Markets rally on pessimism; EU keen to resolve crisis: UBS

Stephane Deo, chief European economist, UBS explains to CNBC-TV18 that all officials and members at the EU summit are keen of resolving the crisis and keeping Europe united.

He also adds that the Italian situation is less troubling as compared to the crisis in Spain and that flexibility in the ESM to buy in the market could send out positive signals. Below is an edited copy of the interview on CNBC-TV18. Also watch the accompanying video. 
Q: How positive is the development that the loans to Spanish banks will be on par with previous loans and that the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) will now be used for banks and not just for sovereign debt?
A: I think the market is rallying because expectations from the summit were extremely low. I talked to a lot of investors over the past two weeks and most of them were pessimistic about the outcome of the summit.
I would still be a little bit cautious because the ESM is just a one-off decision for Spain and I think the market should anyway assume that loans from government will be used on a priority basis one way or the other.
In terms of recapitalisation of the banking sector in Spain, I'm a bit cautious because the communiqué from the Europe is vague. So the timeframe suggests that it will not happen any time soon. So recapitalisation of banks in Spain will be as planned. Q: The German finance minister stated that Germany is open to a joint debt issuance if there was closer fiscal integration. Do you think Germany has softened its stance to a certain extent?
A: No, I don't think Germany has softened its stance at all. I think the German position has been very clear and very consistent for the past few years on the lines of  'we all care for euro bonds' but under the condition of very strong fiscal unions.
From my point of view, that makes sense because if you issue euro bonds then you are using the credibility of Germany to protect other countries. But the German economy needs to be safeguarded from running up an excessive deficit. So from the German point of view, this is probably non-negotiable. Q: I am intrigued by your statement that the amount of money available for capitalisation of banks has not increased much. Do you think the cheer will not last very long?
A: I am not sure. The one-page communique announced yesterday does not have enough detail. The worry is that if you should look at the Spanish situation, the asset-side of the balance-sheet of the banks looks weak till funds are released and recapitalisation will follow.
To implement an ESM that is feasible to recapitalise banks with the European regulator, it could be much longer and presumably take longer.
_PAGEBREAK_ Q: What else is being announced at the summit? There was a demand from Italy and other peripheral countries that before any talk of growth in capital there should be support for the bonds. Do you think the ECB is going to start repurchasing bonds?
A: I think the Spanish and Italian situations are very difficult. The fundamentals for Italy are reasonably less troubling. The debt sustainability is not impaired but if the market continues to price interest rate at 6-7% or higher, the market is going to have a liquidity problem.
So Italy and Spain have asked for European support pleading that they are doing all they can. The demand for ESM and EFSF for more flexibility to buy in the market, is sending out a positive signal that some support can be expected in the future. Q: What do you make of Rompuy's statements of announcing an integration plan by October? Do you think a fiscal banking union is on the horizon?
A: Yes, I think when you talk with European officials there is absolutely no sense about an imminent break-up. All members want to build a stronger framework and Van Rompuy's initiative is part of the plan.
So in the medium-term, the outlook is positive with no break-up of the EU and increased fiscal integration. The market needs to be fixed now or in the very near future. Q: How do you see the more enduring-risk assets moving? We have seen some money coming into risk assets. Equities and emerging-market currencies are doing somewhat better after almost being badgered for eight weeks. How do you think crude will behave? It's quite clearly a proxy for global economic development. Do you see crude returning to the  over-USD 100 levels? Will it touch USD 120 or continue to meander at the USD 90-100 levels?
A: We are actually bullish on oil prices because supply will be restrained. Oil prices will continue to pick up in the near future from the current lows. But in terms of activity, we run a surprise index which compares the actual data with the consensus and over the past eight weeks these indicators have collapsed.
Expectations have been lowered based on this data. The question is whether the expectations have been revised lower are enough or whether there are further downward surprises. We think that to a large extent the negative surprise has been priced now. Q: A lot of economists keep pointing out that there is a crisis of confidence. They say that rise in the yield to beyond 7% is unsustainable. But what is the near-term trigger that could lead to a crisis? Is there a big debt repayment coming up? Why do the markets need a real short-term fix at this point?
A: Firstly, you could hold a sell auction in the near future if the market continues to deteriorate. It’s not really a question of the level of rate, but it's the question of ability of the government to tap the market.
Secondly, the trigger in Ireland is due to problem with the banking sector. In November 2010, Ireland called in the IMF for support against credit on Italian banks. So while there is a big rally, the funding for banks has become extremely difficult.