Pedro Passos Coelho is facing unprecedented protest rallies and criticism from across the political spectrum. The main opposition Socialist Party announced that it will vote against the 2013 budget. Coelho is also coming under criticism even from the ranks of his own centre-right Social Democratic Party. His conservative coalition partner CDC has remained conspicuously silent, sparking speculation that the government would collapse and a snap election would be held. The outspoken former president of the Republic Mario Soares suggested appointing a new government without recourse to early elections, Jornal de Negocios reports. Reuters quotes Adelino Maltez, political scientist at Lisbon Technical University, saying a potential casualty may be Finance Minister Vitor Gaspar.

Spain issues short term debt as speculation on rescue mounts

El Pais (English Edition) reports that Spain continues to benefit from the prospect of an ECB intervention, as it issued €4.6bn in 12- and 18-month bills with yields at 5-month lows. This is despite the uptick in secondary market yields for 10-year bonds reported yesterday. On Thursday there will be an auction of 3- and 10-year bonds.

In the meantime, the discussion about whether or not to go for a bailout has intensified.

Some speak for a rescue…

El Pais also quotes Charles Dallara of the Institute of International Finance hoping that Spain or Italy will ask for an EFSF program or else “massive potential support by the ECB will not materialize”. However, Deputy Prime Minister Soraya Sáenz de Santamaría said in a TV interview with Telecinco that the government continues to study the implications of a rescue.

Others who have encouraged the Spanish government to apply for a rescue include Spanish former ECB board member José Manuel González-Páramo, who said on Tuesday in an interview with Onda Cero that it’s better to ask for a rescue early so as not to be forced to negotiate the conditions from a position of weakness. He wondered whether “the Spanish economy can go on with its normal activity or will be forced to a firesale of many of its assets”. (Onda Cero has audio but no real transcript).

Economist and former minister of public administration Jordi Sevilla also advised against delaying a rescue application that “will come sooner or later”, El Economista wrote on the weekend. Sevilla argues that the financial markets will not be willing to refinance the debt maturing in the rest of the year at acceptable rates. He wondered whether it would not be possible to use the rescue money for growth policies, given that the adjustments carried out so fa are depressing the economy and making it harder to meet deficit targets.

…while others urge caution

The Spanish business owners’ association CEOE has come out against a hasty rescue application, writes ABC. The CEOE’s deputy secretary general Alberto Nadal told the press that the mere announcement of the OMT has improved access to credit for Spanish firms and provides time for the necessary multilateral negotiation process, and expressed hope that “time will be used wisely” by Spain and its European partners. Nadal also said none of this means “homework” shouldn’t be done, and that the 2013 budget should ensure the deficit targets are met, but without compromising “items which foster the country’s productive capacity”.

According to an unsourced story in El Plural, Rajoy’s goal is to avoid being associated with the additional pain associated to a rescue, and the humiliation of applying for it. His strategy is to make cuts attributed to German demands before applying for an ECB intervention, so that there will be no new conditions and the intervention can be presented as “not a rescue”. Thus, he’s preparing swinging cuts in the 2013 budget draft to be introduced at the end of the month, in hopes that these will be so harsh to “appease” Angela Merkel. In particular, Rajoy wants to avoid having to cut pensions. El Plural comments that Rajoy and Zapatero have already made cuts comparable to the amount of the banking rescue, but that this “won’t be sufficient because the cuts strangle the economy and new revenue is not generated”.

(One wonders whether donor countries won’t always insist on some new condition they can present to voters back home. In that case, making cuts beforehand does not eliminate the eventual imposition of more cuts and so the strategy would ultimately be politically self-defeating.)

Cinco Dias reports on an interview with Jean-Claude Juncker in Bayerischer Fernsehen (article and video), in which Juncker said that “harsh conditions” will be imposed on Spain in case of a rescue. Cinco Dias highlights the contrast between the reassurances from the Commission that no new conditions need be imposed (just a stricter timetable and supervision, said Olli Rehn), and Juncker’s words after the Ecofin meeting in Cyprus as well as in his interview in Germany anticipating new austerity measures.

