The most
important aspect is that Eurozone leaders finally recognized that the current
trajectory of Greece’s public debt is unsustainable, and that wave upon wave of
harsh austerity measures will not change it (in fact it can only worsen it). Bondholders (mainly banks) will thus write
down 50% on their current holdings of Greek debt. This should bring the Greek debt-to-GDP ratio
down to 120%, down from roughly 160% - still high, but more manageable. Greece will also have access to €130bn in
bail-out funds to help keep government operations afloat (and, yes, to make
interest payments on the remaining 50% of its bonds). While the 50% haircut has been called
‘voluntary’, it could still trigger payouts on insurance contracts against
default (credit-default swaps or CDSs), if the International Swaps and
Derivatives Association deems a “credit event” to have taken place. The complex web of CDS payments triggered by
the Lehman Brothers collapse was part of the reason for the financial chaos in
2008. So far ISDA says the deal unlikely
to trigger CDS payments. But this will
also lead to many questioning the usefulness of CDSs in the first place; if
they can’t protect you from a 50% sovereign haircut, when can they cover your
losses? This could lead to longer term
instability in that market.
The Bad
At €440bn, the
current bail-out fund (European Financial Stability Fund) is too small to
support Italy and Spain should these countries come under speculative attack
(or if the market simply loses faith in their solvency). Italy’s public debt pile alone is close to
€1.9 trillion. The EFSF relies on the
AAA-rating of the countries behind it. But
these countries will not (in the case of Germany) or cannot (France’s AAA
rating is already at risk) increase their contribution. Germany has also blocked moves to allow the European
Central Bank (ECB) to stand behind the EFSF (the ECB of course has unlimited
firepower, since it can print money). Thus,
to increase the firepower of the EFSF leverage is required. One option is for the EFSF to guarantee only
the first 20% loss of any new government bond, effectively stretching the
€440bn fivefold. But what happens if the
losses exceed 20% (as in the case of Greece)?
Alternatively, special purpose
vehicles (SPVs) could be set up, where the EFSF guarantees the first ‘tranche’
while other investors (sovereign wealth funds or the Chinese for instance) buy
the other tranches. If this sounds a lot
like the financial engineering that caused so many problems in 2008, that’s
because it is. Leverage can work in both
ways - it can also concentrate risk and spread problems from the PIIGS back to
the countries backing the EFSF (especially France). And will other investors want to buy into
these tranches?
The Ugly
The
€106bn recapitalisation of Europe’s banks will help them absorb the losses on
Greek (and potentially other) write-downs. The deal requires European banks to raise core
capital reserves to 9% by June 2012. However,
while recapitalization should make banks safer, it will also lead to a
reduction in lending, potentially starving Europe’s struggling economy of
credit.
The Unknown
Finally, the
plan does nothing to address the fundamental imbalances within the Eurozone,
and the uncompetitiveness of the peripheral countries. Germany will continue to run trade surpluses
with the likes of Greece, effectively stealing demand from them. Greece,
Portugal and to a lesser extent, Ireland, remain trapped in a currency that is
too strong for them, meaning that the only way to regain competitiveness is via
a painful ‘internal deflation’, i.e. pushing down prices and wages. All the while, receiving no assistance from
the central bank (unlike the US or UK, where the central bank has done all it
can to ease the pain.) Italy and Spain,
the third and fourth largest eurozone economies, are not bankrupt (despite
their high debt loads) as long as the interest rates on their debt remain low. If the market frets about default, it will
push yields up and potentially force the very event it fears. While the EFSF has been increased (through
leverage) to prevent this eventuality, no one wants to see the EFSF tested. Finally, while the pieces of the puzzle are
starting to fall into place in terms of a long-term solution to Europe’s woes,
one cannot help but be a bit skeptical. This
was the third ‘comprehensive plan’ so far this year, following the 14th summit
in 21 months. Following the 21 July
summit, it took European parliaments three months to approve changes to the
EFSF, because they all went on holiday! In
this market environment, a day is a year and three months a lifetime. European leaders need to provide detail on
this plan and soon.
With acknowledgement to Fairbairn Capital
