There might have been nothing concrete from the IMF meeting in Washington over the weekend, but the outline of a plan to rescue the Eurozone and its banks was sketched out.
– There would be a haircut or writedown of Greek sovereign debt of 50 per cent. The country would also stay in the eurozone.
– A plan to recapitalise Europe’s banks
– And most intriguingly, a proposal to increase the size of the €440bn European financial stability facility (EFSF) by linking up with the ECB. One proposal is that the EFSF will backstop 20 per cent of any losses that the ECB makes on its purchases, to provide some €2,200bn of firepower. Now that’s a lot ammo.
Easier said than done of course. And critically it all boils down whether Germany and EU law allow the ECB to effectively finance budgets, says Harvinder Sian of RBS.
And he for one is sceptical.
If the EFSF is indeed leveraged via the ECB then this is highly positive for the periphery as the firepower for the periphery would be large and close to the EUR 2 tn we thought would be necessary (see, Euro area faces breakpoint). It would allow the EFSF-ECB combo to easily fund Spain and Italy, where we expect bond issuance to total EUR 1.2 tn between 2012 to end 2015, leaving enough for bank support too.
Conversely, a leveraged EFSF will be dangerous for AAA governments given the clear risk sharing across the region, a point made by S&P over the weekend. It is feasible that both Germany & France are downgraded on the back of this contingent liability and the evolving burden sharing.
Europe has been given a deadline of 6-weeks to get to some solution and in the near term, we expect noise as Europe scratches around for feasible was to raise firepower. In this period, there is risk of a negative skew to the political rhetoric because of the legal obstacles and political tensions with for example the CDU/CSU in Germany not likely to take well to ideas that the ECB is becoming Europe’s bad bank.
As such, we have more doubts than the market in whether the EFSF can indeed use the ECB balance sheet on both these legal & political factors.
There is also an evolving story here that the market needs to monitor. That is, the idea that the ESM can be brought forward to provide additional firepower and probably as an alternative for EFSF-ECB lending. This was the tone of Merkel comments on German TV over the weekend where she outlined that state insolvency can not be ruled out.
If this is the likely course of developments then it is a clear negative for BTP and SPGB holders. Recall that the ESM will still be a senior creditor in loans to non programme countries. (The ESM Treaty says “in the unlikely event of ESM financial assistance following a European financial assistance programme at the time of the signature of this Treaty, ESM will enjoy the same seniority as all other loans and obligations of the beneficiary ESM Member, with exception of the IMF loans.”)
That means, if the ESM is buying BTPs & SPGB or lending directly to non programme countries; then current issuance becomes de-facto junior. It then gets tougher to see a neat exit for a sovereign given that future junior debt issuance (with CACs) means that its fundamentals (debt sustainability, financial stability, political stability, absence of contagion etc) need to be rock solid, and this if feasible, will probably take a couple of electoral cycle. In other words, any emerging view that the ESM will be to the fore of the rescue carries huge stability risks for the region.
Some excellent points in there, particularly on the ESM and the ratings downgrade threat.
Sian reckons markets will remain volatile until the G20 meeting in Cannes in six weeks time.
The idea that Europe is getting ahead of the crisis is premature and in the near term subject to the usual doses of conflicting messages from EU leaders. If the EFSF-ECB link is seen then it kicks the can way down the road and is periphery positive and core EGB negative (including the ratings threat). It will increase political tensions in any case. Hope on the EFSF-ECB will ebb-and-flow until the next G20 and means a dramatic deterioration in risk assets is unlikely but any stabilisation will quickly give way if the ESM becomes a more likely way of getting added firepower. We continue to be negative on the periphery (so still like Bunds) and will adjust the view only if the EFSF-ECB rescue becomes more likely.
In other words, expect more of the same.