Euro Woes May Be Exacerbated By German Court's Conditions

Includes: FEZ, FXE
by: Colin Lokey

Investors can rest easy Wednesday night. The path is now clear for Germany to ratify the European Stability Mechanism (ESM). Although collectively analysts and commentators saw it as profoundly unlikely that the German Constitutional Court would grant an injunction against the rescue fund's ratification, there were nonetheless serious concerns among a relative few that the court might block ratification and in the process strip the ESM of its capacity to make a real dent in the crisis (Germany is set to contribute more than 27% of the fund's capital).

Although the fund received the go ahead regarding ratification, the German court placed a strict cap on Germany's contribution. Germany will not contribute more than its Treaty established share (190 billion euros) under any circumstances unless approved by the German parliament. This isn't a good sign for Spain or Italy as continued questions about the legitimacy of ECB bond purchases make the ESM the only feasible option for primary market purchases of sovereign debt (the ECB's purchases are confined to short-term debt in the secondary market). Given the size of the two countries, the ESM is hopelessly undercapitalized to combat their crises as noted by Open Europe:

"The current lending capacity of the ESM, €500bn, is not nearly enough to take, say, Italy and Spain off the market, meaning that the [German] cap could prove a real obstacle for large-scale Eurozone bailouts down the line."

In other words, the German Constitutional Court has now explicitly stated that their will be no additional contributions from Germany to the ESM should the fund's 500 billion euros prove inadequate to stabilize Spain and Italy. Additionally, the court stated that the ESM will under no circumstances be allowed to borrow from the ECB which would of course be a way for the rescue fund to circumvent German opposition to recapitalization.

These two caveats increase the chances that the ECB will have to resort to questionable tactics regarding the financing of governments down the road. Put simply: if the ESM/EFSF exhaust their capacity to purchases sovereign debt in the primary market, the ECB may have to step beyond its secondary market, short-end boundary in order to keep the situation stable, a move which would once again open the central bank up to accusations of government financing.

Perhaps the worst part of the ruling if you are a struggling periphery nation was this:

"...the Bundestag must individually approve every large-scale federal aid measure on the international or European Union level.""

This means that applying for aid won't be as easy as sweet-talking the troika into sanctioning bond purchases with few meaningful conditions attached. If Spain applies for the ECB's new bond buying program, the German parliament will have to approve the aid -- and the conditions attached to it. Given Mariano Rajoy's insistence on limiting conditionality, this may prove to be an insurmountable obstacle.

In short, this decision is no game changer. In fact, considering that most analysts believed the Court would give the green light to the ratification process, the fact that the above-mentioned conditions are now explicitly spelled-out may prove to be a negative going forward. Investors who have placed bets against the euro (NYSEARCA:FXE) or European equities (NYSEARCA:FEZ) shouldn't be scared-away from their positions as a result of this ruling. For all intents and purposes, this was a non event.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.