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Europe is likely to be the centre of attention this week, in the run up to a summit of EU leaders this weekend. Investors have high hopes. However, given EU leaders’ persistent incrementalism, optimists are likely to be underwhelmed.The debate and rumours this week are going to focus on two different things: bank recapitalization and use of the finally-approved European Financial Stability Facility (which EU leaders should formally ratify at the summit):
1) Bank recapitalization: All the signs indicate that funding problems are now infecting core European banks, particularly after Dexia crashed and burned. Credit Suisse estimates that as many as 66 banks will fail the new, more stringent stress tests being conducted by the European Banking Authority. German banks are already complaining about the tests — a pretty good sign that many will fail.
There are two sides to any discussion about the banks, however. Many EU leaders are now talking about bigger private sector haircuts on Greek debt, which would further pressure European banks. While bank recapitlizations seem to be a big part of any eurozone endgame, EU leaders are shying away from them because they could put sovereign debt at risk.
2) EFSF: With all 17 euro member states finally approving the bailout terms agreed upon on July 21, EU leaders stand ready to wield the firepower of the EFSF. Just how they will do that, however, is anyone’s guess. They know that raising more money directly from national governments will be difficult if not impossible, and so it is crucial that the more than $600 billion in bailout aid is used effectively.
Right now, analysts and traders are deciding on what constitutes the “best” use of the EFSF — and to what extent bank recapitalization is part of the solution. Chatter about possibilities for expansion has already caused a stir, and that is likely to continue as rumours swirl before this weekend’s meeting.
The prospect of a eurozone endgame has bolstered markets in the last few weeks, but investors could stunt that optimism if they realise that expectations for this weekend’s summit have been overblown. With EU leaders already downplaying prospects for this meeting, we’re looking at a cynical start to a busy week in Europe.
Watch Below: Can Europe Really Solve All Its Issues By This Weekened?