The EMU Summit largely confirmed the contours of the comprehensive plan the EMU hopes will help ease the debt crisis. Some additional details were made available, but the large chunk of the implementation details are missing and especially these will decide whether confidence in non-core euro bond markets will return. However, while the market should react ebullient, we think that the EMU plan will get the benefit of the doubt initially, with a final assessment expected when the details become available in the next weeks to months.
Greece
The EMU leaders struck a deal with private investors (banks and insurers) according to which they accept a nominal 50% haircut (about 60-70% NPV cut), which would according to participants lower Greek debt by €100 B, or cutting the debt-to-GDP to 120% by 2020. The official creditors would agree to raise their contribution to the Greek second bail-out package to €130B from an earlier proposed €109B. The deal with the private sector would contain some sweeteners (credit enhancements) for an amount of €30B. It would remain, or at least that is aimed for, a voluntary deal avoiding a credit event. EU Commission Head, Mr. Barosso, said that the entire deal on Greece including the PSI would only be worked out by year-end.
View: Banks do now know that government debt is indeed not risk-free. Earlier assurances on Greek debt have proved to be worthless. Of course, authorities now say that Greece is an unique case, but it would be foolish to buy into that easily. Of course, markets already discounted such an outcome. Nevertheless, it is a negative for the debt of some other countries, especially Portugal. On the other hand, recognizing the inevitable is the start to give Greece some perspective. However, a debt-to-GDP of 120% by the end of 2020 remains a challenge for the country and for EMU. Much depends now about EMU growth in 2012. In case of a recession, more problems are likely in some countries under programme or in Spain or Italy.
Banking recapitalization
The EU leaders also agreed on the banking recapitalization which would amount about €106B. The 9% core tier one capital requirement was accepted as was the rule that the banks’ bond portfolio would be valued mark-to-market to determine the potential loss that has to be taken into account when calculating the needed extra capital. The capital target needs to be reached by 30 June 2012. Shortfalls should first be supplemented by private sources of capital, including through the restructuring and conversion of debt into equity instruments. There are also constraints on distribution of dividends and bonus payments until the target has been attained. If private sources aren’t available, national governors or in last resort the EFSF would provide the capital. Any form of public support will be subject to conditionality. The statement says that national supervisors must ensure that banks’ recapitalization plans do not lead to excessive deleverage. The fear is that banks will try to comply to the capital demands by deleveraging which might hinder the economy to grow. There will also be a scheme of guarantees put in place to support banks access to
term funding. This part of the EMU plan looks appropriate, but it depends crucially on its implementation. If banks go for deleveraging after all, it might be highly detrimental for the economy.
Leveraging EFSF
As expected, EMU leaders also agreed on the leveraging of the EFSF. The ECB will not be involved and the amount of guarantees won’t be extended. The EFSF leverage will occur via two options, notably the insurance of a first loss for newly issued sovereign bonds of some countries and via an SPIV. The latter would be financed by the EFSF for the equity tranche and to be upped by wealth funds and EM (and other investors) for the mezzanine tranche. The statement also says that further cooperation with the IMF will be sought to further enhance the EFSF resources. It is not clear yet what this would mean for the ultimate firepower of the EFSF. The text calls for a 4 to 5 times leverage and a nominal amount of €1T. Of course, the precise leverage cannot be given without knowing the contributions of private investors. It isn’t clear either whether something has been agreed about the current ECB portfolio of sovereign bonds. Will it be taken over by the EFSF? In case of new precautionary programmes, there will be conditionality in line with IMF practices. The Eurogroup should finalize the terms and conditions for the implementation of these modalities in November. Here the devil is in the details (which are not known yet). Indeed, the question will be whether the leveraged EFSF will restore confidence in sovereign bonds and thus avoid contagion, inciting investors to acquire again bonds from countries under pressure. We have some fears that the proposed options are too complicated and may consider the guarantees as not strong enough to ease their fears on losses on government bonds. However, we think that markets may for now be satisfied, as expectations for a Chinese and an IMF contribution will rise.
Treaty changes
Apart from the three main pillars, EMU leaders also gave a mandate to Van Rompuy, Barrosso and Juncker to identify possible steps to strengthen the economic union, including exploring the possibility of limited Treaty changes. An interim report will be presented in Dec 2011. A report on how to implement the agreed measures will be finalised by March 2012. Finally, they also agreed upon ten measures to improve the governance of the EMU. It is amazing that the leaders, under pressure of Merkel, want to change the treaty. We suspect however that the qualification limited points to the wish of the leaders that the changes won’t be subject of referendums. It could lead to an acrimonious political climate between countries.
Italy
At the EMU Summit, Italian (1 2070 CZK, 0,00%) Berlusconi presented extra structural reform measures to boost growth and cut debt. In August, the already announced a €60B austerity package when he was pressured by the ECB to deliver reforms in exchange for support on the Italian government bond market. Yesterday, Il Cavaliere promised that after the balanced budget in 2013 the country will reach a structural budget surplus in 2014, bringing about a reduction in gross government debt to 113% of GDP in 2014. Italy will now implement the proposed structural reforms to increase competitiveness by cutting red tape, abolishing minimum tariffs in professional services and further liberalising local public services and utilities. By the end of the year, Italy committed to reform labour legislation. The document also included the plan to increase the retirement age from 65 years to 67 years by 2026 and the intention to raise €15B over three years through sales of state assets. Interestingly, the European Commission is asked to provide a detailed assessment of the measures and to monitor their implementation. Currently, it seems that the proposed measures are a vague road map and that a more detailed economic plan will be presented on Nov 15.
The initial reaction in Asian markets was cautiously positive. EUR/USD rose to near 1.40 from 1.39, oil gained $1/barril, equities increased modestly and US Treasuries declined. However, all moves were modest and within existing trading ranges. The initial reaction in EMU is for optimism, as reflected in a steep decline of the Bund at the start of trading. EMU spreads versus German bonds are narrowing. The German/Italian and German/Spanish spreads drop 19 bps and 16 bps respectively. The Belgian and French spread narrow by 7 bps.