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Wednesday, October 26, 2011

Q & A: What could tonight’s summit agreement involve?

The hope for a “comprehensive plan” to save the eurozone, as originally touted by the eurozone leaders, looks to be a lost cause. The best outcome we can hope for today looks to be a broad political agreement, with technical details left to be sorted at a later date. Given previous experiences with technical changes (notably the second Greek bailout package and the Finnish collateral deal) it is definitely possible that the deal could be watered down, for example with investors being offered greater guarantees over their involvement in the second Greek bailout or with the bank recapitalisation actually turning out to be less stringent than expected.

How might the revised second Greek bailout look?

The IMF, Germany and most eurozone countries are pushing for a 60% face value cut, although the Institute for International Finance (IIF) – effectively representing banks - still seems someway from agreeing to that. Write down on Greece’s debt are likely to be between 50% and 60%, probably achieved through a bond swap with the new bonds having a maturity of 30 years. EFSF – the eurozone’s temporary bailout fund – is unlikely to offer collateral, although Kathimerini reports that some portion of the bonds may be swapped in cash (essentially bought out or retired, presumably using bailout funds).

Open Europe’s take:

- We still don’t have an exactly detailed plan, but if EU leaders managed to push through a 60% write down, that would be positive. However, the lack of participation and the ‘voluntary’ nature of the plan mean that the actual debt reduction may still be limited and far below what is needed in Greece.
- There is still an on-going desire amongst some eurozone countries, the ECB and the IMF to avoid a so-called “credit event”, involving the triggering of credit default swaps (CDS) – a form of insurance on government debt, which would force some investors and banks to take significant losses. Such an event may be triggered anyway given size of haircuts, but even if it were, he evidence suggests a cascading effect would not take place. It’s worth keeping in mind that not triggering CDS also has an impact, as it could ruin the finances of those who take losses, since they can’t recoup from the hedges they have in place.
- IIF will always have stronger negotiating position until the ‘voluntary’ nature of the plan is abandoned, meaning that banks can still avoid losses despite them having to be incurred sooner or later. In short: a full hard restructuring is needed and will only become more costly in the future.

Can we expect details on the leveraging of the EFSF?

In a word…No. There will be some details, with the plans focusing around two options which can be implemented separately or together:
1) Using the remaining EFSF funds to insure new issues of sovereign debt, likely to be 20% for countries such as Italy and Spain. The insurance is expected to be tradable, not permanently tied to bond it is issued with, and may take form of a certificate with a claim to EFSF bonds or cash repayment.
2) Creating a Special Purpose Investment Vehicle (SPIV) to attract foreign investors (public and private). The SPIV will purchase sovereign debt of struggling eurozone countries, and is likely to take the form of an account with IMF, to which IMF will contribute (amount tbc). Other countries (BRICS and their sovereign wealth funds in particular) and private investors could also invest in this fund. They may chose to create numerous SPIVs, for country specific purchases, and would likely need some EFSF guarantees to get it going, but could then issue its own debt instruments or get capital contributions.
Open Europe’s take:

- This proposal is still massively vague on technical details and how much leverage is achievable. However, no matter what the details look like, the insurance plan is fundamentally flawed, given that guarantees may not be viable when they are most needed and 20% wouldn’t be enough to calm markets any way (see here for a full breakdown of our thoughts). As we’ve noted before, a complicated and tradable form of default insurance is precisely what EU politicians have spent years to try to regulate against. So their ‘solution’ is riddled with irony given many eurozone leaders aversion to CDS. Furthermore, since the current plan suggests offering EFSF bonds as insurance rather than a cash pay-out, it may be close to worthless since it would only be needed in a situation where a default of Italy or Spain is a real risk. So, in such a worst case scenario, the EFSF insurance scheme becomes almost redundant.
- The SPIV plans also hinge on who is willing to invest. Given the massively correlated nature of the risky assets which these funds will be buying, we’d imagine that investors may ultimately get cold feet. To get up and running the SPIV may require significant guarantees from EFSF (such as a pledge to take the first loss, similar to the insurance plan) which would be self-defeating, since the EFSF could not afford this.
- Again, there’s massive irony here, as Europe is now falling back on massively complex ‘Anglo-Saxon’ financial instruments to help save the eurozone. Putting these at the heart of an already complex, diverse and flawed monetary union is far from desirable.

What structure could the bank recapitalisation take?

- Probably marking to market on debt as of 30 September 2011, with target capital tier one ratio of 9% (not clear on which set of Basel rules this measure will be based). Expected to total €108bn, and needs to be done by 30 June 2012
- Banks must first attempt to raise capital from private sources (including debt-to-equity swaps). Drafts suggest that until this is done there will be restrictions on the dividends and bonuses which banks can pay. If the capital cannot be raised on the private markets then governments will have to step in with an effective bank bailout, and failing that, the buck will be passed to the EFSF. We expect that funds from governments and the EFSF will have even greater conditionality, and will probably require some restructuring of the bank.
- Some guarantees of bank liabilities (or bank bonds) may also be required to allow banks access to funding and to stop them shrinking their balance sheets (meaning that they could stop lending money to, say, small businesses).

