The immediate outlook for stocks, fixed income and the euro will clearly be driven by the market’s constantly changing assessment of the potential for some kind of coordinated agreement aimed at alleviating Europe’s debt crisis. There are a number of potential routes forward on the table, including an expanded role for the IMF.
European policymakers are likely to float a deal of some description by the October 23rd meeting of European Finance Ministers. However, it seems most likely that we will see the final result of the deliberations of the world’s leaders at the November 3-4th G20 meeting in Cannes. If no deal on a coordinated response to the European debt crisis is agreed by then, the impact on the world’s financial markets is unlikely to be easy.
None of the potential agreements thus far being discussed can in the end "solve" Europe’s problems at a stroke. That will require serious work to be done at the fiscal level. However, they do have the potential to buy enough time to allow Europe to get the fiscal work done. From this point of view, the value of any potential deal should really be viewed in terms of its ability to restore confidence and convince the markets that there is significant firepower available to support the European bond markets and aid the recapitalization of the continent’s banks.
Rather than evaluate each of the nuanced approaches to such a deal, it seems useful to focus on one which would certainly raise enough eyebrows to deliver a bout of short-covering.
Reading the political tea-leaves, it appears that China may be gearing itself up to play a significant role in a coordinated action to shore up the European government bond markets. This could no doubt also take place within the context of an overall commitment by the BRIC nations - potentially with the IMF as the intermediary.
China’s Foreign Ministry has of course already publicly discussed the potential for their foreign exchange reserve managers to look at for example Italy on a bilateral basis. However, something like that, though possible, doesn’t seem likely on a significant scale – mainly because China would be taking the bilateral risk directly themselves. They probably wouldn’t want to let Germany and France off quite so lightly.
That being the case, the idea that China would make a significant commitment to a plan to leverage up the European Financial Stability Fund (EFSF) seems much more plausible in any reasonable size. Perhaps a plan could look something loosely like the following:
- The authorities let the EFSF leverage itself up to something around euro 2 trillion.
- A number of countries, including the BRIC nations, commit to using their FX reserves to take up a decent portion of the bonds to be issued by the EFSF.
- China commits to being the single most significant buyer – and they make it known that they could buy more.
- The ESFS obviously uses the funds to purchase the government debt of Greece and other higher yielding European bond markets. The EFSF and therefore the European nations behind the institution, are the ones taking the bilateral credit risk.
- European banks obviously get to unload peripheral debt to the ESFS in exchange for new for ESFS debt – changing the structure of the credit risk that they hold on their balance sheets. This would, of course, also necessitate a plan to simultaneously recapitalize the banks themselves.
- China and other participating nations take the credit risk of the EMU block as a whole through the ESFS.
- The ESFS would probably issue both euro denominated debt and USD debt – so that participating countries such as China could buy large swaths without changing the FX mix of the foreign exchange reserves much. They would of course be changing the blended credit risk of their respective portfolios.
In general terms, a plan such as this would make a lot of sense. Of course, the above is unlikely to match the end result in detail. You could cut and paste into the plan a number of alternatives to any individual measure. For example, the banks could simply be asked to take a larger direct haircut on Greek debt alongside aid in a recapitalization process. However, the broad thrust makes sense. Most significantly, China particularly could get a lot of mileage out of such a move. In effect, participating countries such as China would be replacing some of the U.S. credit risk they have with more of the credit risk of the euro block as a whole.
The timing issue is difficult given the issue of the China currency bill currently going through Congress. However, if China plays true to form, we will continue to see a period of saber-rattling in response as China plays to its domestic audience. This may make it look like there is little chance of that China will indeed play a helpful role on the global scene. However, once the domestic audience has been convinced that China cannot be bullied, the stage is likely to be set for China to take some positive steps forward "unilaterally."
Whether or not we can get over the saber-rattling phase before the Nov 3-4th G20 is a tight call. However, it seems reasonable to suggest that in the run-up to the coming meetings we might start to see some discussion about the potential for a globally coordinated deal.
From a market perspective, clearly two issues combined to drive the August-September difficulties for both the euro and the global stock markets:
- Growing evidence of economic weakness and concerns about the potential for a global recession. As I argued at the beginning of the month, however, September’s payrolls were just good enough to allow something of a relief rally in this respect – more detail here. The price action certainly seems to have confirmed that view thus far.
- Europe’s continuing debt crisis. This remains the market’s clear concern.
With the economic evidence suggesting that we will probably just skirt round the edges of a renewed recession, the stage is set for a convincing deal at the G20 to create a significant further relief rally. If the world’s leaders begin to float the idea of anything like the agreement discussed above, the resultant rally would be likely to be significant.