The market is moving up on the back of a quite substantive eurozone deal but, as our inboxes suggest, this is seen as more sticking-plaster than panacea. Essentially, it’s a case of low expectations being surpassed.
The main change is that Spain’s bailout loans won’t have (explicit) seniority status and that bailout funds will (eventually) be injected directly into teetering Spanish financial institutions, meaning Madrid can sweep the burden of the bailouts off its sovereign books. It also looks like rescue funds will also be used to stabilise bond markets.
There is a suggestion that Ireland will be considered for similar treatment — although there is no explicit mention of retrospection. From the Eurogroup statement:
The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.
And Italy got some of the benefit too. From the FT again:
The summit agreement also contained some concessions for Italy, though less than for Spain, setting the stage for Rome to become the sixth eurozone country to request EU assistance as part of the eurozone debt crisis.
But any shift to more flexible bailout funds won’t be put in place until there is a eurozone-wide banking supervision authority in place:
When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly.
And as Angela Merkel said this morning, countries will be obliged to fulfill conditions for bond-buying programmes that the Troika will have to check. There will also be conditions for direct bank recapitalisations. Not a speedy process.
And so, like oft-jilted lovers, most of the analysts are staying bearish. Nomura’s Desmond Supple and Guy Mandy got specific with their concerns:
We have already analysed the possible uses of the EFSF/ESM, and highlight three key problems.
1) The EFSF cannot fund itself in sufficient size in the market. Moreover, for the EFSF to access the ECB, it would require an EU treaty change that would enable it to become a bank. The structure of the ESM is more conducive to it being able to fund in the market, but we similarly doubt that it can issue in the size and at a pace that is required. For the ESM to be relevant as a eurozone TARP or a bond buying entity it will realistically need to be converted into a bank and leverage itself via the ECB. This is not being discussed at present and we believe it is currently a step too far for the ECB at this stage.
2) Even if we assume that the ESM can fund itself, another problem is that the seniority of the ESM in bond buying has not been removed. Subordination of investors by a bail-out entity does not matter if the scale of buying is so large that it represents a solution to a crisis. That is not the case with the ESM as we discuss below.
3) The EFSF/ ESM is sub-scale. The EFSF has around EUR240bn in usable funds, and the ESM has a ceiling of EUR500bn. Raising the ESM ceiling is problematic in that it represents a direct potential fiscal liability for eurozone sovereigns, whereas the ECB balance sheet does not since there is no legal requirement for the ECB to be recapitalised if it suffers losses. The ESM is of sufficient size to represent a TARP, but is far below what is required to be a bond buying entity that could alter the asymmetry of risk facing investors. At its current size it would merely – like the SMP – provide an exit route for investors. This is why we have been highlighting that the ESM – if it receives funding from the ECB – could be valuable as a TARP but would not be effective as a bond buying entity, and could even be negative if its seniority on bond holdings was not addressed.
A practical consideration is that the ESM is unlikely to be ready as planned for 9 July. Italy has suggested it may not ratify the ESM until after the summer recess of parliament.
Given these factors, the announcements regarding the EFSF/ESM do not meaningfully improve the policy response to the crisis.
From Marc Ostwald at Monument Securites:
While there may be some temporary sense of relief that the summit has not descended in to acrimonious discord, what has been thus far agreed is nothing more than sticking plaster. One presumes that the agreement to allow the ESM to buy govt debt effectively puts the ECB’s SMP programme to bed, though what happens with its existing holdings may be a point for some debate. There will of course be plenty who point out that the EFSF/ESM simply does not have enough capacity to buy Italian and Spanish debt indefinitely, let alone directly recapitalize Eurozone banks. The dissent within Merkel’s CDU has already been voiced by one arch critic of the ESM, Wolfgang Bosbach, who has said: “If the ESM is approved today” in Germany’s two chambers of parliament (as has been agreed), “the currency union widens to become a liability union.” Bosbach also said: “The liability union will become a transfer union” because euro members will continue to violate deficit rules, he said.
While not unwelcome, we do not see this as a game changer. More importantly, the Summit opened the door for the ESM to recapitalise banks directly. However, this will come only after a single supervisory mechanism is established and the Council has been asked to consider proposals by the end of 2012 (as a matter of urgency). For markets, this timeframe will seem very long and while direct bank recapitalisation is welcome, we see this as a sentiment boost and not a game changer.
… we remain concerned that the EFSF/ESM will be seen as lacking in both efficiency and size to offer credible support to Spain and/or Italy if requested. Attention is thus likely to turn again to the ECB
From HSBC (who were slightly more positive):
The problem, once again, for the market will be one of extent. The temptation will be to fade this risk-rally as the challenges the Eurozone faces remain many and substantial. Optimism in the EUR has been a fragile commodity. If this latest EUR rally does reverse quickly, EUR bears will feel especially invigorated as its failure to hold onto gains even after demonstrably goodnews would suggest little underlying enthusiasm for the single currency.
However, it is important to remember that the EUR is beginning to see some better news for a change – first the Greek election outcome and now a more productive EU leaders’ summit. Some of the tail risks surrounding the currency have been substantially reduced of late, and the ability to get agreement on some contentious aspects of policy is encouraging.
And from Charles Diebel at Lloyds:
These are all positive steps but equally remain subject to numerous risks in terms of implementation and likewise we as yet to not have a clear outline on how peripheral bond markets will benefit from direct support in the near term. There is a broad brush statement that the EFSF/ESM will stabilise markets but given current yield levels we will need to see more direct support and a significant ratcheting lower in yields for the issue of insolvency to be ameliorated.
Also we did not get any comment on whether the ESM will get a banking licence as while primary buying of Italian and Spanish debt would help, the issue of firepower is sure to be raised once again given many of the ‘solutions’ announced are very long term in nature.
The risk on theme should be sustained in the near term but while there are a number of positive developments, the time scale and unresolved issues have not gone away and thereby we would not expect too much. Equally the focus will now shift to the ECB who are likely to put in place more accommodation at their next meeting (this may lessen the positive EUR risk on theme to an extent). This, combined with some direct bond market support could generate a more sustained risk on in coming weeks but do not underestimate the scale and time frames involved. The outcome of the summit is positive but is in reality just one more step along a very long road for a solution to the crisis.
On to day two of the summit then…