(Photo: Reuters)
(Photo: Reuters)

A main shadow is, yes indeed folks, the return of the Economic Monetary Union crisis!

Only a month ago it seemed that the EMU leaders had pulled off their best yet 'kick of the can' in relaxing the deficit targets for some struggling countries for up to two years.

Since then there have even been a few glimmers of hope in the economic data, especially from Germany, but not France. We should have guessed all was not well as soon as France's President Francois Hollande and European Council President Herman Van Rompuy said the EMU crisis was over.

Everyone appears to be so scared of German Chancellor Angela Merkel (don't mention the crisis!) that discussion of anything controversial is to be dammed up until she is safely re-elected in September.

Meanwhile, the list of problems is growing and it is hard not to see a spill soon over the top of the 'dam', if not a major breach.

Growing List of Problems

The major problem (and source of several minor ones) remains German (and Dutch and Finnish) reluctance to prop up France and the Mediterranean countries.

This manifested itself again over last week's marathon Finance Ministers' discussions on bank bailouts in advance of the Summit on Thursday and Friday. The highly desirable aim is to separate the financial interdependence of governments and their domestic banks.

Unfortunately, that would almost certainly require a huge amount of new capital for the banks, which they do not want to raise and their respective governments would like to see in the form of semi-permanent loans from the European Stability Mechanism (ESM) bailout fund.

Nobody, of course, wants to own up to how much their banks really need but the total for EMU as a whole is probably in excess of €2tn, half of which has already been placed into various national 'bad banks'.

The ESM is clearly far too small to be of much use. Any recapitalisation is unlikely before next year and it still not clear when and how the ECB will exercise its new supervisory role.

A pecking order for 'haircuts' has been agreed but it seems to have potential loopholes and will not take effect until 2018.

No progress has been made on an EMU-wide depositor insurance scheme.

Other Problems

Cyprus is already trying without much success to renegotiate its €10bn bailout package. It has just announced that it will be unable to redeem up to €1.3bn in bonds that mature over the next three years and will swap them into longer-dated paper. The ECB has been obliged to suspend accepting Cyprus sovereign bonds as collateral.

Greece has identified a new €3-4bn shortfall in its funding over the next 12 months, which if unresolved in July will prevent the IMF from advancing any more of its share of the bailout.

The IMF is already unpopular with EMU leaders for its criticism of the first Greek bailout. Adding fuel to the fire, various EMU central banks in May refused to roll over maturing Greek paper and only reluctantly, after bullying by the EU Commission, handed over their profits on their holdings.

Ireland failed to make it out of recession in Q1 but has managed to extend the maturity of its bailout loans to 19.5 years (which looks very much like 'never' or the ultimate can-kicking).

Portugal, which has been in recession since Q4 of 2011, has been given a similar extension but its hopes of returning to the capital markets (and for support from the ECB's OMT programme) are diminishing as its 10-year yields surge back towards the danger level of 7%.

Italy is a long way short of 7% but increases over the last two months of 70bps or more in yields is a major set-back.

Prime Minister Enrico Letta's fragile coalition government is looking increasing unwilling and unable to tackle major reforms, which means the recession will be prolonged and the deficit start to deteriorate again.

A worrying indicator is the poor performance in May and June, following a robust April of the MIB index, which is dominated by banks.

Spain is also mired in fiscal problems with GDP growth unlikely until Q4 at the earliest. Prime Minister of Spain Mariano Rajoy has bravely said that the €40bn bailout of its banks is sufficient but remains sour about Germany's attitude. Investors are not happy either.

France and Germany

France is looking more and more troubled as Hollande is forced to back-track on his election promises and propose policies on pension reform and other cuts in public spending that would previously been the stuff of his nightmares. As a result, he really has no longer a mandate to govern, which is reflected in record low ratings in opinion polls.

His union allies are angry with his U-turns and failure to address unemployment (now almost 11% and rising) but with government spending accounting for 57% of GDP he has very limited options.

The need for scapegoats has meant a rather petulant spat with the EU Commission but the real enemy, against whom he has to supress his rage, is Merkel who has offered him nothing.

In Germany the main worry for some time has been the France's resistance to any changes to its economic and social structures.

In fact, while Finance Minister Schäuble remains zealous in the sacred cause of 'ever closer union' Merkel is showing ever more signs of giving up on it.

Perhaps her experience of growing up in Communist East Germany has spared her from the guilt that many of her colleagues still feel in respect of Nazism and two world wars. It may also have made her profoundly suspicious of centralised bureaucracies.

Interestingly, the Netherlands government, a coalition of centre-left and centre-right, has recently come out in favour of 'less Europe' and repatriation of various powers from Brussels. All this will be music to Mr Cameron's ears and it is surely no coincidence that he is on the most cordial of terms with both Chancellor Merkel and Prime Minister Rutte. Each of them will want to preserve the single market and the UK's membership of it.

Recession and Jobless Rates

Recession and unemployment are the banes of the EMU and any relief will be slow and hesitant. The legal challenge in Germany is bound to inhibit the ECB from anything that smacks of governmental support.

Negative interest rates and another round of low-cost three-year LTRO funding are unlikely to make banks lend more to 'risky' SMEs at a time when they are trying to build up their capital base and while some of them are already sitting on a pile of non-performing assets.

Merkel's re-election is not yet certain despite her soaring personal popularity. She probably will pull it off and then she will have to tackle the problems that have been dammed up.

It is an irony that so many investors still believe that the ECB and EMU leaders will find a way to prop up weak countries and their banks indefinitely.

This complacency is reflected in the bond markets and to a lesser extent in the equity markets and euro exchange rates, all of which are highly vulnerable to a change in sentiment. I still rate the chances of the euro's surviving at 50/50 with the crunch coming in 2014 or 2015.

Alastair Winter is the Chief Economist at Daniel Stewart & Co