As per usual there are lots of topics to be discussed but we don’t expect too many concrete decisions. We’d expect a final draft of the euro fiscal pact to be completed, some progress on ESM - the eurozone's permanent bailout fund - and a commitment to "growth and jobs" (as opposed to recession and unemployment..?). Huge questions over Greece and size of bailout funds will probably remain. Below we outline the key issues to watch out for (take 2):

In a blog post for the Telegraph, we argue,

In his speech in Davos yesterday, David Cameron outlined some very sensible proposals for how to deal with Europe's economic crisis. But, almost in passing, he also called for a eurozone “central bank that can comprehensively stand behind the currency and financial system”, implicitly suggesting that the ECB must be ready to provide more cash to struggling banks and governments around Europe. Unfortunately this statement completely misses the intricacies which the ECB and the eurozone face in the coming months.

The ECB’s balance sheet now stands at a pretty scary €2.7 trillion, higher than that of the money-printing Federal Reserve in the US. By buying government bonds and providing cheap cash to banks around the eurozone, the ECB is now leveraged 33 times – up from 24 times only last summer. This means that for every €1 the ECB holds in reserves and cash, it has €33 swirling around somewhere in the eurosystem.

But it isn’t the size of its balance sheet that keeps ECB officials awake at night – all central banks are leveraged – as much as the circa €60bn of (nominal) Greek bonds festering on its books. This (relatively) tiny item has become political dynamite, as Greece is set to default on its debt in March, either through a voluntary agreement with its creditors or by simply running out of money. As creditors and the Greek government are locked in to talks over which one it’ll be, big question is: will the ECB be forced to take a hit?

The question is crucial as the ECB has said in the past that it will not take losses on its eurozone exposure – ever. For the Germans, losses for the ECB would mark a huge betrayal of the Bundesbank-model, in which a central bank is trusted and prudent, and doesn't take on excessive risks – and therefore has the credibility to control inflation. Many German commentators have spent the past year grumbling about the ECB’s back-handed Quantitative Easing and illegal financing of state deficits. The ECB has got around this by purchasing the bonds on the secondary market, but if it took losses on Greek debt, this argument falls.

But at the same time, if “public” bodies, including the ECB, holding Greek debt don’t accept losses in a Greek default, the write-down may not be large enough to give the country even a hypothetical chance of bouncing back, meaning the EU/IMF cannot give it more loans. For the ECB, this amounts to a pretty awful catch-22: accept losses and see your credibility and rationale undermined or reject losses and at worst prompt a disorderly Greek default or possibly just massive distortions in eurozone bond markets.

So what’s the best solution? We’ve long argued for a full restructuring of Greece’s debt (now 60-70%) and reassessment of Greece’s position in the euro. But that looks unlikely right now. Instead, the ECB could be offered an escape route. It purchased its bonds at around a 30% discount. It could accept a 30% write down without taking any losses and would give Greece some additional debt relief. Another option would be for ECB-held bonds to be bought by the euro bailout fund, the EFSF (at cost price), and then submitted by the EFSF to the voluntary restructuring. The EFSF could absorb the losses, though it too may have to deal with some very uncomfortable questions from taxpayers who will have lost money. But arguably it’s better than sacrificing the credibility of the ECB.

Both options would still be a tacit admission of failure by the ECB, since it always claimed it would hold the government bonds it bought to maturity, but it may have little choice.

All of this should concern the British. Not only because the eurozone crisis is linked to the fate of the UK's economy. But also, as Anglo-Saxon commentators are coming out in droves – alongside the UK government itself – in calling for the ECB to load up on yet more eurozone government debt if need be, it should be a reminder: in the eurozone as in the UK there’s still no such thing as a free lunch.

In the end, someone has to pay – and if you want to keep the Germans fully on board, it best not be the ECB.

- First, Iran must not blockade the Strait of Hormuz, through which Europe accesses Saudi oil. This seems unlikely since doing so would likely cause a full scale military conflict as the US has vowed to defend EU cargoes.
- Second, Iran must not throw a spanner in the works by cutting off oil supply immediately (something which Europe could not cope with as the delayed start of the embargo shows).

“Limiting EU regional spending to poorer countries would be a win-win situation for both Britain and Europe. It would channel more cash to the newest member states and allow the UK to spend exactly the same amount on its regions as it does now, with the option of adding the several billion that it would save from streamlining the structural funds. It would also eliminate a range of additional costs and allow the Government to radically improve the targeting of funds towards poorer areas and to viable projects.”

“There are pretty obvious things that haven’t been achieved on the structural side and in terms of public finances. This is probably one of the worst programmes we’ve ever seen. There has to be a radical improvements in the implementation before there can be a discussion about additional programmes.”

• At the request of Germany, the preamble of the agreement makes now clear that, as of 1 March 2013, struggling eurozone countries will be allowed to apply for a bailout under the eurozone's permanent bailout fund, the ESM, only if they have ratified the 'fiscal pact'. The previous version only required that countries incorporate the balanced budget rule.
  

