The bazooka we won’t get



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Tobias S. Blattner, Economic Research
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX

+44 (0)20 7597 8318

 

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14 October 2011

In just over a week it is summit time – again. On 23 October, euro area Heads of Governments are set to meet for the third time this year. At both of the previous summits markets have expected a big bang solution to the crisis, only to end up disappointed.

Notwithstanding the previous disappointments, expectations are high once again, not least since German Chancellor Merkel and French President Sarkozy, meeting last weekend, promised to provide a “comprehensive” solution to the debt crisis by the end of the month. Markets are therefore expecting a grand plan that will stop contagion and boost investor confidence in the common currency, including a lancing of the Greek boil, a recapitalisation of Europe’s banks and a significant leveraging of the EFSF’s firepower sufficient to shield Italy and Spain from the spreading debt crisis.

So, will they be able to deliver this time? In a word, no.

On Greece – in many ways a tragic side-show these days – the consensus, with the seeming exception of euro area leaders, is that its debt burden is not sustainable. A haircut of at least 60% (and probably more) of all outstanding debt (excluding the IMF but including those bonds hold by the ECB and the loans provided so far by other euro area governments) is required to put Greece on a sustainable fiscal position in the medium term.

But instead of accepting the reality of Greece’s predicament, governments look set to propose on 23 October summit an augmented version of the second bailout package agreed in July. With the Troika (EU/ECB/IMF) earlier this week admitting that Greece is off-track, mainly due to a deeper than expected recession and (predictable) slippages in the privatisation process, the €109bn agreed in July will need to be augmented to ensure continued Greek financing until end-2014, assuming that private bondholders cannot be convinced to increase their contribution over and above the voluntary 21% net present value loss agreed in July. 

Banks will also show resistance to another plan expected to be announced on 23 October. After Dexia in the past week became the first banking victim of the current crisis, forcing the governments of Belgium, France and Luxembourg to split the multinational banking group, a recapitalisation of the major European banks has been proclaimed by Merkel and Sarkozy to be a core element of the “comprehensive solution”.

The truth, however, is that the crisis in the euro area banking system is merely a symptom of the fundamental lack of confidence in some euro area governments to be able to meet their debt obligations. As such, much like Greece, bank recapitalisations are a side-show. Forcing banks now to increase their capital bases – no matter what their exposure to peripheral debt – will not solve the current crisis.

By contrast, it might even aggravate the situation as banks could choose to increase their capital ratios by reducing lending to the real economy rather than raising costly equity at current distressed prices (assuming that private capital is even available). If, as a result, lending was constrained further, growth in the euro area would slow even more sharply than we already anticipate (we expect mediocre growth of just 0.6%Y/Y in 2012). And if banks had to turn to governments for capital, the corresponding increase in debt-to-GDP ratios would add further pressure on already shaky fiscal positions.

In any case, major euro area banks could sustain a Greek haircut of even 50% without needing to raise additional capital. But no reasonable amount of capital could avert a financial meltdown if markets were to push Italy to default. Markets therefore need to be convinced that an Italian default is not an option at all. It is on this issue that euro area leaders must deliver. They must create an effective firebreak that reverses the contagion. If they don’t, the crisis will stay with us for months (or years) to come. That means giving the EFSF the firepower to save Italy (and Spain) come what may.

Unfortunately, the two most straightforward and effective ways to leverage the EFSF look to be already off the table before the show even begins. The EFSF will not be granted a banking license, allowing it to use the ECB to boost its firepower. And nor will the ECB agree to continue to purchase government bonds even with an EFSF indemnity of possible losses. Instead, policymakers seem to be moving towards a plan that would use the EFSF to provide partial guarantees for some euro area government bonds.

So, rather than issuing bonds and using the funds to purchase bonds of fiscally-troubled member states, the EFSF would instead become a bond insurer. The portion of potential losses to be covered by the EFSF would depend on the member state, with recent discussions suggesting it would take the first 40% of losses of Greece, Portugal and Ireland and the first 25% of losses of Italian and Spanish bonds. This, theoretically, would increase the amount of government debt the EFSF could provide some form of comfort on from €440bn to something approaching €3trn.

But this insurance scheme is flawed and is unlikely to pass the test of market scrutiny. First, there is a dangerous degree of randomness embedded in such a scheme. The decision to guarantee the losses of some government bonds and not of others risks generating a two-tier European bond market. Markets would begin to wonder whether an Italian bond with a 20% loss insurance is a better investment than an unsecured French or Belgian bond. Will Belgian (and potentially French) bonds also therefore need protection, watering down further the EFSF’s resources? And which criteria determine the haircut protection on offer?

More fundamentally, however, the plan assumes that the full €780bn of EFSF guarantees can be used. But even ignoring the €130bn of resources already committed to Greece, Portugal and Ireland (which is the equivalent to €230bn in guarantees) and the potential calls on the EFSF for bank recapitalisations, around a third of this (€235bn) are guarantees from Italy and Spain themselves.

Frankly, what use is a guarantee that is partially guaranteed by the country that already (supposedly) guarantees the bond in the first place, particularly in view that the EFSF has no paid-in capital? So, with only around €320bn in guarantees left, the money would be just enough to cover 10% of potential losses of Italian bonds, 15% of Spanish, and 20% of Portuguese and Irish bonds (we see little point in providing a guarantee on Greek bonds at the current juncture).

Will a 10% guarantee on Italian bonds do the trick? It might. But we are sceptical. Markets will have the final word.

 

Tobias S. Blattner
Euro area Economist

 

 

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