In typical European fashion, a summit deal which seemed out of reach at midnight last night was triumphantly unveiled at 4am. The deal does not, and was not intended to, have any effect on the core problems facing the eurozone. There is still an urgent need to restore growth to economies which are hamstrung by uncompetitive business sectors, and continuous fiscal tightening. Recession still looms, especially in the southern economies.
What the deal is intended to provide is adequate medium term financing for sovereigns and banks which have been facing urgent liquidity problems. On that, it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn.
All of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.
There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised.
In the run-up to the summit, I suggested in this blog a few litmus tests to judge whether the measures amounted to the “big bazooka” promised to the markets. In theory, the targets have broadly been hit, though in practice the implementation risks are even higher than it was reasonable to expect. Here is an assessment of the three key pillars of the deal:
1. The Greek debt write-down
The 50 per cent haircut on private debt passes the litmus test, but there has been no participation by the official sector. The effect is to reduce the Greek debt ratio from 152 per cent of GDP in 2020 to 120 per cent, assuming that all of the Greek fiscal restructuring can be implemented in the meantime (which seems highly improbable). These debt figures are higher than expected, and may well prove unsustainable once again. So the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt.
There will now be an anguished debate on whether this restructuring can be described as “voluntary”, and whether a default will be declared in the CDS market. The euro summiteers, who frequently announce that water can flow uphill, claim that it is indeed voluntary. Common sense says that it is not.
2. The bank recapitalisation
The litmus test said that €300bn of recaps would be impressive, while €100bn would be skimpy. Predictably, the summit has chosen the skimpy end, at €106bn. This will only be enough if the rest of the package, designed to calm the sovereign debt markets, is highly successful. Clearly, European leaders were worried about the possible effects of making excessively onerous capital demands on the banks, given that they were threatening to delever their loan books in order to hit the new capital ratios. Regulators have been told to ensure that this does not happen. And, unexpectedly, there appears to be an intention to introduce a new EMU-wide guarantee scheme which will help banks to secure unsecured medium term funding. This could be a very important step towards restoring confidence in the banks if actually implemented.
3. Leveraging the EFSF
This was intended to be the biggest part of the “big bazooka”. The €1,000bn quantum in the litmus test has duly appeared in the headlines, but details of the plan remain very sketchy. The German government has clearly won its dispute with France about using ECB money to leverage the EFSF, which appears to be firmly off the table. This leaves some combination of an insurance scheme and new SPVs which will attract new investors into the troubled sovereign debt markets by offering to cover the first 20 per cent of any future losses they might suffer on their European bond investments. It remains to be seen whether the private sector, or the BRICs, will be attracted by this offer.
It is important to be clear that this does not involve bringing any new money from the eurozone itself to bear on the problem. At most, it involves a subsidy of about €200-250bn (which was already committed in existing EFSF guarantees) from the stronger members of the eurozone to attract new investors into the market for Italian and Spanish bonds. As explained in this blog, it amounts to 8 per cent of the outstanding debt of these two countries, which may not prove compelling. Talk of a trillion of new money, apparently conjured out of thin air by financial engineering, is inherently misleading, or at least very premature.
Overall, then, the headline figures look to be in line with market expectations, but the devil is in the lack of detail. The attention of the markets will now turn to two main issues: whether new money can be raised from China and other sovereigns outside the eurozone; and how the ECB behaves under the new leadership of Mario Draghi.
The ECB was the spectre at yesterday’s feast. It is currently buying sovereign debt in the eurozone at a pace which is similar to that undertaken by the Fed under its QE2 programme. They really do have new money, in bucket loads, if they choose to deploy it. President Draghi said yesterday that the ECB would continue to employ “non standard” measures to achieve the degree of monetary tightness it desired in the markets, but it is not clear what this means. Does it imply further bond purchases, and if so in what size? The ECB is an institution whose independence is protected by treaties, and whose decisions cannot be vetoed by any member state. What they decide to do next will be crucial.