E U R Ooc 26811

Europe

26 August 2011
Macro

Data Flash (Euroland) Economics
Research Team

Eurostress Update Mark Wall
Global Markets Research

Economist
(+44) 20 754-52087
mark.wall@db.com

Marco Stringa, CFA
Economist
(+44) 20 754-74900
marco.stringa@db.com

Last week’s key concern was growth. It was not far from being the key issue Gilles Moec
again this week. The flash PMI was more resilient than expected, but it was Economist
(+44) 20 754-52088
the wrong kind of resilience: production was boosting inventories and this gilles.moec@db.com
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
Economics

deceive. The composite would have been worse were it not for a remarkable rise
Deutsche Bank AG/London
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single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN
APPENDIX 1. MICA(P) 146/04/2011.

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
55 Euro area PMI stock of 2.0
finished goods (lhs)
Ratio of PMI finished goods 1.8
stocks-to-orders (rhs)
50 1.5

1.3

45 1.0

0.8

40 0.5
1999 2001 2003 2005 2007 2009 2011

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
135 German IFO businesss climate index

125 Headline
currrent conditions
115 Expectations

105

95

85

75
1991 1994 1997 2000 2003 2006 2009

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.

Page 2 Deutsche Bank AG/London


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 level
0.74 0.64 0.56 0.87 0.64 0.11
PMI level, crisis dummy
0.75 0.49 0.41 0.70 0.48 -0.02
PMI level, PMI chg, crisis dummy
0.82 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 dummy
0.56 0.44 0.61 0.70 0.61 0.49
ESI level, ESI chg, crisis dummy
0.80 0.42 0.57 0.49 0.14 -0.02
IP ex construction
0.79 0.63 0.86 0.60 0.40 0.22
IP ex construction, crisis dummy
0.84 0.26 0.48 0.23 0.05 -0.12
Real indicators*, crisis dummy
0.92 0.26 0.30 0.65 0.01 0.02
Real & survey indicators**, crisis dummy
0.87 0.31 0.50 0.58 0.32 -0.10
* euro area IP ex co nstructio n, German/French co nstructio n o utput,
euro area car registratio ns and euro area retail sales ex auto s
** euro area IP including co nstructio n, euro area services P M I
A ll regressio n based o n quarterly data since 1999; crisis dummy
impo sed since Q4 2008 (Lehman co llapse); Q2 and Q3'11
estimates based o n data available to date and/o r carryo ver effects
Source: Deutsche Bank, Markit, Eurostat, EC

Deutsche Bank AG/London Page 3


Figure 4: Contraction warning for Q3 GDP

1.5
1.0
0.5
0.0
-0.5
Euro area real GDP, % qoq
-1.0
-1.5
Fitted (regressors: IP incl
-2.0 construction, PMI services,
-2.5 crisis dummy)
-3.0
1999 2001 2003 2005 2007 2009 2011
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?

Irish/Portuguese Spread %
20 Ireland 10-Yr %
Portugal 10-Yr %
15 Greece 10 -Yr %

10

5

0

-5

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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http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.

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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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or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at
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Risks to Fixed Income Positions
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(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 Marcel Cassard
Associate Director Global Head
Company Research Fixed Income Research

Europe Asia-Pacific Germany Americas
Guy Ashton Fergus Lynch Andreas Neubauer Steve Pollard
Regional Head Regional Head Regional Head Regional Head

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