Strategic Insights with the Institutional Bank.

Thursday, 27 October 2011 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 inefficient decision making process within which the frequently exhausted central actors often seem blithely unaware of their ability to generate financial market volatility. If it wasn’t so potentially damaging to the investment community’s bottom line and the world economy, it would be funny. I may be showing my age here, but after what I think is 14 summits in 21 months the whole process smacks of a series of Carry On films – 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 up with the following plan. • There will be “voluntary” restructuring of Greek government debt equivalent to a haircut of 50%, which it is estimated will reduce Greece’s general government debt ratio to 120% of GDP. This compares to an advanced country average of 102.9%. This is a significantly larger haircut than the 21% negotiated in July. But it is less than the 70-80% required to render the Greek public finances truly sustainable and 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 1 capital ratio of 9% by June 2012. Private sources of capital are to be employed first. Then if necessary, national government and EFSF support will be provided. The danger is that the recapitalisation figure proves inadequate. In the interim, European banks are likely to cut back on lending 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 five times to boost its aggregate firepower to some USD1.4trn or around EUR1.0trn. It will provide back-up guarantees (credit enhancement) for new peripheral sovereign issuance by posting its own bonds as collateral. Special Purpose Vehicles will also be created to help individual economies drawing on a combination of supplementary public and private funding. These SPVs will be able to extend loans, be used for bank recapitalisation and buy bonds in both primary and secondary markets. These options will be applied flexibly on a case by case basis. • It would appear that China will be involved as a cornerstone investor in the SPV process, but the details are as yet unclear. Clearly, further negotiations on this issue are set to take place in the days ahead. This is a potential positive, in that it could spur other non-European sovereigns and large international money managers to buy into the process. But it should also be remembered that China’s sovereign wealth funds already invest in a broad array of Triple A rated assets and it would only be logical 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 will also provide additional funding. In the meantime, the ECB has remained unwilling to involve itself in the financing of the EFSF, is obviously a reluctant buyer of government debt under its Securities Market Programme, and has singularly failed to embrace formal quantitative easing. We would see a failure to deliver at least a 25bp rate 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 economic growth, and as long as growth is largely absent, there is little prospect that the peripheral economies will be able to deliver on their fiscal austerity programmes.

AU & NZ Insights. Global Strategy.

Strategic Insights continued
Finally, even if policymakers have managed to cobble together a series of measures that temporarily patch the single currency up and calm market sentiment, there is no sense yet of a rapid movement to create a truly optimal currency zone rather than a half baked and fragile hybrid. As we have stressed on any number of occasions, more than anything, this means the creation of a single central co-ordinating body for European fiscal policy and symmetrical efforts to address cost disparities across the currency union’s members. The suggestion is that the European crisis will continue to rumble on and go through further excruciating iterations before it can be consigned to the history books. The focus now turns to the ECB meeting on the 3rd, the G-20 meeting on 3-4th November and the Eurozone Finance Ministers’ meeting on 7-8th November. In the meantime, we shall be watching the reaction of Spanish, Italian and French government bond yields and their spreads relative to Bunds, as these will give us some idea of European investor buy in. Any tendency for these spreads to widen out would be a powerful indictment of the measures taken to date and of great concern.

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