone countries. The announcement was accompanied by strongly pro-Euro rhetoric from the head of the ECB, Mario Draghi, who declared he would do “whatever it takes” to save the Euro.

This was followed by Germany’s Constitutional Court rejecting legal challenges to the creation of a permanent bail-out fund (the ESM). The court ruled that the ESM is not unconstitutional although it stated that German liability to the ESM must not exceed €190 billion without the approval of Parliament.  The court also agreed to a European fiscal treaty designed to force governments into budgetary discipline. 

The outcome of the recent Dutch election also appeared to send a positive message about the future of Europe, with EU members breathing a collective sigh of relief at the victory of the Dutch Prime Minister, Mark Rute, and his conservative-liberal VVD party who took 41 seats in the 150-member lower house (likely to form an alliance with the Labour party).  These results signify the victory of a pro-European party over the eurosceptic socialists and the populist freedom party, who were not only in favour of leaving the Euro but also the EU.  This goes some way to quelling the potential anti-Euro cries which have recently been heard from the Netherlands.

However, the mood music is not all upbeat and significant challenges lay ahead.

The fundamental economic problems in the periphery countries have not gone away. The Greek economy continues to face severe problems.  The Finance Minister met with Troika inspectors at the start of September and was unable to reach an agreement on austerity measures.  Greece has been unable to stick to the terms of its bailout and it looks inevitable that it will have to ask for a third bailout or face bankruptcy and a possible Eurozone exit without a further tranche of aid. At the same time, the Spanish prime minister’s insistence that a bail out is not yet inevitable (and that Spain would not accept tough austerity conditions) looks increasingly unrealistic, given the continued problems facing its banks, the deep recession and over 25% unemployment.

The increasing popular resistance to austerity in these countries is significant given that the so called “big bazooka” of bond buying by the ECB would come with strings attached. Countries would first have to apply to the ESM for a bail-out and fiscal conditions would be imposed in return (possibly supervised by the IMF). It remains unclear what steps the ECB would take if a country whose bonds it had purchased (in potentially significant amounts) subsequently went back on promises of economic reform.

Additionally, doubts remain over the appetite throughout Northern Europe to guarantee the future of the periphery countries within the Euro. For example, the Finns continue to voice their concerns over the problems facing the Eurozone.  Having initially negotiated special terms for Finland’s contribution to the Eurozone bail-outs, the Foreign Minister was recently reported as having stated that the country has put in place contingency plans in the event of the break-up of the Euro.  The recent decision of the German court, while widely heralded as positive, placed important limits on the ESM (extinguishing hopes it might be given a banking licence which would have allowed it to borrow directly from the ECB). At this stage mutualisation of European sovereign debt (i.e. Eurobonds or debt pooling) still looks unlikely to gather support.

Against this background, all eyes will soon turn to the summit in October where EU members are expected to continue to discuss the possibility of greater integration within Europe and a closer move towards economic union.

Perhaps the biggest issue on Europe’s agenda is the EC’s proposals for central supervision of Europe’s banks (and whether this will cover all 6,000 lenders in the Eurozone or just the “systematically important” banks).  Plans under consideration include the ECB creating a fresh Council with powers to grant banking licences and sanction violators.  The early stages of these plans are expected to be introduced in the middle of next year and extended to cover all banks by early 2014.  However, Germany (and others) remain dubious about the ECB’s capacity to supervise 6,000 banks in the future.  In particular, Germany is not comfortable with the plans for the ESM to recapitalise lenders directly in a crisis. 

The proposed plans will almost certainly cause concern within the UK.  Under the plans UK banks could be shut down or forced into taxpayer-funded bailouts.  The powers being discussed would include the right to police the financial sector in the City of London and allow an independent panel full decision making powers to impose EU law and to arbitrate disputes between Britain and the Eurozone over the risks posed by British banks, with decisions potentially being automatically binding (in contrast to the current position whereby final adoption of the EBA panels’ decisions is subject to the support from the majority of all the 27 EU countries). On the other hand, if the UK seeks to stay outside central supervision this could have implications for the City’s position as a pre-eminent financial centre.

What is clear is that the Euro will continue to face stern tests this Autumn and its future is not yet secured.