The new draft gives the European Commission a greater role, compared with the previous version. In fact,

• The Commission will set out "common principles" on the establishment of the national corrective mechanisms which, under the agreement, should be triggered automatically every time governments fail to comply with their deficit targets;

• Furthermore, the Commission is now allowed to issue a report on whether governments have correctly transposed the balanced budget rule into national law on its own initiative (under the previous draft, it needed to be "invited" to do so by a member state);
  

• More importantly, if the Commission's report concludes that a country has failed to transpose the balanced budget rule properly, "the matter will be brought to the ECJ by one or more of the Contracting Parties." In other words, a government can only be taken to the ECJ by its peers, at least formally. However, what the Commission says in its report plays a key role in the process.

In regards to the ECJ, its jurisdiction remains limited to Article 3(2), i.e. how national governments implement the balanced budget rule. But some very relevant changes have been made in Article 8, in particular:

• If a member state fails to comply with the first ECJ ruling (see above), it can be taken to the ECJ again. If the ECJ confirms that the government concerned has actually ignored its previous ruling, it can now impose a fine (no more than 0.1% of the country's GDP);

• Interestingly, under the latest draft, the fines "shall be payable" to the eurozone's permanent rescue fund, the ESM;

• In addition, a new paragraph has been added, which makes clear that Article 8 "constitutes a special agreement between the Contracting Parties within the meaning of Article 273 of the Treaty on the Functioning of the European Union".

What does that mean in practice?

This new paragraph really reads like an insurance against any possible objections from the UK regarding the use of the ECJ outside the EU Treaties. For those who, unlike us, do not remember the Lisbon Treaty by heart, this is what Article 273 says,

"The Court of Justice shall have jurisdiction in any dispute between Member States which relates to the subject matter of the Treaties if the dispute is submitted to it under a special agreement between the parties."

Therefore, this small paragraph makes the use of the ECJ (albeit still limited to a legislative rather than enforcement role) 100% legal under the EU Treaties.

One last thing is worth noting. Following suggestions from the Polish government that Poland might decide to stay out of the agreement in the end, unless non-euro countries are allowed to be present at future meetings of euro leaders, the latest draft establishes that:

• Non-euro countries that decide to sign up to the agreement must be kept "closely informed of the preparation and outcome" of eurozone summits;

• The leaders of non-euro countries must be invited to eurozone summits at least once a year. However, the invites would be restricted to non-euro countries that not only signed and ratified the agreement, but also "declared their intention to be bound by some of its provisions."
  

Sounds like a tricky trade-off: the Poles are unlikely to take too kindly to having to institute the eurozone fiscal rules before they've joined the euro...

One week after we published the third draft of the new European 'fiscal treaty' setting out tougher deficit and debt rules for eurozone countries, and with a fourth draft imminent, a quick update on where negotiations are at the moment.

The big news today comes from Prague. We reported last week that Czech Deputy Prime Minister Karel Schwarzenberg had threatened to pull his party out of the ruling coalition if the government decided to stay out of the 'fiscal treaty', but Czech President Vaclav Klaus had insisted that he would not sign the agreement "under any circumstances."

Well, the Czech government has now decided to put the issue to a referendum after several rounds of "very bloody negotiations", in the words of Radek John, the leader of Public Affairs - the smallest party of the coalition (pictured). The Czech Republic is not part of the euro, meaning that eurozone countries could still go ahead with the adoption of the fiscal treaty, without having to wait for the outcome of the referendum (non-euro countries can join at a later stage).

However, the announcement is extremely relevant for at least two reasons. First, there's now a concrete possibility of the Czechs staying out of the 'fiscal treaty', which would be the coup de grâce for the 26-versus-1 scenario depicted by a large portion of UK and European media in the wake of Cameron's veto at last month's EU summit (we had a go at showing why these reports were rushed, to say the least, see here and here).

Second, the news of a Czech referendum may trigger public and political pressure for a referendum in Ireland. This would not necessarily destroy the treaty because if a referendum were held on Irish ratification of the treaty, rather than simply the government's agreement to it, the treaty could still enter into force in theory. The last draft required 12 ratifications among euro states to enter into force but, certainly, it would throw a major spanner in the works and thoroughly undermine the credibility of the treaty if Ireland (the recipient of a bailout package) were not fully signed up at an early stage.

But there could be another problem, and a quite surprising one. In fact, it looks like the Polish government is not happy with the latest draft, which (as the previous two) would exclude non-euro countries from attending meetings of eurozone leaders - a strong incentive for many of the non-euro countries to sign the treaty.

And sure enough, the Polish government is now suggesting that it might not join the 'fiscal treaty' unless its request is taken on board - Germany is thought to be rather keen on having the Poles signed up. This is what Polish Prime Minister Donald Tusk told the press yesterday,

"Our efforts aim at a fiscal agreement the shape of which does not make the division of Europe into two clubs - the eurozone and countries outside the club - more lasting than is safe in our opinion."

Meanwhile, a fourth draft of the agreement is being finalised, and should be made available ahead of the next meeting of finance ministers on 23-24 January. The way ahead still looks quite rocky...