France starts ratification its fiscal pact law

Francois Hollande’s government on Wednesday will start ratification of the budget law on the EU fiscal compact treaty, requiring member states to limit their structural deficits to 0.5% of GDP under penalty of sanctions, except for exceptional circumstances.  Le Monde has the details: A three-year budget plan with limits for budget credits and social security spending and a nine-member budget watchdog panel, the so-called High Council of Public Finance, to ensure that France complies with the EU fiscal treaty.  If spending and revenues diverge from their expected trajectories, the council’s job will be to issue a public warning to the government and the parliament to start the correction mechanism.  The budget law is due to be submitted to the French parliament in early October. It should pass through easily if, as they have stated, some of the deputies in Sarkozy’s conservative UMP party vote for it, Reuters reports.

This “golden rule” was expected to be enshrined in national constitutions, but France’s Constitutional Court ruled recently that the government could implement the treaty through an overriding budget law. Hollande in turn can skip a referendum on it which he would not be certain of winning. A recent survey showed that nearly two-thirds of French would now reject the 1992 Maastricht Treaty.

Bloomberg: Deposit flight, home bias and the danger of financial fragmentation

An accelerating flight of deposits from banks in four European countries is jeopardizing the renewal of economic growth.  A total of €326bn was pulled from banks in Spain, Portugal, Ireland and Greece in the 12 months ended July 31, according to data compiled by Bloomberg. The flight of deposits from the four countries coincides with an increase of about €300bn at lenders in seven nations considered the core of the euro zone, including Germany and France, almost matching the outflow. The erosion of deposits is forcing banks in those countries to pay more to retain them — as much as 5% in Greece. Banks in the core countries also have been reducing their holdings of Spanish, Portuguese, Italian, Irish and Greek government bonds. At the same time, lenders in the periphery have been buying more of their own governments’ debt. That has further contributed to the fragmentation of credit along national lines, as banks collect deposits from people and companies in their own countries and lend internally.

Dutch Liberal and Labour start coalition talks, austerity to continue says Rutte

The Dutch Liberal and Labour parties are set to start negotiations on forming a new Cabinet a week after Sept. 12 elections, with caretaker Prime Minister Mark Rutte setting the tone by urging continued austerity, Bloomberg reports. “The austerity policy must continue; we’re not there yet,” Rutte, who heads the Liberals, said in an interview in The Hague, where the 2013 budget was presented to Parliament yesterday. Talks between the two strongest parties still may prove difficult due to policy differences on how to deal with Europe’s debt crisis.

The Netherlands’ 2013 budget, featuring about €12bn in spending cuts, is based on an emergency austerity deal struck after Rutte’s previous government collapsed in April. A new government might decide to adjust it. According to this budget, the deficit is set to narrow in 2013 to 2.7% of GDP from 3.7% in 2012. The Dutch economy is expected to grow 0.75% after shrinking 0.5% this year, assuming that policy makers succeed to prevent an escalation of the euro crisis and won’t shy away from unorthodox measures, according to the economic forecasting institute CPB. Dutch economists critised the budget in the Volkskrant newspaper, as a budget with too little emphasis on growth enhancing measures.

Is the ECB about to publish minutes?

Suddeutsche Zeitung has a story this morning that the ECB may soon decide to publish minutes of its council meetings, a demand that has been made, and rejected, repeatedly since the start of the euro. The pressure comes from Jens Weidmann, presumably because he is now in a minority, and feels that the publication of minutes would make him heard more clearly. It was, of course, Germany which resisted the publication of minutes in the past. The article said the governing council may soon decide to publish the protocols relatively close to the meeting itself (it is 30 years now). The article says Weidmann and Erkki Liikanen both favour greater transparency.

Napolitano reiterates commitment to Euro in an indirect criticism of Berlusconi and Grillo

The euro is an achievement that can’t be given up and we are determined to protect it, Italian President Giorgio Napolitano said during a meeting with Greek President Karolos Papoulius in Rome, Il Messaggero reports. According to Napolitano, Greece must stay in Eurozone and Italy’s politicians should have more accountability when they talk about the Euro. The last comment is aimed at Silvio Berlusconi and Beppe Grillo, founder of Movimento 5 Stelle, now the third Italian party, an staunchly anti-euro.

