Sunday, July 24, 2011

Europe’s partial debt breakthrough

The latest breakthrough on a second bailout for Greece is enough to keep the markets happy for the next few months. It’s holiday season, people are dreaming of sandy beaches, so we think the markets will accept this plan as more of a plaster cast than a Band-Aid that will go some way at least to sorting out Greece’s problems.

We’ve all read the details from the emergency EU Summit: the loan extensions, rate cuts and private sector involvement has already been widely written about, but what about the details of the plan? We take a look at the pros and the cons and what it means for market sentiment.


• Although the private sector has agreed to reduce Greece’s burden by just over 10 per cent, Athens will still have a debt –to-GDP ratio of more than 120%, a level considered unsustainable. It is likely that private sector bond holders will be asked to take an even deeper haircut in the next few years. Although the private sector played ball this time, it’s not a given they will continue to take cuts on their holdings of Greek debt in the future.

• The stabilization tools to improve the effectiveness of the EFSF and ESM were welcomed developments. It is now designed to provide loans to re-capitalise banks and intervene in the secondary bond markets to help relieve the pressure of bond yields during “exceptional circumstances.” But this has highlighted the inadequacy of the size of the EFSF. It needs to be much larger than EUR440BN to make a difference, especially since Spain’s banks are likely to need large capital injections over the coming years.

• This plan is only designed with Greece in mind – what about Ireland and Portugal? Ireland made some progress yesterday by securing a cut in the interest rate of its bailout loan, but it will only reduce Ireland’s liabilities by a measly EUR800bn, not enough to stabilise Irish debt levels. Have people forgotten about Portugal?


• The ECB are on board. They were the only branch of authority in the EU that had the power and the will to veto any of the plans put forward by Germany and France. Without their support for partial defaults the plan would not have worked. If they hadn’t succumbed to the German plan then it would have caused panic in the markets.

• Europe’s leaders have finally grasped the gravity of the situation and have come together in a show of unity to provide a solution. It would have been more effective 18 months’ ago, but better late than never.

• This is a credible plan, the EU authorities, the ECB and the private sector are all working together, which should be celebrated, but this is only a very small step to fiscal sustainability for Europe’s periphery.

Market reaction:

• Germany and France get hit

The elation in the markets was probably a very large sigh of relief. The market had low expectations, so yesterday was a huge step for European leaders and the markets’ duly rewarded them for it.

Interestingly, although Italian and Spanish bond yields fell sharply, French and German yields rose. The EFSF fund is most likely going to have to increase in size in the coming months and years and that leaves France and Germany on the chopping block. Bond investors know this, and we could see the yields on French and German debt creep higher in the coming months, we will be keeping an eye on this.

Spain and Italy (white and orange lines) vs. France and Germany (green and yellow)

• The euro is likely to recover strongly, however we think there is more scope for gains in EURUSD than EURCHF. The single currency may recover back to the 1.20/1.22 zone versus the Swiss franc, but we think gains will be capped. In contrast, debt problems are now panning across the Atlantic and the US and its debt ceiling are now in focus. Depending on whether a plan can be found in the next week, EURUSD should remain fairly supported. Above 1.4600 we may see towards 1.5000, although we think that would be the high in the medium-term.

• The bigger issues for the euro (which the markets are not focusing on) include France and Germany’s position on the hook for a much larger EFSF fund, another round of haircuts for private sector bond holders, and signs that growth is slowing and the ECB may scale back their policy normalisation plan for the rest of this year. This isn’t on FX investors’ minds right now, but it could hurt the single currency in the coming months.

• Stocks: markets gave a big thumbs up to the Greek plan as details trickled out yesterday, but stocks have also been buoyed by good earnings results, which have laid to rest some fears that the global economy is slowing down. However, the markets have selective memory right now and don’t seem to be concentrating on weak economic data in China and Europe. They will start to focus on this, which leaves the recent rally in stocks vulnerable in our view.

• Watch out for credit rating agencies, we haven’t heard from them yet, and if they start cutting Greek debt to D then it may cause a flight from risky assets.

Overall, EU leaders have gone some way to fill the credibility gap that was building around their failure to find a sustainable solution to the problems of Greece et al. However, the EUR109bn second bailout for Greece is adding more debt to Greece’s enormous pile. It may have filled Athens’ financing gap, but it will have to be paid back eventually. The hard work begins now. Greece needs to show it can bring down its deficits and reform its public sector; so far we have seen little evidence of this.


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