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On the eve of the eurozone summit Spain received a heavy blow to its already endangered image as the credit rating agency Moody's downgraded the country from Aa1 to Aa2. The reason is that, according to the agency, the cost of banking restructuring substantially exceeds the estimates of the government. According to The Financial Times, instead of 20 billion euro as the authorities estimated, the country will require additionally 40-50 billion euro to restructure its banking sector, and in a “stressed” situation, the price of banks' saving could reach the staggering 120 billion euro. “Spain's vulnerability to market disruption remains elevated given the high funding requirements, not only for the sovereign but also for the regional governments and the banks”, the agency argued.

The news is a cold shower to Madrid who proudly announced only a few days ago that it has met its budget deficit target of 9.3% for 2010 and has even performed by a 0.1% better than projected. The government expressed confidence that it would achieve this year's deficit target of 6% of GDP too (against 11.1% budget deficit in 2009). The problem is that the data for the central budget are in a sharp contrast with those for the implementation of the regional budgets, as only 8 out of 17 local authorities in the country have managed to achieve their deficit targets.

Against this background, the assessment of Moody's for the higher cost of bank restructuring sounds even more scary, because it has been known since last year's stress tests that the problem of Spain are the regional savings banks (“cajas”). The situation of the country is compounded by the reduced estimate of the European Commission for 2011, according to which the Spanish economy will grow by only 0.8 percent. The country maintains a record high unemployment of 20% while it is trying to implement painful reforms in the labour market, the pension system and the banking sector.

The potential need of Spain to request assistance from rescue fund for the euro area is a nightmare for European politicians. Because the amount would seriously exceed that for Greece and Ireland, as well as of any possible aid for Portugal, which is expected to happen this month. That is why one of the ideas for widening the scope of activities of the rescue fund was the EFSF to be granted the right to buy sovereign debt of euro area countries, which have trouble to raise market funding.

However, just days before the eurozone Council, the German Bundestag adopted a resolution against such an action. This ties the hands of Chancellor Angela Merkel, who faces a serious domestic challenge - state elections in several provinces after the Christian Democrats faced a heavy loss in Hamburg. And as you know, if Germany is against an idea, it will be hard to realise it unless a compromise is not found, which to satisfy German lawmakers.

For the same reason a change in the Treaty on the functioning of the EU (TFEU) was needed to set up the European Stability Mechanism (ESM) to succeed the temporary rescue fund for the euro area. However, the change must be consulted with the European Parliament. And as it is easy to assume, MEPs disagree the Mechanism to be based only on an intergovernmental agreement between the Member States. They insist the ESM to be incorporated in the EU framework and the roles of EU institutions in it to be guaranteed, as the Commission will propose and monitor the implementation of the decisions and reporting back to Parliament.

Although there are negotiations under way between representatives of the Parliament and the Member States, it is unlikely the requests of the Parliament to be fulfilled. Not least because any institutionalisation of the Mechanism would need a more serious Treaty change, as it can be interpreted as an extension of Union’s powers. And this, in turn, will not allow the change to be adopted under the simplified procedure, aimed at avoiding referenda and potential problems in individual Member States. Deputies will vote on the Treaty amendment on March 24, shortly before the European Council on 24 and 25 March, when EU leaders must finally approve the ESM.

In addition to the changes in the current rescue fund, as well as the type and functions of the future one, on Friday the eurozone leaders will discuss the proposal to establish a Pact for competitiveness. The initial idea for the Pact came from France and Germany and caused quite controversial reactions. Subsequently, however, President of the European Council Herman Van Rompuy prepared a new proposal, in cooperation with the EC, which is expected to be a softer version of the Franco-German proposal.

Among the important issues on the table are those of the renegotiation of the terms of the rescue loans to Ireland and Greece. German Chancellor Angela Merkel has already hinted of a possible extension of the maturity of the Greek loan to 7 years as that of the Irish one. And the new Irish government wants to lower the interest rate on its loan, which is considered disadvantageous to the country. The newly elected Irish Prime Minister, Fine Gale's leader Enda Kenny, will also take part in the meeting on Friday evening.

These issues, however, as Ms Merkel explained earlier, can be resolved only in the context of the discussion on the changes in the current rescue fund and the design of the future one. If serious controversy emerges on this, the problems of Ireland and Greece will remain in the background, moreover, given the recent bad news about Spain, which will surely further boost market pressure on peripheral economies.

As euinside has repeatedly written, the greatest task of EU leaders is to convince markets of the stability of the euro area. Despite the multiple statements in this sense, market reactions have not responded to the expectations of relief. EU Economic and Monetary Affairs Commissioner Olli Rehn commented that the markets should react in a “more reasonable and realistic manner”. He recalled that during the first decade of the EMU, the spreads of Greece, for instance, as compared to German bonds were minimal, yet there was a growing indebtedness and reduced competitiveness. For some reason, market forces did not respond to this at all, Olli Rehn said.

The European Commission has also been angry for long at the credit rating agencies and is considering a change of rules for their work within the EU. According to the Commission, their forecasts reinforce panic of the financial markets and thus prevent countries concerned to restore confidence.