After hours of tough negotiations, EU heads of states and governments, central bankers, bankers and IMF representatives finally hammered out an agreement early Thursday that aims to put a floor under the downward-spiraling debt crisis by …
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The cornerstones of the comprehensive package: On Greece: The agreement calls for private owners of Greek government bonds to voluntarily accept a nominal discount of 50% (haircut) on their investment. This would lower Greece’s debt-to-GDP ratio of currently 160% to a more sustainable 120% by 2020. On recapitalizing banks: In order to weather the haircut as well as potential further market turbulence and ultimately restore confidence in the banking sector, major European banks are to raise their core capital ratio to 9% by mid-2012 after accounting for market valuation of sovereign-debt exposure. This would require up to EUR 106bn, according to preliminary calculations by the European Banking Authority (EBA).
On leveraging the EFSF: The summit agreed that the capacity of the extended fund should be used to maximize its firepower without extending the guarantees underpinning the facility. The remaining EUR 250bn out of the EUR 440bn (after deducting the aid already approved to Ireland, Portugal & Greece) is to be able to be leveraged 4-5 times, translating into a headline figure of at least EUR 1 trillion available. Bottom line: It is now clearer than ever that the eurozone political leadership is committed to – and capable of – acting. In addition to working out the details, the biggest risk is now growth over the next two quarters. If we are right in predicting only a marginal contraction in this quarter, followed by marginally positive growth in 1Q12, then we are on our way towards a better world. If we are disappointed with a greater and/or longer contraction of GDP, then the enhanced EFSF may need to be employed, e.g., via a contingent credit line. But even without the SPV component, there is enough money, e.g., to take both Italy and Spain out of the market for more than two years.
Risks will never disappear completely, but the key message is that the political leadership will deliver whatever it takes. In itself, that is likely to be enough. This week will see another busy event schedule. The FOMC meeting (2 Nov) will be closely watched for hints of upcoming unconventional measures. However, any drastic announcement would be a surprise in light of the 2.5% increase in 3Q GDP growth. The ECB meeting (3 Nov) will see Mario Draghi’s debut as the new ECB President. We expect rates to be kept on hold, with some modest “risk” of a 25bp cut. The press conference will want to show that Draghi’s arrival has not led to any fundamental shift in the ECB’s economic and monetary analysis. We think that the ECB will retain an easing bias, but we do not see a further meaningful softening of the rhetoric aimed at preparing the ground for a December rate cut. The central bank, however, stands ready to act if needed. The G20 meeting (3/4 Nov.) may bring further insights into whether foreign sovereigns have any strong interest in investing in European bond markets. Top-tier data releases (PMIs and US labor market report) will indicate whether economic pessimism has been exaggerated lately, as the economic surprise indicators in many countries suggest.
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