Yet more chaos and confusion in the Euro Zone

Kiron Sarkar lives in London and Ireland where he works as a money manager. His full bio follows below.
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Apologies for being off line for a while – currently traveling in the US and don’t have my normal access to info etc + got the Boss (the wife) in tow – apparently shopping is far more important – well, she’s certainly helping out the US economy.

I summarise below, the current situation in Europe, as I see it, though I must say it’s even more confused and chaotic than usual and a lot of the comments below involve (I hope educated) guesswork on my part.

Earlier this week, an English newspaper (the Guardian) reported that the Euro Zone had agreed to a beefed up EFSF (up to E2tr) – has proved to be wildly incorrect. Generally, the FT/WSJ are much, much better and, in addition, beware of US based comments/ market moves re the Euro Zone situation;

Germany is adamant (so far) that the EFSF will not be increased above E440bn. However, even the E440bn is illusory, in my humble opinion.
Excluding prior commitments to Greece, Portugal and Ireland, I believe that the EFSF has only about E230bn of firepower left – and that’s before the likely increase in bail out funds necessary for Greece, following the Troika report (see below);

It is clear that the Euro Zone is considering an insurance scheme. In accordance with this scheme, the majority of losses (shared approx 80%/20% by the EFSF and investors respectively, up to a cap of between 20% – 25% (probably 20% for Italian and Spanish bonds), though higher (say 40%) for Portuguese, Greek and Irish bonds), purchased in the primary markets, will be indemnified by the EFSF. This increases the EFSF’s “firepower” to a max of E1.15tr (5 times, E230bn, uncommitted by the EFSF). Basically, that’s not enough – the market wants E2tr at least and for this plan to work – quite frankly, even more than E2tr is necessary;

To complicate matters, the French (BNP) have suggested that the EFSF issue CDS’s as an alternative to the insurance scheme. As the EU hate CDS’s, this proposal is going nowhere;

The EFSF will be able to buy bonds, both in the primary and secondary markets. Leaked reports suggest that they will be entitled to buy up to 50% of any issue by the PIIGS countries, at the average auction price. However, the EFSF will only be able to buy bonds in the secondary markets, if the relevant Euro Zone country, has a sustainable debt level, meets its commitments to deficit reduction, has a sustainable current account and, finally, has no major insolvent banks (to be confirmed by the ECB/Euro Zone finance ministers – at least the start of a (long overdue) sensible fiscal regime, with teeth, if complied with – though bureaucratic and time consuming).
Furthermore, the EFSF will be allowed to dispose of their bond holdings in due course and/or repo them, which provides some additional flexibility;

Germany/the ECB is strongly opposed (at present) to granting the EFSF a banking licence which, if granted, would have enabled it to be leveraged significantly, thereby increasing its firepower much further. The ECB has, to date, refused to finance the EFSF. Sarkozy is trying to persuade Trichet/Merkel to change their minds in respect of this issue – he flew to Frankfurt yesterday, to attend the hand over ceremony to Draghi (as the next President of the ECB) from the (at
last) retiring (in my opinion, mentally retarded) Trichet, but really to meet Merkel/Trichet. Also in attendance were, the French and German Finance Ministers and Van Rumpoy, Barosso (from the EU) and the IMF’s MD, Lagarde (Lagarde’s presence is IMPORTANT – the EU representatives are irrelevant, as they have virtually zero influence over the final decision);

Following a recent “deal”/Constitutional Court ruling, Merkel and her Finance Minister (Mr Schaeuble) need to obtain agreement from a Budget Committee of the German Parliament, before any “deal” they agree to can be approved/acted on – a major hurdle;

A Euro Zone Finance Ministers meeting has been called for tomorrow, to be followed by the EU heads of State meeting on the 23rd. There were rumours that the 23rd meeting would be postponed, but these rumours were denied subsequently;

Clearly Sarkozy is trying to get Lagarde to support (she will be
supportive) his case for increasing the EFSF’s firepower, by transforming it into a bank – basically the Geithner’s proposal.
Remember, Lagarde was, until very recently, the French Finance Minister and knows, only too well, of the serious problems of French banks (significant under capitalisation). There were no press release/comments (Sarkozy is always keen to grab the headlines at any
opportunity) issued post that meeting, which suggests that Germany/the ECB have not moved from their position and Sarkozy has FAILED;

