After many hours of burning the midnight oil’, eurozone leaders produced in the early hours of October 27 the widely demanded comprehensive plan to save the euro. The Economist (October 29) reported that one weary negotiator told questioning diplomats that ’We think we have an agreement, but we are not sure what it is’. By their own admission, eurozone leaders have struggled in understanding the complex financial engineering within this plan that they were asked to approve in order to give it the needed ‘fire power’ to solve the crisis.
This is the third ‘comprehensive solution’ so far for solving the eurozone crisis. It is certainly complex and many questions still need to be answered. Many details are missing and the plan appears vulnerable under possible stress scenarios. As a result, this latest plan is unconvincing as the needed ‘big solution’ to the eurozone crisis. This third ‘package’, then, is unlikely to be the last one. It is certainly better than many hoped for just a week or so ago, but it is unlikely to convince the markets that the eurozone crisis is over.
The plan is in three connected parts. First, a reduction of 50% in Greece’s debt via a ‘voluntary’ agreement with private creditors. Second, a recapitalisation of around E106bn ($146bn) of Europe’s banks to help them absorb Greek debt write offs and other debt losses. Third, expanding the scope of the European Financial Stability Facility (EFSF), the bail-out fund for the eurozone, to E1trillion. Expanding this latter firewall is vital to protect other vulnerable and bigger eurozone countries (especially Italy) from possible contagion (panic) risk.
It is positive step that this plan recognises the reality that Greek debt had to be written down by 50 %. A potential problem is whether and to what extent payouts are now triggered on credit-default swaps (CDSs). CDSs are kinds of insurance contracts against default on government bonds. Both governments and the ECB (European Central Bank) are determined that such payouts will not be triggered. The question here is whether losing 50% of the face value on a Greek bond constitutes a default (and, therefore, triggers CDS payouts)?
Even If the answer is ‘no’ this time and CDS payouts are avoided, this could have unintended consequences. For example, investors as a result may seek other ways to reduce such risks in the future – for example, by demanding higher yields and/or reducing their risk exposures. These latter moves could then push up the borrowing costs of other countries. The July 2011 proposals for writing down Greek debts (by less than half the present proposals) were followed in August by investors dumping Spanish and Italian government bonds.
So the proposed write down of Greek debt carries with it the threat of potential contagion and the banking system is a possible channel for such risks. As a result, the second plank of the new plan had to be a recapitalisation of all Europe’s (not just the eurozone) banks.
The new 9% bank capital ratio will be computed after re-valuing the banks’ government bond portfolios at market prices. This means write downs on Spanish and Italian bonds, whilst German and British bonds will be re-valued upwards. Such a move shifts the burden of additional capital- raising on to Spanish and Italian banks. The Economist (October 29) also suggests that ‘the criteria are suspiciously kind to France’ by using a September 30 date in the bond valuations when French bonds were still earning a lower yield (and were, therefore, at a higher market value). The Economist also expressed concern that the new capital ratio does not use a stress test that simulates the banks ability to meet an economic recession at a time when Europe’s economy is faltering.
The banks have nine months to meet the new capital standards. Since the appetite for bank stocks is not likely to be high in the current and developing scenario, the banks are expected to meet the new standards through measures like cutting back on dividends, bonuses and pay. There is also a real danger that many banks will seek to meet the new targets by shrinking their balance sheets and reducing lending to vulnerable but important sectors like small businesses. They may also try to sell off other government bonds (like those of peripheral countries), thereby adding to the problems of Spain and Italy in selling their government bonds.
A fundamental problem is restoring market confidence in government bonds. This underscores the importance of the third plank of the plan – building up the EFSF as a ‘firewall’ to help protect vulnerable countries. The problem is that the proposed EFSF as it stands is simply not big enough to protect the bigger counties (like Italy and Spain). The solution to this dilemma is to use the new funding as leverage in financial engineering solutions that are designed to expand the fund’s capacity.
The proposed financial engineering schemes can be complex and risky themselves. They involve the kinds of instruments (called Special Purpose Vehicles [SPVs] and Collateralised Debt Obligations [CDOs]) that helped fuel the build up to the last (2008) global crisis. A preferred solution within the plan appears to be to use the EFSF to insure (or ‘credit enhance’, that is improve the creditworthiness) government bonds – for example, by agreeing to take the first 20% of any losses.
This kind of ‘credit enhancement’ role could be used to support, or ‘lever up’, a higher volume of government debt. Using this kind of ‘model’, SPVs could be set up to attract in private investors, sovereign -wealth funds and foreign countries (like China) to invest in the bonds of struggling eurozone countries.
The new eurozone rescue plan, then, is complex, not clear on many key details and could have several unintended consequences. It also is a reminder that the eurozone countries alone (even with mighty Germany) do not have the resources to stave off a full-scale contagion that brought in major countries like Italy, Spain and/or France. For the present, though, this latter scenario is a nightmare one. The immediate and overriding aim was to convince the markets that this new plan could work to contain the eurozone crisis and help put eurozone economies in trouble back on to a sustainable recovery path. On present showing, it has not done this.
Italy’s borrowing costs (despite intervention on the open market by the European Central Bank) rose to record eurozone-era highs a day after the new plan was announced. Many now see Italy as being a decisive factor in how the eurozone crisis plays out. At the same time, Spanish unemployment has jumped to a record high in the past fifteen years. The Belgian economy has also slowed down significantly in the third quarter.
European officials have turned to China and Japan to provide needed additional funding for the new, increased bail-out fund. The eurozone is China’s biggest trading partner. Support from China is likely to have significant costs and conditions attached; Chinese negotiators have already made a series of economic and political demands. At the same time, there is growing concern in the Far East about possible contagion from the eurozone spreading to the Asian economies.
The Greek shock proposal for a referendum on the proposed eurozone rescue package has been greeted with dismay. The potential here is catastrophic for the latest eurozone plan. A ‘no’ vote could produce disorderly default on Greek debt and Greece’s exit from the euro. On present showing, over 50% of Greek voters believe that the new plan is not positive for Greece.
The new plan, then, has failed to encourage markets not to bet against the eurozone. It is a step in the right direction, but it is not enough. This means that there will be at least one more such plan and continuing uncertainties. It also means that the eventual resolution costs of the crisis will inevitably rise. In the meantime, the shock Greek referendum may be the trigger for either the markets or the eurozone politicians to act decisively.
It is to be hoped that the forthcoming Cannes G20 summit in November can finally help the eurozone politicians to nail down a convincing and sustainable solution. If this does not happen, the markets could force the issue. This will be painful, costly and the outcomes uncertain.
Professor Ted Gardener
