4 reasons the recent EU summit agreement will fail
August 2, 2011 2 Comments
I was planted firmly on a beach chair on holiday during the EU summit on July 21st and was worried I might be missing a piece of European history-in-the-making. As it turns out, I didn’t miss much at all. Upon my return a few days later, analysts were just as confused about the outcome of the EU summit as they had been immediately following its conclusion. Digging into the details of what was agreed at the EU summit, there are four main problems that will preclude the agreement from drawing a line under this crisis.
The first main problem with the agreement is that EU leaders have said they will change the scope of the EFSF without increasing its size. Spanish and Italian government bond yields have already risen to higher levels than they were before the big July EU summit, indicating that investors are not convinced that contagion has been stemmed. If the EFSF needed to intervene in the secondary markets to purchase significant amounts of Spanish and Italian government bonds on top of providing funding for Greece, Ireland, Portugal and (almost certainly) Cyprus, it would quickly run out of money. It is a bit like trying to fight a fire with a shiny new truck and seasoned crew, but only 10 gallons of water. This will have to change. Investors will continue to demand ever higher yields for Spanish and Italian debt until EU leaders either raise the ceiling for EFSF lending to a level so high it could never be reached or remove the ceiling altogether.
The second main problem with the EU agreement is that the private sector involvement (PSI) with respect to Greece will not go nearly far enough to return Greece to solvency. According to the European Commission’s press release to clarify the terms of the agreement (bottom p2), the net present value (NPV) loss for private bondholders is only 21%. Because Greece will have to raise collateral for the debt swaps, its public debt burden will actually increase in the short term, to around 165% of GDP. To return Greece to solvency, a haircut of at least 50% would need to be imposed on private sector participants. The current arrangement is just teeing Greek investors up for an inevitable further haircut down the road.
A third major problem with the agreement is the precedent it sets, both for other bailout countries and for other non-bailout peripheral countries. I have argued previously that if Greece defaults on its debt, Portugal and Ireland could decide to default strategically. This is particularly likely in Ireland, a country with an economy structured well enough that it could conceivably return to sustainable growth once the government is relieved of its considerable debt burden. EU leaders insist that the agreement on private sector involvement and debt buybacks reached on Greece pertains only to Greece. However this is unlikely to hold water if Portugal and Ireland choose to refuse to honour their debt obligations.
Similarly, the summit statement in July was careful to refer only to Greece, Ireland and Portugal with respect to the new terms of EFSF lending, which included a lower interest rate (around 3.5%) and longer maturities. Italy and Spain are currently borrowing at around 6% in the markets (for ten-year government bonds). It seems fundamentally wrong that two peripheral countries currently under attack in the markets and on the hook for around 30% of the EFSF funds should have to borrow at 6% when bailout countries are granted a much lower interest rate. I imagine Italy and Spain would immediately lobby for a bailout themselves as soon as the changes to the EFSF are implemented.
The fourth problem with the EU summit agreement is the assumption that Greece will be upgraded from a selective default quickly. European leaders have agreed they will provide €35bn in collateral for Greek banks to borrow from the European Central Bank (ECB) in the very likely event that Greece is downgraded to a selective default when the voluntary debt swaps/rollovers take place. The assumption is that Greece will be upgraded immediately though, and that the €35bn in support can be provided in accounting terms only and can be withdrawn instantaneously. This is a false assumption; the EU will have to raise and commit this money to Greek banks for a period of time. As I have already mentioned, a 21% haircut on Greek government debt is not sufficient to return Greece to solvency. It might make Greece a little less insolvent, but that is a bit like being a little less pregnant; you are either insolvent, or you aren’t. Private sector involvement will take place after 2014 and a subsequent haircut will need to be imposed on Greek government debt. Greece’s selective default rating is therefore likely to last some time.
The markets are rightly unconvinced that the July EU summit agreement will draw a line under the crisis. Already another EU country—Cyprus—looks sure to need a bailout imminently as well. Still, Cyprus is responsible for only 0.2% of the euro area’s GDP. A much larger concern is the significant pressure the markets have placed on Spain and Italy over the past week. In addition to bond yields rising sharply in the secondary markets for both Italy and Spain, Italy issued 10-year government bonds on July 29th at a yield of 5.77%, the highest in 11 years. Consequently Italy has decided to suspend bond auctions originally planned for mid-August. Borrowing costs for Spain and Italy are simply unsustainable, and if they remain this high could turn questions of liquidity in these two countries into questions of solvency. So much for a quiet summer.