There are several things that you need to know about the eurozone crisis and Wednesday’s Summit agreement:
- It isn’t over.
- The European Monetary Union’s (EMU) “architecture” is a failure.
- They spent too much and can’t possibly repay the debt.
- Banks will need to be bailed out.
- They will print money.
In order to understand the EU summit “breakthrough”, we need to understand how the players in eurozone look at it. Last week a leaked confidential assessment of the problem that was prepared by the IMF was published by Linkiesta’s Fabrizio Goria. The document revealed the IMF’s private assessment of Greece and the requirements for a bailout. We were tipped off to the document by our friends at TrumanFactor.com. The complete document can be found here (.pdf).
Here is a summary of how the IMF sees the problem:
- The Greek economy is increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity. This is due to “administrative capacity limitations in the Greek government” which is a diplomatic way of saying that the Greek government can’t pull off the reforms.
- In keeping with experience to date under the program, it is assumed that Greece will take longer to implement structural reforms, and that a longer timeframe is necessary for them to yield “macroeconomic dividends” (i.e., economic growth). They paint a dismal picture as Greece falls into a severe recession.
- Greece won’t raise as much money as projected through privatization of public assets. Through 2020, total privatization proceeds would amount to €46 billion, instead of the €66 billion assumed.
- They assume that Greece will run fiscal surpluses starting in 2013 but note that it requires “sustained and unwavering commitment to fiscal prudence by the Greek authorities.”
- They won’t be able to return to private markets to finance their debt until after 2020. This will require “official financing” (i.e., a bailout from the solvent eurozone members) of €252 billion through 2020.
- They are very concerned that Greece will not meet these targets because their economy and government is not robust enough to withstand economic shocks (low growth, high interest rates), thus throwing off the entire projection on which the bailout is based. If this occurs, then Greece may not be able to go back to the markets to refinance its debt until 2027.
- In order for Greece to have “sustainable” debt levels, the following needs to happen:
- Generous official support (up to €440 billion under the worst case scenario), and
- At least a 50% haircut to their debt, which requires cooperation from its private bank creditors. This would get Greece down to a debt level of 120% of GDP by 2020. Under the worst case scenarios, they see the debt level rising to 208% of GDP.
- Another requirement is €30 billion of support for creditor banks to recapitalize.
As you can see, these policy conclusions are based on assumptions that someone in the IMF just made up (they understand this). Like all projections, especially ones going out more than a few years, they are fictions and are impossible to verify or have any confidence in. Yet, if you look at these assumptions, this is what the Summit participants are basing their agreement on.
Here is what happened Wednesday at the Summit.
The whole deal revolves around the European Financial Stabilization Facility (EFSF). This is the entity that will issue bonds over-guaranteed by EMU members. The facility can issue up to €440 of bonds secured by €780 of EMU member sovereign guarantees (+65% over guarantee). These bonds will be issued in exchange for the Greek bonds (which are, in effect, in default). They will also be used to back the bonds of Spain, Italy, Portugal and perhaps others.
In order to get all member guarantors in line, the deal had to include bond creditors taking a 50% hit.
The private bank creditors were never really happy about this. It does several things to them (not the least is an earnings hit), but mainly it reduces their Tier 1 capital—any EMU sovereign bond may be counted as Tier 1 capital at face value no matter what the market value is. By taking a 50% haircut, they would need to boost their core capital.
Late, late Wednesday night in direct talks with Merkel, Sarkozy, and the IMF’s LaGarde, the chief negotiator for the Institute for International Finance, the bankers’ lobbying entity, reached an agreement with the group. In exchange they got several assurances. One of them is that they would get €30 billion of “official funding” to help stabilize their Tier 1 capital. One estimate says they need €106 billion of additional capital (two-thirds of which is related to Greece, Spain and Italy). They will be required to have a 9% Tier 1 capital ratio by July, 2012. They also got assurances from their respective governments that they would not be allowed to fail. Remember that they have also financed other sovereigns on the brink. It was literally a game of chicken and they blinked when threatened with Greek default which could spread to other sovereigns whose debt they hold.
For the Greeks, they get a temporary reprieve and a total of €130 billion of additional funds (up from €109 billion). They are supposed to reduce debt to 120% of GDP by 2020 (per the IMF assessment) and carry out structural reforms. 120%!
Here is the problem: they all know that the €440 billion won’t be enough. So the French are out raising money from non-EMU members with the hope they can increase the fund from €780 to €1 trillion. Thus their trip to China to beg Hu Jintao for money. The Chinese are experiencing a kind of schadenfreude over this whole thing, secretly enjoying their new power role in international finance as the Europeans go hat in hand to them for contributions for the EFSF. They have said they will contribute but they have also said they want their kilo of flesh: stop complaining about the Chinese currency exchange rates. Fair enough since they fear that it will be perceived as a bailout of the West and that won’t be popular with Chinese citizens. They are entirely correct in that assessment.
The bottom line is that the Europeans are piling debt on top of debt except that the new bonds will be paid on demand with the sovereign guarantees of EFSF. This is not popular with German and French taxpayers since they will account for almost 50% (48.51%) of the Facility. Add in Italy’s 18% and these three countries are on the hook for a potential €530 billion.
You can be assured that ultimately some part of this will be monetized by the ECB. Presently they have bought €169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August. This little detail wasn’t mentioned in the Summit statement. Yesterday, Trichet’s ECB successor, Italy’s Mario Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.” Which means they will print if needed.
I have little faith in Papandreou’s socialist PASOK government’s ability to adhere to the agreement. (See “Greece: The Problem With Socialism.”) I feel it may be one, if not THE, stumbling block in this whole eurozone mess. Greece will be dragged down perhaps for a decade or more because I don’t see them instituting the necessary free market reforms that will spur future growth. I also don’t believe it will be easy to dismantle the elaborate social welfare system there without political unrest. I wonder if not only the Papandreou will last long, but if a democratic form of government in Greece will last long.
And Greece is not the only problem. Spain and Italy are large economies and face similar problems, just not quite the scale of Greece’s. It all comes down to their ability to fund their excessive debt. Even France is being warned about its credit rating.
The EMU is built on a weak foundation. They allowed in countries that according to the Maastricht Treaty were not supposed to run deficits of more than 3% of GDP, yet they all did, even Germany. They allowed their members to spend and borrow without regard to economic reality and now the money has run out. At some point one wonders if Germany will be outvoted and they elect to bail out debt through inflation by printing money.
It’s a mess and it’s not over.
This article originally appeared on the Daily Capitalist.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.