Wednesday, October 19, 2011

Assessing the probable eurozone Grand Plan

As the financial world waits the results of Sunday's yet-another-euro-summit, there have been enough leaks and trial balloons that we know the approximate shape of the approximate shape of the plan. So let me look at the anticipated Grand Plan to assess it in the context of the framework that I had outlined earlier in the week.

The "Grand Plan"
Here is my draft of the "Grand Plan".

Preamble: We are committed to keeping the eurozone together. Greece is a special case and we will take steps to alleviate the pressures on Greece and other peripheral countries in order to put them on sustainable path to growth. At the same time, we will undertake steps to ring-fence the financial problems stemming from Greece so that the financial contagion does not spread to other member states. With that in mind, we will implement the following five point plan.
  1. The EFSF will become a bond insurance program, insuring the first 20% of the debt of any eurozone member that wishes to participate in the program. Member states that wish to use EFSF insurance will pay a fee of X% to the EFSF for that privilege. Thus, the capacity of the EFSF will expand from €440 billion to €2.2 trillion.
  2. We will offer any holder of Greek bonds a voluntary exchange: Take a 50% haircut on your paper and in return you will get an EFSF insured Greek bond of some long maturity.
  3. European banks will be required to re-capitalize to 9% of Tier 1 capital. Banks are urged to seek private sector solutions to recapitalize to the target ratios, but those that cannot will be offered equity injections from member states (i.e. the German solution).
  4. A Tobin tax will be imposed on financial transactions, either in the EU or the eurozone, in order to finance this scheme.
  5. The ECB stands ready to provide any level of liquidity to the banking system. Banks can go to the ECB for unlimited loans, collateralized by the "qualifying debt" issued by member states. The ECB continues to be mindful of its anti-inflation mandate and opposes any form of quantitative easing.

Market disappointment
If that is indeed the Plan, then it will be hugely disappointing to the market. While the €2.2 trillion figure is large enough to shock and awe the market, many of its other features of are problematical.

Let's go through them one by one.

EFSF insurance: The devil in the details
First of all, the EFSF insurance program is likely to burden France to such a degree that it will likely lose its coveted AAA credit rating. Moody's is already watching France closely (and not in a good way). Here is Ambrose Evans-Pritchard of the Telegraph:
Professor Ansgar Belke, from Berlin's DIW Institute, said any leveraging of the EFSF would be "poisonous" for France’s AAA rating and would set off an uncontrollable chain of events.

"It counteracts all efforts made so far to stabilize the eurozone debt crisis, which are premised on the AAA rating of a sufficiently large number of strong economies. In extremis, it would probably cause the break-up of the eurozone", he told Handlesblatt.

France is already vulnerable. It has the worst budget deficit and primary deficit of the AAA states in Euroland. (Yes, Britain is worse, but the UK has a sovereign currency and central bank. Chalk and cheese.)

Dr Belke said France is already under pressure. BNP Paribas, Société Générale, Crédit Agricole may need €20bn in fresh capital, with knock-on risk for the French state. He warned that France’s public debt (Now 82pc of GDP) would shoot up to 90pc of GDP if the debt crisis rumbles on. Variants of this theme were picked up by other German economists in a Handelsblatt forum.
Constantin Gurdgiev, who is the head of research at St. Columbanus AG, points that, in addition to a number of structural problems with an EFSF insurance program, there are unintended consequences [emphasis added]:
(1) How on earth can EFSF guarantees resolve the main problem faced by over-indebted nations, namely the problem of unsustainable debts?
(2) If the EFSF were to remain a €440-billion fund, how can that amount be sufficient to provide already committed sovereign financing backstop through 2015-2017, supply banks’ recapitalization funds, provide additional backstop funds for current (Greece, Ireland and Portugal) and potential future (Italy, Spain and possibly Belgium and France) borrowers, while underwriting a new tranche of CDS-style insurance on bonds? Especially since such EFSF insurance contracts will have to cover ALL of the debt issuance by the distressed sovereigns. Assigning only partial (by stressed maturities or specific issues) cover will risk destabilizing the yield curve on government bonds, inducing additional maturity profile risks.

Who recapitalizes the banks?
Then there's the problem of bank recapitalization. I assume that the German solution will be adopted as individual EU countries will be responsible for recapitalization their own banks. Not all of the banks will be able to get new equity through the private market solution. If they go the full or partial nationalization route , where will the money come from? The funds for the EFSF are already committed. Individual EU members will have to even dig deeper into their own pockets to save their banks.
It will be bad enough for France, which will likely lose its AAA credit rating but survives. What about Cyprus? Or Portugal?
Can you say "contagion"?
The ECB sticks to its anti-inflation mandate
I wrote on Monday that the success of any grand plan will depend on the cooperation of three players:
  1. The EU needs to formulate a credible plan.
  2. The ECB needs to become more pragmatic and embark on quantitative and qualitative easing.
  3. The Greek Street has to agree to any austerity plan.
So far, the ECB has been silent on the plan and does not appear to want to bend on quantitative easing. It is unclear whether they will even cooperate on the issue of qualitative easing. Suppose a European bank that is facing a bank run goes to the ECB and asks for a loan under their liquidity facility. It then offers as collateral, not Bunds, but Greek, Portuguese or Irish debt. Will the ECB collateralize that 100%?

The failure of the ECB to engage in quantitative easing is a potential disaster. I offered the following scenario:
Can you imagine the Lehman aftermath without the cooperation of the Federal Reserve? The government unveils TARP, TALF and an alphabet soup of programs to rescue the American financial system. The Fed then proceeds to obstruct the rescue by refusing to engage in quantitative easing. Their efforts to supply liquidity to the market is limited to collateralization by Treasury issued securities (and not mortgage backed and other "toxic" paper)? What would have done to credit spreads? What would that have done to inter-bank lending and counterparty risk?

Greek cooperation
Another question is, "Will Greece cooperate?"

The Greek Street is already highly stressed. The BBC reports that Greek suicide rates are skyrocketing as ordinary citizens and small business owners struggle with the fallout from the financial crisis.

Can Greece grow sustainably after the restructuring? I pointed out before that a 50% haircut only amounts to a 22% debt reduction, assuming that the ECB and IMF do not tender to the "voluntary" debt swap. The Irish Times reports that Greece and Portugal are mired in deflationary trap.

Is a 50% haircut enough?

Could the debt crisis spread to Portugal?

These are all good questions to which I have no answer, but I believe that the market will assign a high risk premium to compensate for those events. In such a case, the ring-fence will have failed.

A negative market reaction
Late yesterday, the Guardian reported that France and Germany had agreed on a grand plan, which included an EFSF insurance program and bank recapitalization (what a surprise!), and equities rallied on the news. The story was later denied. I am assuming that, given all the leaks, that the grand plan consists of the elements that I described.

I would say that my projection represents the best case - anything less would mean a more negative reaction. As it is, my draft of the "Grand Plan" doesn't stand up to scrutiny and would likely fall apart within days.

Enough analysis for now. I am now going to curl up in a foetal position and read King Lear, just to cheer up.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


a.t. said...

well, if they introduce a tobin tax on transacion CFD brokers in singapore and switzerland will be delighted.

moremiles said...

Thanks Cam, I was having trouble sleeping.

Macro Rants said...

Cam, hope you don't mind -- I used your post as an inspiration for one on my blog