Europe’s mortgage linked securities has bounced back

The FT has an interesting story this morning about the return of the mortgage-backed securities market in the eurozone. Since July prices of residential mortgage-backed securities have been rising rapidly, as a result of which funding costs are the lowest since the collapse of Lehman. This does not yet translate into lower mortgages, as the banks pocket the profits, but may do so eventually. There are various reasons for that: changes in ECB collateral policy, an easing of tensions in the credit market, An example was a €650m sale by Santander UK of two year RMBS at a spread of 75bp over Euribor. But the article also says the lower spreads are unlikely to trickle down to consumers until banks wean themselves off central bank funding.

Why Europe’s capital markets need a banking union

Ralph Atkins notes in the Financial Times that the toxic state of the banking system has driven companies to tap the capital markets directly, especially in Italy and Spain. He says dreams of the European market to rival the US market are returning, and in this case one may well ask the question a banking union for traditional banks is all that important. Atkins makes the point that traditional banking remains strong, especially in Germany. More importantly, national capital markets remain distinct precisely because of a lack of financial integration. So the fate of banks and capital markets are intertwined. Banks need capital markets to provide finance, and manage risk, but capital markets need efficient banks. This is why a banking union matters to the capital markets.

The other goal of OMTs is good sterilization

According to Nicola Borri and Giuseppe Ragusa, one of the aims of the OMT is to restore a correct functioning of sterilization. In an article on Lavoce, Borri and Ragusa argue that the sterilization with fixed term deposit auction, week by week, will reactivate the correct monetary policy transmission mechanism. The question is: is it enough? Maybe not. The access to OMTs will be a source of uncertainty and tension for the requestor country, Borri and Ragusa write. And with a balance sheet of over €3,085bn, the ECB should take more risks than forecasts. Mario Draghi’s big bet continues.

Appalled by Reding

This comment by Joachim Jahn, Frankfurter Allgemeine, is a good example of the outrage by German conservatives, who are appalled how the European Commission and the ECB have completely turned around the legal interpretation of the No Bailout clause. He quotes Viviane Reding’s speech to the German legal association, in which she said that the no bailout clause was a populist phantasy, not back by law. European law foresaw that countries help each in an emergency – which has a higher legal priority than the no bailout clause. Jahn says this twist his entire understanding of EU law, and shows that the institutions will stop at nothing to expand their own power, and mislead the public.

Why Germany’s Target 2 surpluses are much less risky than the headline numbers suggest

This is a very important column by Paul de Grauwe and Yuemei Ji, who argue in an article in Vox that the best way for Germany to neutralise any risk associated with the Target 2 surplus is to refuse automatic conversions of euro to mark balances in case of a breakup. The authors make the point that the Target 2 surplus is gross, and is driven up in part by speculative flows. Hence a loss on a claim can be compensated for a refusal to convert. The net balances are much lower. The best metric for Germany’s net risk are not Target 2, but net foreign assets. “Since these surpluses are the result of policy choices of that country, it can be said that Germany has chosen to take these risks. Germans should stop complaining about these risks,” they write.

10-Y Spreads, Forex, ZC Swaps and Euribor-Ois

Spreads are creeping up from a still low level.

10-year spreads
	Previous day	Yesterday	This Morning
France	0.648	0.656	0.662
Italy	3.472	3.558	3.535
Spain	4.346	4.314	4.371
Portugal	6.717	7.109	7.405
Greece	19.191	19.216	-1.64
Ireland	3.643	3.665	3.789
Belgium	1.036	1.040	1.038
Bund Yield	1.648	1.612	1.635
Euro Bilateral Exchange Rate
	Previous	This morning
Dollar	1.308	1.3081
Yen	102.950	103.59
Pound	0.806	0.8042
Swiss Franc	1.212	1.2114
ZC Inflation Swaps
	previous	last close
1 yr	2.05	1.99
2 yr	1.83	1.77
5 yr	1.96	1.92
10 yr	2.23	2.21
Euribor-OIS Spread
	previous	last close
1 Week	-7.086	-6.786
1 Month	-2.843	-2.643
3 Months	5.157	7.357
1 Year	61.143	60.843
Source: Reuters