A Weak Eurozone Deal Smacks Of Compromise

Includes: ERO, FXE
by: Nicholas Kennedy

The Greek debt burden not sustainable at 120% of GDP. Growth is more vital than ever.

After much haggling and no doubt some bashing of heads behind closed doors, eurozone leaders have finally settled upon a solution the debt crisis that has been plaguing markets for the past year or so, agreeing to increase the voluntary haircut (helping avoid one criteria for a credit event) on Greek debt from the paltry 21% agreed back in July to 50%, while plans have also been approved to increase the notional size of the EFSF (gearing its 440 billion euros to 1 trillion euros) and finally to recapitalize the banking sector.

Markets have responded positively to the apparent breakthrough (Eurostoxx 50 up 4.2% and the DAX +4.0% approaching lunch), but as ever the devil is in the details. What grabs our attention immediately is the rather worrying statement that the Greek deal should bring the debt to GDP ratio down to 120% of GDP by the end of 2012. A staggering number based on a 50% write-down for private bond holders and hardly a route to debt sustainability given the pressures the economy remains under.

Some of the underpinnings of the deal appear particularly optimistic, such as a further 15 billion euro increase in the already elevated 50 billion euros the government will have to raise from its privatization program. It is easy to be cynical in these matters; nonetheless we don’t think the package can create the necessary conditions for growth which is vital to stabilize the terrible debt dynamics. It looks reasonable to expect further write-downs if the official lenders are not willing to take a haircut on their commitments too. Private investors’ hands should at least be strengthened by this, even if in the first instance the cost is expensive.

As for the EFSF, expanding the facility was critical. By the looks of things the fund will effectively provide some form of insurance protection to bond holders, although how this will actually fits together is vague; it looks like the technical details are still being worked on. On paper the increase looks to be enough, but given the questions over the Greek element of the deal, it might not in six months’ time. Equally interesting is how eurozone leaders broached the subject of bank recapitalization. Rather than any official action, the banks will have to raise capital themselves (106 billion euros in total) so that core tier 1 capital ratios reach 9%, which ought to have interesting implications for credit going forward.

Overall its clear progress has been made, but whether this marks a clear break with the past is uncertain. Fine details are largely absent, as it typical for European summits, and we’re not convinced the steps are aggressive enough to draw a line under the issue. There are plenty of risks; questions remain over Portuguese solvency; Italy is still in precarious territory, due to its huge financing needs and political dynamics. From a market perspective, we think a lot of this good news is priced in. Of course, there is room for the euro and equities to rally in the first instance, as some money had been taken off the table ahead of the summit. But we think as the plan is digested, some caution will creep back in, investors likely to be wary of execution risk as ever.

The reaction of Greek bond yields might be telling, the 10-year till trading at less than 35c to the euro, which even we can work out is more than a 50% implied haircut. Selling into the EUR/USD rally looks a natural way to play it from our perspective. There still remains little room for shocks even with an enlarged EFSF. Growth trends across the block are worrying with recession risks elevated, without growth solvency issues can only creep back in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.