Europe: Decision Week Looms

As pointed out in the Diary (see below), the coming week is going to be crucial for the future of the euro and Europe's slumping economy.

Even though it's a big week for the Australian economy, the Reserve Bank will have its attention held by the course of events this week in the euro battle, and not so much what it sees in the economy which is travelling better than many analysts think.

The struggles of the EU and eurozone leaderships to craft a convincing defence of the euro and the zone will hold the attention in the RBA boardroom.

Europe has to, once and for all, convince markets that what they agree on will stick, and defend the eurozone and the rest of the EU against any further outbreaks of volatility and fear.

For that reason a rate cut here probably won't happen because the RBA will want to see what happens in Europe at the end of the week.

Italy started the ball rolling with cabinet agreement on new austerity measures (the third this year) on Sunday night with the tax rises and spending cuts totalling 20 billion euros according to media repairs.

Tonight, German Chancellor, Angela Merkel and French President, Nicholas Sarkozy meet to try and get agreement on a joint plan for revamping the eurozone and the EU to be put to the summit on Friday.

No matter what the EU and eurozone leadership talk about, decide or proclaim at their summits on Thursday and Friday, only two organisations can make it convincing: The International Monetary Fund and the European Central Bank.

Without their active and prominent involvement, in fact, without their domination, the decisions by the political leaders won't matter a jot to nervous markets and fretting bankers who still fear the worst about the euro, the eurozone and the EU.

Two figures underline the validity of those fears. The European Central Bank said on Friday that borrowing by eurozone banks had jumped to the highest levels since March.

As of Thursday, 8.64 billion euros had been lent to banks in the eurozone who couldn't borrow in the markets to square their books.

(In March lending soared when Ireland's broken banks were forced to borrow heavily to avoid total collapse.)

But at the same time, eurozone banks had deposited 314 billion euros on Thursday night, the highest since June last year. (The ECB pays just 0.5% interest on these deposits.)

So despite having all this money just a mouse click away from the market, eurozone banks remain scared their peers could default, so they won't lend to each other.

This is a credit freeze and unless it's broken this week, the eurozone and the euro won't survive because it will lift the chances of a bank, or other group, or even a country, from collapsing.

And even though yields on Italian and Spanish sovereign debt fell on Friday, they remain at historically high levels (near 7% for the Italian debt).

The ECB meets next Thursday and is expected to reveal a new program to allow eurozone banks to borrow for up to three years, and to put up a wider range of collateral for those advances.

Yesterday it became known in Europe that a mooted plan for the ECB to lend money to the IMF which would then use those funds to backstop the likes of Italy and Spain, was being developed by regulators to be announced this week.

In media statements, the IMF has confirmed that it could raise new funds for on lending from Europe, amid speculation that the ECB might provide money to the Fund that could be used to help Italy and Spain.

"The IMF will need more resources should the crisis deepen further, and... the European authorities - like some other IMF member countries - are exploring bilateral loans to the IMF," IMF spokesman Gerry Rice said in a statement.

"As we have also noted, such loans could indeed come from member country central banks, and indeed these central banks are already lending to the Fund under the new arrangements to borrow and bilateral agreements since 2009," he said.

Speculation has been rising that the International Monetary Fund could be the conduit for money from the ECB and other central banks that could possibly be used to shore up the finances of Europe's fiscally weak countries like Italy and Spain.

IMF Managing Director Christine Lagarde has said several times that the Fund needs to boost its resources, though without singling out countries or regions with specific needs.

Currently the Fund has $US389 billion ($A381.41 billion) available to lend to its member countries.

China repeated previous statements at the weekend by ruling out using its $US3.2 trillion of foreign reserves to help the Europeans out of their hole.

"The argument that China should rescue Europe does not stand, as reserves are not managed that way," Vice Foreign Minister Fu Ying said at the Lanting forum, a gathering of Chinese officials, scholars and social groups held by the Ministry of Foreign Affairs to discuss international issues and foreign policy.

"China is not absent from international efforts to rescue Europe; it has been a positive and healthy participant," Fu said in a story on the official news website, Xinhua.

"Since the outbreak of the European financial crisis, China has dispatched more than 30 procurement delegations to Europe, helping to boost imports from the continent," Fu said.

Fu added that there are many misunderstandings about the use of China's foreign reserves. "Foreign reserves are not domestic income or money that can be disposed of by the premier or finance minister.

"Foreign reserves are akin to savings, and their liquidity should be ensured," Fu said.

The Fund has come under criticism for the huge sums it has already committed to a single region, Europe, but it has also resisted pressure to get more involved in shoring up Italy and Spain, after the European Union has exhausted much of its emergency financial resources (The Stabilisation Fund) supporting rescues for Greece, Portugal and Ireland.

But ECB chief Mario Draghi hinted on Thursday that if eurozone members signed on to a strict, enforceable fiscal discipline pact now under negotiation, the central bank might be willing to take more steps to help stabilise the fragile single currency zone.

That could involve lending large sums to the IMF to be lent on to needy sovereign borrowers, that would come under the Fund's strict conditions for fiscal probity, according to media reports yesterday.

It is quite likely the outline of a plan along these lines will be announced, and will be fleshed out in coming weeks.

The reaction of some eurozone countries (Greece, Ireland, Portugal and Italy) plus EU sceptics like the UK, will be crucial to making this idea work. Everyone has to say 'yes' otherwise it will fail.