A Yuletide rally could be railroaded if the Europeans are too hard on the banks this week in what will be the crucial test of the European Union’s rescue plan.

That said, judging from Wall Street’s positive reaction over the weekend to the right noises coming out of Europe ahead of this weekend’s EU Summit and the inevitable outlining of the rescue plan on Wednesday, it looks like we’re set for a good finish for the stock market in the run-up to Christmas.

I did say ‘good’ and avoided the word ‘great’ because the US Congress could hurt optimism with spending cut decisions.

But I’m gambling that they won’t behave as badly as they did in August, when the market nosedived on not only the antics of those in Europe, but also on the US credit rating downgrade and the impasse of the debt ceiling extension in the US Congress.

But back to the issues at hand, and the French leader, Nicolas Sarkozy, was very upbeat over the weekend.

“Work is progressing well on the banks, on the fund and the possibilities of using this fund, the hypotheses are narrowing, and a rather broad agreement is in the process of being drawn up,” Sarkozy said, as reported by Reuters.

“On the question of Greece, things are progressing. We haven’t finished yet. We have until Wednesday.”

So Wednesday is the big day where we should get a definitive plan, and it will set the scene for shares for the rest of the year. But there could be one tricky issue — the haircut for the banks.

A part of the deal will have to involve the banks that have lent to Greece and that now have debt in the vicinity of 160% of gross domestic product (GDP) this year. The European leaders need to come up with a level of debt loss for the banks, which is better than the market was expecting, but good enough to ensure that the debt rescue plan works for the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

Reuters says a debt study showed losses for lenders might have to be as high as 50-60% to make Greek debt and others sustainable into the future.

That’s a lot higher than the 20% loss the banks were talking about previously, so there’s a big debt repair gap that will have to be dealt with by the EU leaders. It’s critical that the market thinks the banks are going to be better off, or there will be a sell-off.

Another important test for the plan will be convincing the market there is enough money in the European Financial Stability Facility to stabilise the region. The starting point is €440 billion (A$589 billion), but we need to see a lot more in there to build on the rising investor confidence we have seen in the past few weeks.

On the subject of money, and with many European countries strapped for cash, there are suggestions that China could bankroll some of the rescue in return for treatment as a ‘market economy’, which would improve the country’s access to European markets. But the Europeans are divided on whether to go down that road.

As Aussie investors, this calendar year has been a shocker, but if we can see a new and credible plan emerge out of Europe this week, then shares will rise for a decent finish for the financial year.

By the middle of next year, I can see another market take-off in anticipation that 2013 will be a much better year for the US and global economy. But this all rests on a damn great plan coming out this week.

Let’s hope the Europeans can achieve an overdue personal best.

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