Posted on October 21, 2011

Euro Crisis: Canadian Consternation Warranted

Governor Mark Carney has also loudly suggested that the European bailout fund (the EFSF) is woefully inadequate and needs to be increased from its current level of €440 billion to €1 trillion. Despite this and other considerable foreign pressure, Germany has warned that Sunday’s EU summit could fail, once again, to produce a solution to the euro crisis. Moreover, at this late date, Chancellor Merkel is begging for more time as the Bundestag is still refusing to give her authority to negotiate on behalf of Germany at this weekend’s summit—the big concern is how to increase the firepower of the EFSF. And now, European leaders will be forced to hold a new summit, possibly as early as next week, because France and Germany can’t get it together to reach a deal on key parts of the rescue plan.

Is there any wonder that market participants are sceptical that a resolution to the debt crisis will be forthcoming? In the meantime, Moody’s warned of a possible reduction in the outlook for France’s AAA rating from stable to negative, citing that while France has “ample capacity to absorb shocks”, the “global financial and economic crisis has led to a deterioration in French government debt metrics—which are now among the weakest of France’s triple-A peers”. Europe’s second largest economy could be forced to take on more contingent liabilities due to the debt crisis.

This is yet another worry for French banks. Bond markets have responded by pushing French 10-year yields up about 5 bps, widening the spread versus German Bunds to as high as 113 bps, a euro-era record. France losing its AAA rating would make it tough for the EFSF to maintain its AAA rating, creating yet more potential issues for the troubled region. Today, Standard and Poor’s concurred with Moody’s position, while Fitch rating service told Bloomberg News that it had no plans to change France’s AAA credit rating. They said they “don’t think the changes to the EFSF put France’s AAA at risk.

So what are the key issues yet to be resolved by the EU leadership, the IMF and the ECB? They are three-fold: the orderly default of Greek sovereign debt; the recapitalization of the European banks; and, the purchase of Italian, Spanish and Portuguese bonds to ring-fence the Greek contagion.

All three of these issues are interrelated and require a far larger bailout fund than the current EFSF, begging the question of who is going to pay for it. Taking each in turn and giving you the Coles Notes version: Greek Default Even a 50% writedown of Greek government debt is not sufficient to reduce the debt-to-GDP ratio of Greece to a target of 80% by 2016. (And certainly the 21% haircut proposed last July defies credibility that the troika is serious.) It is highly unlikely that the 50% haircut can be accomplished ‘voluntarily’, which means that a technical default will be triggered, despite the ECB’s opposition.

So Greece will need either a larger writedown or more official money from the EFSF, the ECB or the IMF. Recapitalization of the Banks The stress tests for the European banks have not used realistic worst-case or even baseline-case scenarios. Much depends on the size of the Greek writedowns and the possible future contagion to Italy and Spain, but most analysts at the IMF and elsewhere suggest the price tag for bank recap is roughly €200-to-€275 billion, which would increase the Tier 1 capital ratio of the big European banks to 9% or more. Incredibly, according to reports this week, the European Banking Authority’s current stress test suggested only a far-smaller €80 billion bank recap would be necessary.

This is not credible and relies on fantasy-land assumptions about the likely scenarios. Banks will be given time to raise the capital in private markets, but only the strongest have access to private capital. The shortfall will come from national Treasuries or from the EFSF, and each of the EU countries wants to minimize their own bills. Preventing Contagion Ring-fencing the effects of Greek default requires a marked increase in the size of the EFSF. Leveraging the bailout fund is a key component of the rescue package as far as market confidence is concerned. Using the fund to insure new bond purchases in, say, Italy and Spain, is one way to leverage the capital. Assuming that the “equity capital” available to the EFSF after payments already committed to Ireland, Portugal and possibly Greece, is about €200 billion, if it is used to insure 20% of the first losses on new debt issuance, it would be possible to insure about €1,000 billion of new bond purchases. That would cover the new bond issuance of Italy and Spain for the next three years.

Bottom Line: There is no way this Sunday’s summit or the one after that will provide all that is needed to really deal with the European Debt Crisis. The true litmus test for credibility is a writedown of Greek debt of €200 billion, a recapitalization plan of €200 billion, and an increase in the effective capacity of the EFSF to €1 trillion. Anything short of this extends the crisis and suggests the Europeans still don’t get it or at least not enough to accept the real price tag of the mess they are in.