Van Rompuy Lays Out a Plan for Europe's Future

Herman Van Rompuy, President of the European Council, issued a draft report of his views on the future of Europe ahead of this week's Eurogroup summit. For reference, the European Council does not have legislative power. Instead, the Council serves to suggest policies and ideas for consideration by law-making bodies across the continent.

In his latest paper, entitled Towards a Genuine Economic and Monetary Union, the President acknowledged the hardships faced by many nations. In addition, he proposed a four-step plan for a longer-term view of the euro's future. These four steps include an integrated financial framework (encompassing a banking union), integrated budgetary controls, integrated economic policy, and ensuring accountability within the Eurozone.

The President said that an integrated financial framework should be a priority of European leaders at this week's summit. He added that an integrated financial framework would fix shortcomings that were revealed in the financial crisis. Also, he stipulated that this framework should differentiate between euro-member countries and countries outside of the currency union, but within the European Union. Moreover, the President's proposed financial framework would be built around two key elements: a single European banking regulator and deposit insurance.

A European banking regulator would be the ultimate banking authority, according to Van Rompuy. In addition, the regulator would supersede the national regulators. However, national regulators would still exist so as to aid the European regulator.

Van Rompuy wrote, "Such a system would ensure that the supervision of banks in all EU Member States is equally effective in reducing the probability of bank failures and preventing the need for intervention by joint deposit guarantees or resolution funds. To this end, the European level would be given supervisory authority and pre-emptive intervention powers applicable to all banks. Its direct involvement would vary depending on the size and nature of banks."

According to the President, Pan-European deposit insurance would be the first step towards the mutualization of liabilities amongst eurozone nations. This insurance measure would help to prevent capital flight within the Eurozone and would thus help to reduce the Target II liabilities that stem from this capital flight. Later, the European Union would create a pan-European resolution authority. This new entity would resemble the F.D.I.C. In addition, the pan-European resolution authority would be in charge of orderly unwinding of positions in bankruptcy and deposit insurance.

The President is also an advocate of closer integration of fiscal affairs. He said this fiscal integration would begin with countries first meeting existing eurozone budget conditions, such as deficit limit and debt ratio requirements. Once countries get their finances in order, joint fiscal decision making and eventually the pooling of risks would be possible. He suggests "upper limits on the annual budget balance and on government debt levels of individual Member States" as the first step towards this joint fiscal decision making. Also, he suggests that Eurobills and then Eurobonds could follow, once individual nations' finances are cleaned up. Van Rompuy said, over the longer term, he would like to see a European Treasury come to fruition as nations cede all budgetary decisions to the national level.

President Van Rompuy expects a full report on these matters by the end of the year, with an early date sometime in August.

Implications

Eurobills and then Eurobonds would likely have huge implications for markets, especially sovereign bond markets. Eurobond issuances may cause German Bunds' yields to rise markedly, as market participants begin to believe that Germany's AAA credit rating is on the line for other European nations. Peripheral nations' yields may fall in this scenario, as traders would see these nations as able to take advantage of Germany's strong credit rating.

Based on budget deficits and credit ratings of each nation, the credit rating of a Eurobond would likely be either A+ or A from S&P, A1 or A2 from Moody's, and A+ from Fitch. Thus, one might expect all bonds to reflect this rating, and Bunds to fall while peripheral bonds, with lower ratings, rallying. This is a risky trade in current market environments, but if Eurobonds are a real outcome of this week's summit, it might be a good trade for a brave trader.

Eurobonds would be a market positive and would probably alleviate stresses on embattled European bank stocks. If any of these measures seem like real possibilites after the summit, this would be euro positive and European bank stocks would likely rally. Traders could express this view through the iShares European Financial ETF EUFN and through the Currencyshares Euro Trust FXE. Also, bond traders would see peripheral bonds rally, most notably those of Spain and Italy.