Open Europe’s take:

- Bank recapitalisation is definitely necessary, although the marking to market on all sovereign debt does set a dangerously pro-cyclical precedent. Again more technical details to come, but definition of 9% threshold is key - if watered down, this could undermine the whole process.
- Applying restrictions to banks raising money on the private market is also not necessarily desirable. This could cause huge fluctuations in share prices and lead to market distortions. Obviously, it is important to make sure banks recapitalise during the given time frame, however, setting these conditions could do more harm than good. Strong conditionality needs to be imposed on banks when the governments or the EFSF lend them money.
- Offering guarantees can also be dangerous, as was demonstrated in Ireland. Some guaranteeing of bank bonds to maintain access to funding may be necessary, but offering broader guarantees could begin to weigh on the debt and deficit of states.

What role will the ECB play in all of this?

Germany has won out the argument over whether the ECB should step in and fully back stop Italy and Spain, despite protestations from France. So the ECB is likely to play a limited role for now – though that could change should there be no solution to the crisis this week. Recently, France was still pushing to include a phrase which encouraged the ECB to continue its bond buying even after the EFSF was leveraged, however this looks to have been dropped from the draft summit conclusions.

Meanwhile, Martin Wolf’s article in the FT today called for the ECB to step in and backstop the eurozone.

Open Europe’s take:

- It’s definitely desirable to keep the ECB role at a minimum, given already big questions over its independence, credibility, and the risks on its opaque balance sheet. The ECB currently has an exposure of €590bn to the PIIGS, up from €444bn only 4 months ago.
- In his article, Wolf makes some valid and interesting points, but, uncharacteristically, glosses over the fact that the problems with the ECB’s monetary policy helped to fuel the crisis (by cycling cheap credit to the peripheral economies, which fuelled asset bubbles and sovereign spending). Looking at the averages of the eurozone is massively misleading and says very little. On average the picture for the eurozone doesn’t look too bad but it masks the huge divergences and imbalances which are nearly impossible to overcome.
- Having the ECB step in now and expand its balance sheet with no clear exit strategy or conditionality would have unknown effects and would be undesirable in the long run.
- The ECB cannot act as full lender of last resort in the eurozone without engaging in fiscal policy. This is a structural flaw in the eurozone, which cannot be overcome by some panic solution.
- The ECB will ask for a say in exchange for providing the funds – having policy dictated by an independent, unelected central bank is not desirable or sustainable. To expect the ECB to just put up the funds without a say would make it a political pawn and would cease to be effective at any of its goals.
- In any case, forcing it through would risk German support for the eurozone. There’s no point sacrificing the long-term viability of the eurozone, in return for short-term stability.
- See here and here for a full discussion of the ECB issue.

Facts on Italian and Spanish funding:

- Even if the rumoured leverage of €1.25trn - €1.4trn could be achieved, it will not be enough to fully backstop Italy and Spain. Italian funding needs over the next three years total between €825bn and €907bn, depending on budget policies. Spanish funding needs could reach between €500bn and €602bn. Add into this the cost of bank recapitalisation and the needs of other countries and it becomes clear the fund can never really be large enough to act as the full backstop which markets want.

- The main point in the short term is that it significantly undermines the planned budget cuts of around €100bn, even if this target is achieved which seems very unlikely. If yields reach these levels or increase, then Italy will miss its deficit targets for the next few years. This will increase market fears and impatience of Eurozone leaders and ECB.
- All of this adds significantly to longer term debt, plays on debt dynamics, as average interest rate paid increases and makes it harder to keep balanced budget.


Peripatetic Scribe said...

A splendid evaluation. From it I assume that what has been agreed is a 2-year band-aid. Interesting that there has been nothing said about how to minimise the underlying problems, but then perhaps those involved have little or no interest in what happens 2 years hence. I perceive the EZ will be back to its current state of chaos in 2 years.

Open Europe blog team said...

Thanks for the comment Peripatetic Scribe.

Indeed, it does look to be a temporary solution at best as you point out, although given the questions over the second Greek bailout it may not even last two years! There was of course the usual talk about structural reform and improving competitiveness although very few details or policies on how this can and will be achieved. We’d agree that this plan continues the muddle through process and there are plenty of issues which will raise the spectre of crisis once again in the near future. We’d add, even if they had found a more effective short term solution, the long term flaws in the eurozone which you hint at would still be there, as of yet there seems no clear way (at least that can be balanced economically and politically) to overcome these.

Peripatetic Scribe said...

Thank you to the team. When I review your analysis with the comments from Sir John Major, the more I am inclined to think that a clear, agreed. viable strategy in line with Sir John's thinking is the appropriate way ahead.