EU Summit Reaction: Sum of the Parts is No Greater than the Whole
October 28, 2011 1 Comment
After 11 hours of negotiating behind closed doors, eurozone leaders emerged in the wee hours of the morning on October 27th to announce that they had agreed a series of principles. The markets rebounded later that day as everyone breathed a collective sigh of relief that at least the EU summit hadn’t ended the same way an Italian parliamentary meeting had earlier that day, in a fist fight. EU leaders found agreement on Greece, bank recapitalizations and a leveraged EFSF as I expected. As investors and analysts begin to dig into the details of the communiqué, a number of gaps will emerge in the plan, indicating it is nothing close to the “comprehensive solution” to the crisis originally promised.
The Greek Problem
A bigger haircut on privately held Greek government debt was agreed in the context of a renegotiated 2nd Greek bailout package. According to the new 2nd Greek bailout package, up to €100bn will be lent to Greece through the EFSF and the IMF until 2014, on top of which €30bn will be provided as a sweetener for private sector involvement (PSI). PSI will involve a bond exchange with a 50% haircut on privately held Greek government debt. According to Merkel, this should allow Greek government debt to stabilize at 120% of GDP by 2020. An additional aspect of the 2nd Greek bailout package is that Greece will raise an extra €15bn in privatization revenues to reinvest in the EFSF. In exchange for the 2nd bailout package, troika representatives will be based in Athens full-time to monitor implementation of austerity measures and structural reforms.
Gaps in the plan:
- There are no details on the terms of the new bonds, including the maturity of the new bonds or which legal jurisdiction they will fall under.
- No details have been provided on what will be done about holdouts. If holdouts are not told that 1) they will receive nothing in the event of a default and 2) the bonds they hold will not be eligible as collateral at the ECB, it may be difficult to get a high participation rate in the PSI.
- It remains unclear whether the exchange will be ruled as voluntary by the ISDA, and therefore whether CDS payouts are triggered.
- It is unclear whether the €30bn sweetener will come from EZ member states or the EFSF.
- A 50% haircut on privately held Greek government debt will reduce the government’s overall debt burden to around 107% of GDP. Cutting the stock of Greek government debt does nothing to solve the flows of debt that the government is accruing in the absence of major structural reforms and economic growth. A 50% haircut is therefore extremely unlikely to return Greece to debt sustainability.
- No plan has been laid out for how Greece can raise an additional €15bn in privatization revenues when its original target of €50bn by 2015 was already wildly overoptimistic.
- The Greek constitution requires any significant changes in sovereignty—such as having the troika monitor Greek ministries full-time—be put to a vote in the Greek parliament, with 180 out of 300 seats required to pass the measure. It is extremely unlikely prime minister George Papandreou will achieve this.
Most of the details on the bank recapitalisations were released following the October 23rd EU Summit. EU leaders agreed that 70 systemically important banks must meet a 9% Core Tier I capital ratio by mid-2012, accounting for market valuations of sovereign debt exposures. The European Banking Authority (EBA) estimated this would cost €106.5bn. Additionally, EU leaders recommended a coordinated, EU-level public guarantee scheme to restore confidence in term funding markets.
Gaps in the plan:
- It remains unclear who provides the guarantees in those countries where the government clearly cannot.
- As we enter a period of significant adjustment, future loan losses (which were excluded in the EBA estimates) could drive the total cost of bank recapitalizations significantly higher.
- It remains unclear what the impact of bank deleveraging might have on economic growth in the EZ. If deleveraging undermines growth significantly, bank profitability will fall and the bank recapitalisations could be self-defeating.
Increasing the EFSF
Two options were agreed for increasing the size of the EFSF. The first option involves the EFSF bonds being used to back first-loss insurance certificates on sovereign bonds issued. The insurance certificates and the sovereign bonds issued will be traded separately. The second option involves creating a Special Purpose Investment Vehicle (SPIV) funded by the EFSF and foreign public and private investors. The EFSF funds will be first-loss capital, and the foreign funds will be senior.
Gaps in the plan:
- EU leaders suggested the fund would be leveraged 4 or 5 times its current size, but have not estimated how big the big bazooka will be in the end.
- Both options for leveraging the EFSF create various tranches of debt, with the old sovereign debt (which has no guarantees) made junior to the new debt with built in first-loss guarantees. If investors demand higher borrowing costs for the old sovereign debt, this will mitigate the overall effect of using an EFSF guarantee to reduce yields.
- If the EFSF loses its credit rating as is likely if (when) France loses its AAA credit rating, its borrowing costs will rise and its effectiveness will be undermined.
- Option 2 relies on foreign investors, and eurozone leaders seem to be pinning all their hopes on China. In the past, China has shown interest in purchasing eurozone infrastructure but has shied away from intervening and purchasing eurozone peripheral debt in any meaningful quantities. I therefore do not expect China to be the eurozone’s white knight.
Devil is in the details
As with virtually all policies announced at the EU level since the onset of the eurozone crisis, the devil is in the details. Just as important as what was announced yesterday morning is what was not announced. Even if EU leaders manage to hammer the fine print details out, which could take weeks, it seems unlikely they will ultimately end the crisis.
For more detailed analysis on the October 26th EU Summit, see my piece “EU Summit Reaction: The Devil is in the Details” at Roubini Global Economics.