FYI | Oct 28 2011
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
The markets’ positive reaction to the conclusion of the EU summit and announcement of the broad measures Europe will take to create a financial back stop to stem the sovereign debt crisis may be nothing more than a relief rally. Whether or not stocks and the euro can sustain gains to year end depends on a whether investors (and the international community) believe that the Eurozone has done enough to stabilise the financial system and if the groundwork has been laid to deal with the longer-term structural issues that plague parts of the region.
Stabilisation in the near-term:
Without question, in the near-term progress was made. Firstly, there was an injection of capital into Europe’s beleaguered banking system totalling EUR106bn. This is below IMF and analyst estimates of capital requirements of EUR200-300 billion, but it is a step in the right direction and the stress tests (at last) included write-downs of sovereign debt, which the re-capitalisation plan some much-needed credibility.
Greek haircuts
This was the lynch pin of the whole deal. If the banks weren’t re-capitalised then write-downs of Greek debt could not happen, let alone a disorderly default, without dragging the whole financial system down. The size of Greek write-downs was the main stumbling block to negotiations last night and Merkel and Sarkozy scheduled an impromptu meeting with bankers at midnight to address the issue. Reports from the politicians said that the bankers were told in no uncertain circumstances to accept the write downs or collapse under the pressure of a disorderly default. However, this morning there are murmurs from the banks that the extent of the write downs (or the reduction of the net-present-value of Greek debt holdings) is still up for negotiation. The markets are brushing off this detail, as it seems highly likely that banks will take larger haircuts on the Greek debt holdings, so the issue of re-capitalisation (which is fixed, as far as we know) is more important.
Is 50% enough?
The other sticking point with the Greek debt write-downs is that even at 50% they may not be enough. This is estimated to reduce the debt-to-GDP ratio to 120% by 2020; but anything above 100% is considered unsustainable and haircuts may need to be 60% to make Greece’s debt burden sustainable. However, it’s unlikely the banks will agree to any cuts on this scale. Added to that the ECB won’t take any haircuts on its Greek bond holdings, which protects the integrity of its balance sheet but may also ignite the wrath of other bond holders who are subject to losses.
The EFSF: A big bazooka?
The extension of the EFSF was considered the ultimate stabilising factor. We know that the plan is to extend this to EUR1 trillion – four times its current size. There are three questions we now need answered: 1, where the money will come from; 2, what the fund will be: a monoline insurer or SPV; and 3, what the fund will do.
Dial Beijing for cash:
Looking at the first point, hastily-arranged calls between the French President and the head of the EFSF with Chinese authorities in Beijing suggests that Europe is coming round to the idea that it needs outside help to save the Eurozone. Other potential investors include cash-rich sovereign wealth funds and potentially the IMF, which would mean all contributing members of the IMF would help with funding. What we do know is that Germany has said that it will not contribute any more funds, which leaves the rest of the world to fit the bill. But this may have some benefits for potential investors as it would give them more influence in European affairs: for example enforcing fiscal discipline and boosting trade links etc.
Will insurance work?
The second point is more complex. For example: will the fund be an insurer of European government debt? Reports suggest that the fund could be used to insure the first 20-30% of Europe’s debt, but would this really be enough to entice investors especially since haircuts on Greek debt may top 50%. Thus, it may not trigger demand for Europe’s most troubled states’ credit.
Added to that, who would provide the insurance? Right now there are only a few northern European countries with the finances to cover any trigger of the insurance scheme – France can’t afford to without threatening its credit rating. What if Germany and co. fail to deliver on promises for other indebted countries? Investors may well come to the conclusion that counterparty risk is too high to justify investing in European credit.
Europe’s SPV
The SPV idea may be easier to implement (as long as there are willing investors, of course!). We know that the plan is for the fund to be levered four times to EUR1 trillion, but now that Italy and Spain are drawn into the Eurozone fray is this enough to really stabilise the markets? Some people note that the EFSF would need to be more than EUR2 trillion to provide a backstop big enough to bring Italy, and maybe even France out from the cold.
Structural issues: a long-term problem
There was some progress here too. Italy has pledged to raise its retirement age from 65 to 67, which is vital for a country like Italy who has a rapidly aging population. We need to see more action like this in other southern European nations to ensure long-term sustainable finances.
One area we haven’t heard much about is closer fiscal integration. However, the EU summits this week were all about stabilising the current situation, we believe that meetings, Treaty changes and closer fiscal union will come in time. Extra German support for its European neighbours has probably come at the price of closer economic ties. However, this will require changes to the EU Treaty, which requires ratification by all 27 EU members, so could take years to implement.
Unless structural issues are addressed then this crisis is far from over. We need some sort of fiscal ECB to act as a monitor that can veto national spending plans if they look unsustainable. We also need proper tax collection systems in place in countries like Greece. Overall, the Eurozone needs to re-balance, with southern states becoming a bit more Germanic, and Northern states becoming a bit more southern and spending more. People have been calling for this since the start of this crisis – so expect progress to be slow.
Conclusion: A plaster caste rather than a plaster
Events this week are definitely a step in the right direction, and although we believe this may be a relief rally in risky assets it may last for some time. These plans are also much bigger than previous rescue efforts, and in that sense Europe has delivered what was expected of it, which it has failed to do in the past.
So, the actions from this summit – the 14th this year – could be considered more of a plaster caste than a plaster. However, there are issues that remain.
In various interviews over the last few days I have been asked whether the 26th October will go down as a historical turning point for Europe. My answer is no. My reason is that there is still so much work to do. For example, haircuts on Greek debt may need to be increased from 50% to stabilise the Greek debt load in the long term. Added to this, the EFSF may not be big enough even with a 4-fold increase in its size to EUR 1 trillion. So there could be many more summits and re-writes of the deal in the future.
But in the near term the picture is looking brighter than it did for risky assets a few months ago. EURUSD needs to break above 1.4099 – the 200-day moving average – for a target of 1.4500 to become realistic. Right now this cross is still trapped between the 50-day moving average at 1.3850 and the 200-day just below 1.4100. So we are still at risk of some whipsaw action as investors digest the rest of last night’s deal.
Stock markets also look fairly constructive; however they have a long way to go, especially in Europe. The Eurostoxx index jumped above the 100-day moving average at 2,422, the next major resistance level is 2,673 0 the 200-day sma. Overall, we continue to believe that European equities will underperform their US counterparts for the rest of this year.
Yesterday’s debt deal has a complex relationship with risk assets since stronger US data and signs that lose monetary conditions may persist around the globe for some time yet are also boosting investor risk appetite. But, crucially, the risk of a systemic crisis has been averted, and the debt deal, even with its short-comings, may help to re-build economic, business and household confidence levels going forward. This is providing some much-needed certainty to the markets.
The views expressed are the author's, not FNArena's (see our disclaimer).
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