European leaders finally thrashed out a comprehensive response to their sovereign debt and banking crisis which culminated in a detailed communiqué released this morning in Brussels. This is a summary of the key features of this document together with our assessment of its effectiveness:
• After enormous pressure from both the German Chancellor and the French President, Italy has ‘committed’ to both fiscal consolidation and meaningful structural reform. On the former, the aim is to achieve a balanced budget by 2013 and to introduce a balanced budget rule by the middle of next year. On structural reform, Berlusconi has apparently promised to introduce legislation to increase the retirement age to 67 from 65 by 2026 (far too slow), abolish minimum tariffs for professional services (a major impediment to competitiveness) and review dismissal rules (also a big problem). On paper, this all sounds encouraging, but implementation is critical; given Berlusconi’s track record for slipping on commitments, and his tenuous grip on power, even these relatively minor commitments may fracture his coalition and trigger a fresh bout of political instability for the country.
• The statement makes it abundantly clear that Greece remains in intensive care and is effectively under full-time observation by the doctors from the troika. In particular, a full-time on-the-ground monitoring team will be stationed in Athens “to advise and offer assistance” and “ensure the timely and full implementation of the reforms”. A great and necessary initiative, but once Greek citizens get wind of this they will almost certainly respond with hostility.
• On the question of Greek-debt haircuts, after lengthy consultation private bondholders have apparently agreed to a “voluntary” bond exchange equivalent to 50%, which supposedly will secure a reduction in government debt/GDP of 120% by 2020. The specifics are yet to be hammered out, but the IIF (the key negotiator for private bond-holders) expects take-up to be high. In addition, the member states of the eurozone have pledged to stump up an additional EUR 30bn to help sweeten the deal. In our view, private bond-holders have again done well – a 50% reduction in net present value equates to around a 30% reduction in face value. Most Greek bonds out past two years are trading at a price of around 35. Private bond-holders should sign-up straight away. That said, this is unlikely to be the last word – there is every chance given the diabolical state of Greek government finances that Europe will again require bond-holders to contribute more over time.
• On the EFSF, as expected, the summit endorsed two complementary approaches: first, where the facility provides credit enhancement for new bond issues by member states, and second where funding comes into the EFSF from “rich donors” (private and public institutions and investors), probably into some form of SPV. According to the French President, the uncommitted portion of the EFSF (around EUR 250bn) could be leveraged four or five times (that is, the EFSF will offer insurance of either 20% or 25%). This supposedly boosts the firepower of the EFSF to over EUR 1trln, not including any funds that come in through the rich donors’ option. From our perspective, there was no surprise in these announcements. That said European leaders are taking a big risk with this insurance proposal. Also, implementation will be interesting. Who will decide whether the insurance option is available for a particular sovereign issue? Will it be optional? Will there be a two-tier bond market for an individual sovereign, those bonds with the guarantee and those without? Will troubled sovereigns be successful in issuing bonds without the guarantee? If not, then the EFSF’s firepower could run out rather quickly. With respect to the EFSF, there are a whole range of unanswered - and unanswerable - questions at this point. It might work, but there is a reasonable prospect that it will not.
• On banking recapitalisation, the summit endorsed the proposal that the capital ratio for eurozone banks should be raised to 9% by the middle of next year. The EBA earlier this week claimed that 70 of Europe’s major banks would need collectively to raise EUR 106bn of fresh capital in order to comply. Importantly, national governments have been asked to supply guarantees to assist with the funding requirements of banks which are struggling, a critical step to ensure that deleveraging is not the chosen path to achieving the 9% capital adequacy target. That said, the latter does add further to the contingent liabilities being taken on by many eurozone sovereigns at a time when they can ill afford to do so. A further critical question is just how this capital will be raised – the private sector will probably be quite reluctant to recapitalise banks in the likes of Greece, Portugal and Spain.
All things considered, it is probably the best that could be hoped for given the clunky governance structure of Europe and the hopelessly-constrained predicament many of these sovereigns now find themselves in. It will buy some time, perhaps a few months. Unfortunately however, the EU will probably have to revisit all of the major elements of this package next year, because by then it will have been proved to be inadequate.