The fate of Europe's latest rescue fund will be decided this week by a high court in Germany.
At issue is an injunction that would block the German parliament from ratifying the international treaty governing the European Stability Mechanism, or ESM.
The ESM is a key component of the "breakthrough" agreement announced in June by euro area leaders, including German Chancellor Angela Merkel, that is aimed at stabilizing financial markets and strengthening the region's banking system. The German Constitutional Court is expected to rule on the issue Wednesday.
The stakes are potentially high for Spain, which is widely expected to tap the ESM in order to qualify for the European Central Bank's new bond buying program. Spain has already requested up to €100 billion in bailout loans to recapitalize its banking sector.
Italy could also come under pressure if the court rules against the ESM, since many investors see the fund as a key backstop for the nation's €1 trillion bond market.
The court was asked earlier this year to issue the injunction by a group of conservative German lawmakers who want to have more say over how Germany's contribution to the ESM is spent. The ESM is also facing legal challenges by German legal scholars, and a class action suit.
German finance minister Wolfgang Schaeuble has said he expects the court to allow the ESM treaty to be ratified. But analysts say the court could demand changes that would potentially hinder the fund's ability to respond quickly to a crisis.
"Any strings that would be attached to the operation of the ESM would be seen as a negative factor by the markets," said Timo Klein, senior economist at IHS Global Insight in Frankfurt.>
The ESM will eventually have €500 billion in capital, paid in by governments over a period of years, to provide loans for troubled members of the 17-nation currency union. It is designed to replace the European Financial Stability Facility, which has backed bailouts for Greece, Portugal and Ireland.
However, many Germans are opposed to the idea of giving more money to nations that have been criticized for lacking fiscal discipline.
The court heard similar arguments last year concerning the EFSF, which ultimately resulted in the German parliament being granted powers that had previously been held by a particular committee.
Henning Berger, a Berlin-based lawyer at international law firm White & Case, estimates that there is a 60% probability the court will refuse to grant the injunction, which would be a "green light" for the ESM.
But he also said there's a 40% chance the court will grant the injunction and attach conditions that would give the German parliament "more strict rights to decide certain financing measures by the ESM."
In addition, Berger said the court could insist that the upper limit of the ESM cannot be raised without the consent of the German representative to the fund, giving Germany "an all-time veto power" over the ESM.
"The court must weigh the consequences of what they are doing," said Berger. "But if they see there is a clear breach of constitutional law, that will not -- and should not -- prevent them from granting the injunction."
This week's ruling is on a preliminary injunction. The court will not make a final decision on the ESM's legality until later in the year, but analysts say it is highly unlikely that the court would change course.
Despite political rhetoric to the contrary, Germany has a stake in seeing the ESM ratified and preventing a messy break-up of the euro currency union, said Michelle Gibley, director of international research at Charles Schwab.
"There is incentive for the Germans to keep this intact," she said. "They don't want the euro to break apart because the cost would be very large."
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