It would be easy to be cynical. For almost all of the 10 EU Summits that attempted to save the euro zone, market behavior followed the same pattern: post-announcement relief for a few days, and then a depressing realization that the “plan” would not work. With equity markets soaring by more than 4%-5% today, should we be ready to short risky assets soon?
The EU Summit Statement has shortcomings. But unlike past Summits, the lack of details is not a surprise.
The details on the EFSF leverage are minimal.
Credit enhancement and SPV to maximize its funding. Both options can be implemented simultaneously; modalities will be delivered in November.
As we have emphasized before, beyond the size of the leveraged EFSF, the question of its use was the most important. The EFSF does not solve the solvency problems of countries. It can ensure that a liquidity crisis does not turn into a financial fiasco. Expanding its side suggests that big non-core countries may be excluded from market financing.
It seems that the option to use the EFSF to alleviate the pressure on the secondary market for EGBs is no longer on the forefront. We have always said that the best way to avoid contagion is through the Central Bank. We are glad to hear that Mario Draghi guaranteed that the ECB would continue to implement the SMP: The risk of contagion to “too big to save” countries is therefore limited.
What matters most in the medium term is that countries actually implement -- not just commit to -- fiscal adjustment plans. Remember that according to our calculation, Italy and Spain do not face solvency crises.
The Private Sector Involvement is a clear case for what economists call “time inconsistency.”
Remember that on July 21, the EU wrote that “As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.”
Now, banks will have to accept a 50% haircut without benefiting from their offsetting CDS hedge as the ‘”voluntary exchange” will not be considered a credit event (ironically, the official threshold for haircut is now 50% while the EFSF “credit enhancement on new debt issued is said to be a 20% first loss guarantee.”).
This has two implications:
- The necessity to make sure that growth and fiscal adjustment expectations for the Greek economy are consistent. (“The mechanisms for the monitoring of implementation of the Greek programme must be strengthened, as requested by the Greek government.”) Can we consider that a 120% target for Greece debt to GDP ratio in 2012 is a sound definition of “fiscal sustainability”?
- Provide support to banks who are asked to take a higher loss and have to strengthen their capital base (a procyclicity should have at least been accompanied by a lengthening of the write-off period). According to EBA, the capital shortfall for European banks to reach a CET 1 ratio of 9% by mid-2012 amounts up to €106 bn (€8.8 bn for French banks according to our Equity Analysts).
The EU authorities are concerned that this balance sheet adjustment would result in further deleveraging and translate into a credit crunch. For that reasons there is a willingness to “ensure medium-tem funding of banks” through guarantees on senior debt (bank redemptions for 2012 stand around 700B euros).
There is still no detail on the nature of the possible guarantees. An EFSF-like system in France would be possible, but may endanger the AAA status through contingent liabilities).
Beyond the obvious shortcomings:
- For the first time in two years there is a comprehensive plan (don’t forget that in the meantime the ECB is providing liquidity support – LTRO, SMP, CBBP2).
- There have been genuine steps towards governance and integration.
The main challenge in the short run is, of course, to come up with more details on the plan. But above all, the biggest short-term challenge is growth, as many leading indicators have nosedived. An ECB rate cut would be welcome.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.