By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
The most recent summit failed to meet even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions. This summit follows the 21 July 2011 declaration of a definitive grand plan to solve the problem. Like the ones before it, the 26 October meeting yielded a plan to have a plan to have a plan etc. There’s no reason to believe that this summit will be the last.
The actions need to try to stabilise the European debt crisis are well recognised. Countries like Greece need to restructure its debt to reduce the amount owed – an euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilised by injecting new capital and ensuring access to funding to avoid insolvency. A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.
Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.
Greece has an unsustainable level of debt. The only way that the country’s solvency can be restored is by writing off a portion of this debt. On 27 October 2011, the Institute of International Finance (“IIF”), on behalf of the banks and investors holding Greek bonds, agreed to a 50% haircut.
At best, the reduction of Euro 100 billion is less than 30% of outstanding debt, as only private investors were covered. Greek bonds held by official institutions such as the ECB are excluded, to avoid embarrassingly large losses for the European Central Bank (“ECB”), which would then require an injection of capital into the institution.
Without the write-down, a leaked assessment by the”Troika” (The European Union (“EU”), ECB and International Monetary Fund (“IMF”)) indicated that a 50% haircut reduces debt to 120% of GDP and funding requirements to Euro 114 billion through 2020. These forecasts are optimistic, assuming a return to growth by 2013.
While the write-downs were needed, it is unclear whether the quantum is sufficient and whether Greece’s residual debt burden is sustainable. A debt to GDP ratio of around 60-80% may be more realistic. This would require further write-downs. History suggests that a write-down of debt for distressed borrowers is frequently followed by others.
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The EU, to date, has carefully confined discussions about debt restructuring to Greece. The attention of financial markets will inevitably turn to Ireland and Portugal.
Ireland’s economy is improving with growth projections having been recently revised upwards. The country has implemented an aggressive austerity package, entailing tax and spending cuts equivalent to 20% of the country’s GDP (around Euro 30 billion) over a 7 year period. Government finances have improved with the budget deficit likely to shrink to a still very large 10% of GDP, from 32% in 2010, with a target of 3% by 2015. Government debt is now expected to peak at around 120-125% of GDP in 2013.
The improvements in the economy have come at a cost. Output has shrunk by nearly 20%, unemployment is 14% and house prices have fallen 43%. Bailouts of Irish banks have cost around Euro 85 billion to date.
With domestic demand flat at best, Ireland is dependent on exports. The deteriorating global environment is a major risk, with the potential to reduce growth and making it harder to meet budget and debt targets prescribed by the bailout package. The need for further capital injections into the banks as the property market continues to weaken cannot be ruled out.
Portugal is in the midst of its deepest recession for 30 years, with the economy contracting by 5% this year. Unemployment is over 13%. Promised structural reforms are proving difficult to implement. A return to growth by 2013 looks ambitious.
Despite measures, such as a 27% cut to public sector pay, hidden debts of Euro 3.4 billion, including Euro 1.1 billion on the island of Madeira, have undermined efforts to regain control of public finances. The budget deficit this year will be around 7%. A reduction of Portugal’s credit rating to “junk” or non-investment grade has also increased its cost of funds.
The Greek write-downs may create speculation for Ireland and Portugal to follow suit, especially if economic condition deteriorate.
The EU plans calls for Euro 106 billion in recapitalisation of European banks, primarily to cover losses on holdings of sovereign debt such as Greece, by June 2012. The amount is at the low end of what is required. The amount of recapitalisation focuses on losses from holding of Greek bonds. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalisation is around Euro 200-250 billion.
In total, global banks have exposures around $2.2 trillion to Portuguese, Irish, Italian, Greek and Spanish debt. The exposure of German and French banks to troubled European countries is around $1 trillion.
According to the European Banking Authority stress tests conducted in July 2011, the 90 largest European banks have exposure to Greece of Euro 90 billion. These European banks have larger exposures to Spain (Euro 287 billion) and Italy (Euro 326 billion) as well as to France (Euro 215 billion). These banks also have large exposures to private sector debt in these countries, which would be affected by problems of the sovereign. For example, French banks hold around Euro 400 billion of Italian private debt.
In addition, the recapitalisation does not take into account “second order” effects. The write-offs, covering the cost of recapitalisation and the general de-leveraging (reduction in debt) is likely to reduce economic growth resulting in increasing credit losses that must be covered. This may increase the required recapitalisation by another Euro 100 billion bringing the total to Euro 300-350 billion.
It is not clear where the additional capital is coming from. Banks must try to raise the capital privately through equity raising or restructuring and conversion of existing instruments into equity. Banks should also reduce dividends and bonus payments to improve their capital position. If this is insufficient or unsuccessful, national governments are required to provide support. Recapitalisation funded via a loan from the European Financial Stability Fund (“EFSF”), the European bailout fund, is the last resort.
