As this weekend’s eurozone summit looms into view, the key question for markets is whether the new financing arrangements will be sufficient to handle three separate problems: the necessary writedown of Greek debt; the recapitalisation of eurozone banks; and the restoration of private funding for Italian and Spanish budget deficits.
It has been clear for a long while that the €440bn currently available to the European financial stability facility is far from sufficient to do the job. Consequently, it seems that the summit will agree to “leverage” the bail-out fund to give it much greater scale. This has triggered optimistic talk about a “big bazooka”, but achieving the right order of magnitude still looks to be a very tall order.
Unfortunately, the three problems that the EFSF needs to handle are interrelated. Financing the future needs of Greece, Ireland and Portugal is likely to absorb around €100bn of the fund’s resources. The recapitalisation of eurozone banks will need at least €200bn in total. It would surely be prudent to assume that the EFSF will need to provide half of this. Finally, the possibility of that the fund would be involved in a potential rescue for Belgium, and other contingencies, must be considered.
This leaves only about €200bn of “free” capital at the EFSF, available for leverage. Anything more than this threatens to undermine the credibility and triple A status of the fund itself.
The €200bn will apparently be used to insure future purchasers of Italian and Spanish bonds against the first tranche of any losses they may suffer in a sovereign default. If the first 20 per cent of losses are insured, the EFSF could cover €1,000bn of bond purchases.
The key question is whether this would be a sufficient inducement to bring a large amount of fresh capital into the troubled bond markets. The subsidy would be worth 180 basis points on new Italian bonds, according to Andrew Bevan, Fulcrum’s bond specialist, given the market’s assumption that a sovereign default is 40 per cent likely over the next five years, and assuming that there would be a 50 per cent recovery to bond holders after that default.
It is not clear that this will be enough to transform the market’s perceptions of government debt in these struggling economies. The eurozone could increase the incentives to future bond purchasers by increasing the insured amount of any future loss from 20 per cent to (say) 40 per cent. But that would automatically reduce the amount of bonds covered from €1,000bn to a modest €500bn.
At its absolute maximum, the subsidy can never be worth more than €200bn, which is equal to 8 per cent of the current outstanding debt of Italy and Spain. The eurozone cannot make this subsidy any bigger by using the smoke and mirrors involved in leverage. Talk of trillions of new money, apparently conjured out of thin air by financial engineering, is inherently misleading.
The only way of squaring this circle is to increase the size of the EFSF itself. Germany remains steadfastly opposed to this, as it would increase the potential size of fiscal transfers to other countries. If this is Germany’s final word, then the fund will remain too small, and the eurozone will once again discover that it cannot make a silk purse out of a sow’s ear.
The writer is co-founder of Fulcrum Asset Management and Prisma Capital Partners.