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Strategic Insights_Carry on Brussels

Strategic Insights_Carry on Brussels

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Published by: david_llewellyn9804 on Oct 27, 2011
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 AU & NZ Insights. Global Strategy.
Strategic Insights with theInstitutionalBank.
Russell Jones
Carry on Brussels!
The response to the European sovereign risk crisis continues to be characterised by incrementalism,partial solutions and a painfully unwieldy and inef 
cient decision making process within which thefrequently exhausted central actors often seem blithely unaware of their ability to generate
nancialmarket volatility. If it wasn’t so potentially damaging to the investment community’s bottom line and theworld economy, it would be funny. I may be showing my age here, but after what I think is 14 summits in21 months the whole process smacks of a series of Carry On
lms – the same jaded set of characters,similar scripts, and similar chaotic and, on occasion, farcical outcomes.After an exhausting round of negotiations, the latest European Leaders’ Summit in Brussels has come upwith the following plan.There will be “voluntary” restructuring of Greek government debt equivalent to a haircut of 50%, whichit is estimated will reduce Greece’s general government debt ratio to 120% of GDP. This compares toan advanced country average of 102.9%. This is a signi
cantly larger haircut than the 21% negotiatedin July. But it is less than the 70-80% required to render the Greek public
nances truly sustainableand which is currently discounted by the CDS market. The ECB will not participate in the restructuring.The European banking sector will require an estimated EUR106.4bn of additional capital to hit a tier 1capital ratio of 9% by June 2012. Private sources of capital are to be employed
rst. Then if necessary, national government and EFSF support will be provided. The danger is that therecapitalisation
gure proves inadequate. In the interim, European banks are likely to cut back onlending to small and medium sized companies and households and generally sell off non-core assets,which could temporarily bolster the Euro.The EFSF will be leveraged four or 
ve times to boost its aggregate
repower to some USD1.4trn or around EUR1.0trn. It will provide back-up guarantees (credit enhancement) for new peripheralsovereign issuance by posting its own bonds as collateral. Special Purpose Vehicles will also becreated to help individual economies drawing on a combination of supplementary public and privatefunding. These SPVs will be able to extend loans, be used for bank recapitalisation and buy bonds inboth primary and secondary markets. These options will be applied
exibly on a case by case basis.It would appear that China will be involved as a cornerstone investor in the SPV process, but thedetails are as yet unclear. Clearly, further negotiations on this issue are set to take place in the daysahead. This is a potential positive, in that it could spur other non-European sovereigns and largeinternational money managers to buy into the process. But it should also be remembered that China’ssovereign wealth funds already invest in a broad array of Triple A rated assets and it would only belogical for them to purchase more EFSF assets if they were highly rated.The IMF has also indicated it will be a “partner” in the enhancement of the EFSF, suggesting that it willalso provide additional funding.In the meantime, the ECB has remained unwilling to involve itself in the
nancing of the EFSF, isobviously a reluctant buyer of government debt under its Securities Market Programme, and hassingularly failed to embrace formal quantitative easing. We would see a failure to deliver at least a 25bprate cut at next week’s Governing Council meeting as a singularly unsympathetic act.What is more, the overall response to the crisis continues to lack any real plan to regenerate economicgrowth, and as long as growth is largely absent, there is little prospect that the peripheral economies willbe able to deliver on their 
scal austerity programmes.
Thursday, 27 October 2011
 Strategic Insights
Strategic Insights continued
Finally, even if policymakers have managed to cobble together a series of measures that temporarilypatch the single currency up and calm market sentiment, there is no sense yet of a rapid movement tocreate a truly optimal currency zone rather than a half baked and fragile hybrid. As we have stressed onany number of occasions, more than anything, this means the creation of a single central co-ordinatingbody for European
scal policy and symmetrical efforts to address cost disparities across the currencyunion’s members.The suggestion is that the European crisis will continue to rumble on and go through further excruciatingiterations before it can be consigned to the history books. The focus now turns to the ECB meeting onthe 3rd, the G-20 meeting on 3-4th November and the Eurozone Finance Ministers’ meeting on 7-8thNovember. In the meantime, we shall be watching the reaction of Spanish, Italian and Frenchgovernment bond yields and their spreads relative to Bunds, as these will give us some idea of Europeaninvestor buy in. Any tendency for these spreads to widen out would be a powerful indictment of themeasures taken to date and of great concern.

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