November 7th, 2011
in Op Ed
by Jon Chait
With great drama, the EU announced a package of measures designed to end the current fiscal crisis sweeping Europe. Most economists polled are cautious as to whether the plan will work. As with everything with the EU, it is one step forward and......simply hard to say whether it is also a step back.
(1) The Barber Shop
A "voluntary haircut" on Greek debt held by banks (but not the debt held by the ECB) of 50%. This seems rational, but the irrational part is that it was accompanied by a statement that the Greek debt is to reach a level of 120% of GDP by 2020!!!. Of course, 2020 is a long time, which implies that the Greek debt load is way out of balance today and benchmarks long in the future have a tendency to get diluted over time when the spotlight moves away. This latter term is highly speculative for reasons I have discussed previously. Simply restated: the cut in Greek spending is so large as to imply a massive cultural change, not just a tinkering with the Budget. This cultural change must be unprecedented in the annals of economic history; at least since the hyper-inflation of the 1930s.
Also, there is no real discussion of how much money Greece, Italy, or Spain, will need in the short term or how it will be financed. But see below. Finally, this deal is "voluntary" only as it relates to large Euro banks (who will be forced to accept the deal) and will not be considered a default under the terms of standard CDS instruments. What about the other holders: hedge funds and non-Euro investors? They might not be so accommodating.
(2) The Big Lever
The EFSF fund is going to be leveraged "4 to 5x" and will reach $1.4T. First, we don't actually know how big the Fund is today, but assuming the math is right, it implies that the fund is down to something around $300B from €440B . Second, it is a bit of a mystery how this leveraging is going to take place. If outside lenders/investors don't join, isn't this just going to lead back to France and Germany who effectively guaranty the bonds of the EFSF today? On what terms will outsiders lend or invest? Will the Chinese or IMF make an investment with any risk of loss, or will they, particularly the Chinese, require concessions or other quid pro quo? Doesn't this lead right back to France and Germany being the funders of last resort? (Italy and Spain don't have the cash, and the others are too small to matter). The EFSF will have two roles apparently: (a) to provide funds to bailout EU governments; and (b) to purchase Sovereign bonds in the market.
But even $1.4T doesn't go very far. Apparently, the bond purchases are designed to hold bond rates down, and provide financing of a last resort to the beleaguered sovereigns (e.g., Greece); but this reminds me of currency intervention and we all know how well that has worked. Also, is the ESEF willing to take a loss on the bonds that it purchases? Apparently not; which makes it is a sort of Ponzi scheme in which the EFSF buys bonds and then lends money to the sovereigns to pay the interest on the bonds just purchased. If outside investors in the EFSF are going to be guaranteed against loss to some extent, isn't this leveraging merely creating a contingent liability of France and Germany--as the largest countries in the Eurozone? Whew.
(3) Capital Required for Banks and Sovereigns
Banks will be forced to raise capital by June 2012 to bring capital ratios to 9%. Apparently, in addition to discounting Greek debt by 50%, the banks must discount Spanish Debt by 3%. I haven't seen anything on Italian debt. This equity will be raised through all sources including cuts in dividends and bonuses, sales of assets, contraction of assets and sales of equity with the sovereigns, not the ESEF, being the investors of last resort. Since the French banks are rumored to have the largest problems, doesn't this lead back to France and their vulnerable AAA rating. Or will this become basically the "mother of all sales" on French bank equity? Economists have been critical of the capital requirement because they see it as highly contractionary--at a time of Euro recession.
Keep Kicking the Can
You have to ask the question: Why all the machinations? Why not just the obvious simple solution? Well, of course, the Germans are trying to limit their exposure and save Merkel's government, and the French are trying to save their AAA rating and Sarkozy's career. At the same time, EU leaders know that they have to provide a "shock and awe" blast to the markets to cool the fear of contagion. Again, we are short on the "details". Probably, this plan will work, with periodic agony, over a period of time; but we have just lived through one Black Swan event, and now we remain vulnerable to another. "Kicking the can down the road" has become the fiscal strategy of choice outside of the UK.
Notes on European and USA Bank Exposures by Elliott Morss
The Dance of the Weak Sisters – Part 2 by Elliott Morss
EU: The Pitfalls of official First-loss Bond Insurance by Daniel Gros
Greece: The Sudden Stop that Wasn’t by Aaron Tornell and Frank Westerman
analysis and opinion.
analysis and opinion.
analysis and opinion.
About the Author
Jon Chait is a retired CEO of Hudson Highland Group, Inc, a global recruitment and talent management company. He has held senior executive positions in global companies for the last 20 years.