Markets went mad overnight as they gave the European solution (or at least, the third one in 19 months), the thumbs up. Asian markets rose, European markets surged (some by 5% and 6%) and US markets leap by 3%.
Gold, oil and copper rose as well. It was euphoric as the promise of silver linings and Euro hot air again worked their magic on sentiment.
US markets are on their way to the best October ever.
Dr Shane Oliver, the Chief Economist of AMP Capital Investors says October has seen a strong rebound in share markets driven by a combination of improved data out of the US and signs Europe is heading towards a “comprehensive” response to its sovereign debt crisis.
After some delay, Europe has finally announced a range of measures.
Unfortunately much of the details are yet to be worked out so it looks more like a work in progress than the final solution.
This is the third attempt by Europe to get its debt problems under control.
Dr Oliver asks will it work and what does it all mean for investment markets?
Debt response 3
The key elements of the latest package are as follows:
A 50% haircut for private investors in Greek bonds.
A program to recapitalise banks thought to require around 110bn euros, with banks given till mid 2012 to get core capital ratios up to 9% (after writing sovereign bond holdings down to market levels), after which they have to rely on their governments or lastly the EFSF for funding.
A scaling up in the firepower of the remaining funds in the EFSF (around 200bn euros) to around 1 trillion euros, probably by using it to provide first loss insurance on sovereign bonds and associating it with a special purpose investment vehicle which would buy bonds issued by struggling countries such as Spain and Italy, with funding hopefully coming from non-European sovereign wealth funds, the IMF and private investors.
Will it work?
The latest set of measures go further than those before and should help to head off a near term meltdown.
Europe has accepted the reality that Greece is insolvent (with its debt to GDP ratio projected to grow to 180% of GDP next year) and so it has moved to further reduce Greece’s debt burden and protect banks and other countries in the process.
However, announcing a plan is one thing, but implementing it is another. Europe hasn’t done too well on this front over the last 18 months.
More broadly, it’s doubtful this is the end of the European debt crisis.
First, while the Institute of International Finance has apparently agreed to the “voluntary” 50% write down of Greek debt, actually achieving acceptance from individual banks and financial companies won’t be easy.
It took two months to reach 90% acceptance to the 21% haircut announced on July 21.
Also, one wonders what’s the point of having so-called credit default swap insurance on Greek debt if it won’t pay out on a 50% loss.
Investors might start wondering whether CDS insurance on other investments is equally as useless.
Furthermore, the proposed hair cut is probably not enough because once allowance is made for debt holders who won’t participate in the haircut (such as the IMF) it will only amount to a 25% write down to Greek debt.
Second, it’s doubtful the recapitalisation of European banks thought to cost 110bn euros will be enough, with most estimates suggesting the figure should be 200bn.
Allowing banks until mid next year to recapitalise on their own will only allow uncertainty to linger.
More importantly, and despite regulatory oversight, many European banks would rather boost their capital ratios by shrinking their balance sheets (i.e. by cutting lending) than accept government funds.
Asset reduction plans already announced add up to around 1 trillion euros. If banks follow through with this, the impact from such a lending cutback on growth will be significant.
The forced recapitalisation approach used by the US Government in late 2008 was arguably more effective in making sure banks maintained lending levels.
Third, numerous uncertainties remain around the enhancement to the firepower of the EFSF:
Confirming IMF and non-European sovereign involvement likely means waiting for the G20 Summit next week and probably beyond.
The US already seems to be sceptical of greater IMF involvement, participating in such a fund would go beyond anything the IMF has ever done before, and sovereign wealth funds are likely to be sceptical after the bad experience of helping to recapitalise US banks three years ago.
In fact it’s hard to see anything beyond token involvement from China.
The involvement of sovereign wealth funds would probably entail a cumbersome governance arrangement.
Getting private sector involvement may be difficult, without attractive terms.
It’s doubtful the proposed firepower of 1 trillion euros will be enough. This would only cover Spain and Italy’s gross financing needs over the next two years.
To cover Belgium and France will require 1.7 trillion euros.
Whose bonds would be bought? Obviously Spain and Italy are prime candidates, but what about France and Belgium?
And if it’s not the latter, why won’t speculators attack those markets?
This already appears to be happening, with a sharp rise in the relative