Reluctant to dilute existing shareholders, some large banks may choose to sell assets and stop new lending to meet capital targets. The EU and national regulators will prevent excessive “deleveraging” to ensure adequate flow of credit flow to the real economy to avoid slowing down growth. As much as $2 trillion of assets may be sold as part of the program to reach the new capital levels with an unknown effect of economic activity.
European banks, especially banks in weaker countries, have faced significant difficulties in raising long term money from financial markets to fund their activities. The EU proposal wants banks to reduce reliance on short-term funds but offers no concrete proposals, at this stage, for actions to improve the ability of banks to raise term money. If the states provide guarantees to support the banks, then this would affect the credit quality of the sovereign and increase its potential financial obligations.
An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis.
The EFSF will provide loans to or purchase bonds in order to support market access for Euro-Zone Member States faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency.
After accounting for existing commitments to Greece, Ireland and Portugal, the fund’s available capacity is around Euro 200-250 billion. If it has to finance recapitalisation of banks in member states, then this capacity is further reduced.
The EFSF does not have adequate resources to perform its functions. The amount available can be compared to the financing requirements of beleaguered European countries.
In the period to the end of 2013, Ireland, Portugal, Spain, Italy and Belgium will need to raise about Euro 700 billion to finance their deficits and refinance maturing debt. In 2012, Spain faces maturing debt of around Euro 120 billion. Italy has debt maturities in 2012 of Euro 260 billion and another Euro 150 billion in 2013. Crucially, Italy faces debt maturities of around Euro 40 billion in February 2012.
Italy’s total debt is Euro 1.9 trillion (118% of GDP), the fourth-largest debt in the world after the United States, Japan and Germany. Spain’s total debt is above Euro 600 billion (61% of GDP).
In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund.
The EU proposes provision of credit enhancement to new debt issued by member states to reduce its funding costs. In the absence of details, it is widely assumed that this will entail the EFSF guaranteeing a certain percentage of the first losses on new bonds. Promoted by German insurer Allianz, the plan would entail investors in say Ireland, Portugal, Italy and Spain being protected against losses on bond holdings, up to an unconfirmed amount of around 20%.
The plan raises several issues:
1. The bondholders would still look to the issuer and assess its solvency and ability to meet its obligations.
2. If losses turn out to be above the insured first loss amount then the investor would be at risk. Losses on sovereign bonds are variable and difficult to predict.
3. Technical details such as the trigger of the payment, the loss determination and payment mechanism are complex.
4. The insurance would apply to new issues and may create a two-tier market – one for existing bonds and another for the new insured securities.
5. This risk insurance would be offered to private investors as an option when buying bonds in the primary market for a price. There are uncertainties about the price. It is also not clear that it would be preferable to alternatives already commercially available such as CDS.
6. The legal impact of such insurance on legal provisions of existing bonds, such as the negative pledge and pari passu clause which prevents the borrower from pledging its assets to prefer a particular group of creditors or change the ranking of investors.
To address some of these problems, the EU has proposed the issue of detachable insurance certificates that can be freely traded which would be available with new bonds. The price of this insurance would be reflected in the lower interest rates on such bonds. Following a default event, the certificate would entitle the holder to claim their entitlement for the loss suffered not in cash but in EFSF bonds.
In the absence of full details, it is difficult to assess the arrangements. Their complexity may create uncertainty.
The structure introduces unnecessary problems. If the certificates are regarded as derivative contracts then many investors may not be able to purchase them. The accounting treatment of these certificates, vital to ensuring protection against losses in financial statements, is uncertain. The structure also introduces exposure to the credit standing of the EFSF itself as the insurer.
It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy.
The enhanced EFSF plan does not address fundamental problems of its structure. The EFSF in severally guaranteed by Euro-Zone member states (up to a stated amount). Major guarantors are Germany 29.07%, France 21.83%, Italy 19.18%, Spain 12.75%, Netherlands 6.12% and Belgium 3.75%. Given that Italy and Spain as well as others may need to avail themselves of the assistance of the EFSF, the circular nature of the scheme remains an issue with weakened nations undertaking to rescue themselves and their banks.
What’s Chinese for Begging Bowl…
A second option proposed is to enhance the EFSF using resources from private and public financial institutions and investors through Special Purpose Vehicles (“SPV”). Few details are available currently.
The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the funds capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralised debt obligations (“CDOs”) and Structured Investment Vehicles (“SIVs”).
Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.
China has considerable “skin in this game”. Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in Euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.
The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. China’s officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.
China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.
But China seems desperate to be seen as a “global power”. Ego might seduce them into committing more money.
Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around Euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.
Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.
The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.
The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.
Time will determine whether the plan creates “confidence” or is just a “con”. Promoters of the first loss guarantee scheme seem to believe that just providing it will solve the crisis and the commitment will not be drawn upon. When the EFSF was originally instituted, EU policymakers also thought it would never be needed to be activated.