European debt crisis: a dangerous week ahead

European debt crisis enters a dangerous phase with a German court ruling, Dutch election, and EU finance ministers meeting this week. A reversal of support for the EU's beleaguered nations could intensify the European debt crisis. 

The euro zone enters a dangerous week, strewn with potential landmines, in a somewhat more optimistic mood after investors welcomed a European Central Bank plan to prevent a breakup of the single currency.

German judges, Dutch voters, IMF inspectors and Brussels regulators could all spring surprises that make it harder to resolve a sovereign debt crisis which is almost three years old and weighing on the world economy.

Wednesday is the main day to watch.

Germany's constitutional court rules then on the legality of the euro zone's permanent financial rescue fund, the European Commission unveils detailed plans for a euro zone banking union, and the Netherlands holds a cliff hanger general election.

Then European finance ministers meet in Cyprus from Friday to try to thrash out differences over banking supervision and possible extra aid for Spain, the zone's fourth biggest economy, and Greece, the problem country that first triggered the crisis.

Decisions on Spain and Greece are not likely until October, but the talks may point to whether Madrid will apply for European assistance, at the risk of unpalatable conditions and supervision, and whether EU and IMF inspectors are leaning towards allowing a vital aid instalment to keep Athens afloat.

Europe has been holding its breath for two months for the German court ruling, a potential show-stopper.

All 20 legal experts polled by Reuters expect the judges to let the European Stability Mechanism and a European fiscal discipline pact go ahead, but most expect them to add tough conditions for future bailouts.

That could potentially tie Chancellor Angela Merkel's hands or, at the least, make her backing for bailouts politically even more difficult given a public backlash against last week's ECB decision to buy the bonds of vulnerable states.

If the court were to rule against the ESM, it would have a devastating effect on bond and currency markets, pushing the 17-nation currency zone deeper into turmoil by casting doubt on future rescues of heavily-indebted southern member states.

But if as expected it gives a green light, it may set out caveats that scare investors and complicate crisis-management.

STRINGS

Among strings the judges may attach are giving parliament a power of veto over each future aid disbursement or declaring a limit to German liability for other euro zone countries' debts.

"I think the Constitutional Court will let both treaties pass," said Kai von Lewinski at Berlin's Humboldt University, adding that it might insist on attaching a "clarifying sentence that German liability has to be limited".

A quarter of the public and constitutional law professors surveyed expect the court to say that European integration has reached the limits permitted by Germany's Basic Law and any deeper union would require an unprecedented referendum on a new constitution.

For months, it looked as if the Dutch election could end in paralysis or throw up a government in thrall to hard-left or far-right eurosceptics, making any parliamentary backing for future euro zone bailouts well nigh impossible.

But latest opinion polls show the centre-right Liberals of caretaker Prime Minister Mark Rutte and the centre-left Labour party pulling ahead neck-and-neck, with support for leftist and anti-immigration populist parties fading, suggesting a pro-European coalition may emerge.

Even so, it may takes months of negotiation before this increasingly sceptical founder member of the European Union has a fully empowered government, casting doubt on its ability to agree to any early steps towards closer euro zone integration.

"Irrespective of the outcome of the Dutch election, anti-austerity sentiment and bailout-phobia in Holland is likely to become more pronounced," said Nicholas Spiro, managing director of fixed income consultancy Spiro Sovereign Strategy.

BANKING BATTLE

A fierce battle has already begun over proposals for a single banking supervisor based at the ECB and a future bank resolution system which European Commission President Jose Manuel Barroso will outline to the European Parliament.

Germany, keen to preserve its politically sensitive regional Landesbanken and savings banks from outside control, insists the ECB should supervise only the top 25 systemic cross-border banks and leave the rest to national regulators.

German Finance Minister Wolfgang Schaeuble has said the ECB cannot realistically oversee all 6,000 banks in the euro area - something of a red herring since the real issue is the 200 banks that hold about 95 percent of banking assets, according to the Bruegel think-tank.

However, crises have spread from institutions such as Britain's Northern Rock and Spain's Bankia which had appeared to pose little threat to the wider banking system.

The Commission and the ECB therefore want the new supervisor to have ultimate authority over all lenders, even if it delegates to national watchdogs. Bankers tend to agree.

"If we put all banks under the same supervision mechanism, that would ensure a level playing field," the chief executive of Italy's UniCredit, Federico Ghizzoni, told Reuters in an interview. "And it's not only large banks that pose systemic risks."

German lawmakers fiercely oppose longer-term plans for a common banking resolution fund and deposit guarantee scheme, which Barroso may raise in a state of the union address that will lay out steps to deeper economic and monetary union.

The ECB's promise to buy short-term bonds of vulnerable countries that accept a partial bailout programme has given governments a breathing space to repair the design flaws of the euro, but EU leaders remain far apart on what to do.

The EU's top economic official, Olli Rehn, sought to make such assistance more politically palatable to Spain and Italy, saying the conditions attached would be based on existing policy recommendations but "would have to include very specific objectives and a timeline on how to meet the objectives".

Spanish Prime Minister Mariano Rajoy has said Madrid, which has already agreed to European aid for its troubled banks, should not have to meet extra conditions for sovereign assistance, such as cutting pensions.

Barroso will lay out the building blocks for closer fiscal integration and changes that may be needed to ensure "democratic accountability" in a more centralised euro zone. But several countries, including the Netherlands, have deep misgivings about yielding more sovereignty and there is little public support for such moves.

"Nobody, least of all investors, should be under any illusion about the reason why the ECB is acting more forcefully to shore up Spanish and Italian debt markets," Spiro said.

"These steps are being taken in the face of repeated failures on the part of Europe's leaders to solve the political, economic and institutional problems that continue to bedevil the single currency area. The big issues of a fiscal and banking union, to say nothing about growth and competitiveness, remain in the hands of politicians, not central bankers."