SERIOUS MONEY:JEAN MONNET, the chief architect behind the European Union and one of its founding fathers, once quipped that "people only accept change when they are faced with necessity, and only recognise necessity when a crisis is upon them". The late-Frenchman's sentiment was visible at the special euro-zone summit in Brussels on July 21st, as European leaders grappled not only with a second bailout for Greece, but more importantly, with the disturbing contagion of the continuing crisis beyond the periphery to a "soft-core" that includes Italy, which is simply too big to save.
Market action threatened to spark a broader systemic crisis and with the entire euro project edging ever closer to the abyss, the elevated stress appeared to focus minds and not surprisingly, euro zone governments alongside the European Central Bank agreed not only to a second Greek bailout, but also on a number of far-reaching proposals that are designed to underpin financial stability across the monetary union.
Financial markets reacted enthusiastically to the news through the end of the week, but time for reflection at the weekend allowed attention to shift towards the agreement’s glaring deficiencies. The initial euphoria proved decidedly short-lived, as both Italian and Spanish government debt securities gave up some of last Friday’s gains early in the week, such that yields remain uncomfortably above the levels registered at the start of the month. Meanwhile, the rates available on public debt instruments across Greece, Ireland and Portugal are still at levels that suggest investors continue to believe that eventual default is probable. The capital markets’ verdict is clear; the euro crisis is far from over.
Last week’s summit agreed on a new three-year EU-IMF rescue programme for Greece that included €109 billion of official financing, alongside a series of measures designed to materially improve the troubled nation’s public debt-to-GDP ratio over time.
The measures agreed upon include a reduction in the interest rate on official loans to 3.5 per cent and an extension in loan maturities to between 15 and 30 years. Further relief stems from private-sector involvement and a debt buyback plan funded by the European Financial Stability Facility (EFSF). All told, the measures, alongside the successful implementation of the Greek fiscal adjustment programme, are expected to reduce the public debt-to-GDP ratio to 130 per cent by 2015 – a 16 percentage point reduction as compared with the IMF’s most recent projection.
The debt relief contained in the new programme is undoubtedly welcome, but the projected Greek public debt ratio through 2015 and beyond still looks uncomfortably high, while the fiscal adjustment required to realise those projections is of a magnitude that seems far too optimistic. The Greeks have already reduced the primary budget deficit, ie before interest costs, by five percentage points to below five per cent – a Herculean achievement given that the economy shrank by 4.5 per cent last year – but much more is needed if the public finances are to be put on a sustainable path.
The cumulative improvement in the primary balance required from 2011 to 2014 amounts to eight percentage points of GDP, while a significant amount of state assets must also be sold if the projections are to be achieved. Slippage should be expected as political unity is relatively low and social disquiet relatively high. Thus, it seems reasonable to conclude that the Greek problem won’t go away anytime soon.
The summit also agreed to broaden the capabilities of the EFSF and the European Stability Mechanism (ESM) that replaces it in 2013, a decision which effectively transforms these facilities into a European Monetary Fund. Under certain conditions, the EFSF/ESM will be able to extend “precautionary” loans, finance the recapitalisation of banks in the overall euro zone, and intervene in the secondary bond markets of all euro zone countries “in exceptional financial market circumstances” that the ECB believes are “risks to financial stability”.
The new tools are designed to mitigate contagion, but the EFSF simply does not have sufficient resources to prevent the emergence of stress across the euro zone’s sovereign debt markets. The facility was created in May last year and originally offered €440 billion in guarantees, but the amount available in EFSF issuance was reduced to €367 billion as a result of the 120 per cent over-collateralisation provision. The amount of loanable funds was reduced further to €255 billion given the decision to maintain an AAA-rating, which imposed an on-lending constraint equivalent to the AAA country proportion of the guarantee facility.
A decision to increase the size of the EFSF to about €750 billion in order to raise the facility’s on-lending capacity to the original €440 billion, has already been agreed politically, and is expected to be fully ratified by euro zone parliaments by September. However, the facility would only barely cover Spain’s funding requirements until 2013 – let alone Italy – should the need arise, and thus, the EFSF could well prove incapable of fulfilling its broader, ambitious remit.
Reliable estimates indicate that the deployable funds available to the EFSF would need to be increased to €1.5 trillion if the facility is to become a credible deterrent. However, the required guarantees from the euro zone’s “hard-core” and the accompanying increase in contingent liabilities is almost certain to be politically unacceptable and particularly so, given that rating downgrades may follow.
The bottom line for investors is that the euro crisis is far from over and peripheral sovereign debt positions should be sold into strength.
charliefell.com