Sarkozy’s real problem is that European (in his case French) banks need to be recapitalised and the amounts involved are extremely large;

Forget the E100bn being talked about and/or the E200bn the IMF suggested is needed to recapitalise European banks – the number is much, much bigger, in my humble opinion – recall the amounts necessary to recap the Irish banks. However, the market will welcome an amount of E200bn, even though more will certainly be necessary later.
However, the FT reports that the bank recap will amount to E80bn – clearly far too little and, therefore, market negative;

A further problem is that Germany has insisted that the banks first try and raise the capital themselves. If they cant, they should seek help from their own Government and finally, if finance is not possible by their Governments, the EFSF – who will lend money to Euro Zone Governments to recapitalise their banks. Banks that seek financing from their Governments/EFSF will be subject to restructuring and possibly an orderly winding down, which will make banks reluctant to seek this solution. This is bad news, as banks will try to reduce their balance sheets and limit lending – the last thing you want, together with selling assets;

However, lending to Governments by the EFSF (to recap European banks) will, presumably, reduce its firepower by a factor of 5 times (I would argue) for every E1 used in bank recaps – bad news, as it reduces the EFSF’s ability to buy PIIGS bonds/indemnify investors against losses on purchases of PIIGS bonds as discussed above;

Sarkozy’s other major problem, is that any move by the French Government to bail out French banks, commit more funds etc, etc will result in an (virtually instant, in my opinion) DOWNGRADE of France’s AAA credit rating – arguably, France should not be rated AAA (certainly most peoples view, which I totally agree with). Moody’s warned of exactly this;

OK so France gets downgraded – what’s the problem you say – after all, the market expects it and has (sort of) priced it in – though, in reality, it will still be a (very?) market negative event, given France’s importance in the Euro Zone. In addition and very importantly for Sarkozy, a loss of France’s AAA credit rating prior to the impending 2012 French Presidential election makes it virtually certain he will lose – a very major consideration in this game;

Banks do not want to be forced to recapitalise, particularly given the above terms and, in addition, as their shares are trading well below current alleged “book value” – I remain highly sceptical as the the alleged book value.. They have suggested that they will raise some E1tr, through the sale of assets. Impossible, especially as there will just be sellers around and prices for assets will be well below “distressed sale” prices, even assuming that there are buyers around for this amount of assets – virtually impossible. Therefore they will try and shrink their balance sheets as quickly as possible, if they can;

The banks have indeed threatened that they will shrink their balance sheets – OK, they will to a degree, but, in reality, they cannot reduce their balance sheets by enough and certainly not in the limited time available. Furthermore, European banks are sensitive to political influence/direction, far more than is the case in the US. In addition, remember, the EU/Germans etc want banks to raise sufficient capital to have a core Tier 1 ratio of 9.0%,(after marking to market their holdings of Sovereign Bonds), within 9 months;

The European Banking authority is to report on new stress tests/level of capital required this week. I hope its far more credible the 1st 2, which resulted in Irish banks needing to be recapitalised shortly following the 1st Stress test (which claimed that everything was OK) and Dexia to seek refinancing, a short while post the 2nd Stress Test.
Markets are highly sceptical and the EBA’s credibility is (lets be
polite) limited;

The Troika’s (EU,ECB, IMF) reported on the Greek fiscal position – to be presented to the EcoFin meeting tomorrow. They have recommended that the next tranche of aid should be given to Greece asap. Amazing, since they admit that Greece will have missed every target – yet again and, surprise, surprise (I think not), that the amount of the bail out , negotiated just 3 months ago, will not be enough. Apparently Greece will do better in 2012 – oh yeah !!!!;

Greece will clearly need to be financed until they no longer represent a threat to the Euro Zone, in spite of the certainty that Greece will never meet its targets, nor have any intention of doing so. I cant see how funding can be refused at this time, as refusal to finance Greece at present, will set off a chain reaction which could well destroy the Euro Zone. However, in due course, Greece (quite rightly) will be subject to fiscal targets – the free (souvalaki) lunch is over. Will Greece survive – quite frankly no one really cares. They just don’t want to avoid contagion spreading to the rest of the Euro Zone.
Personally, I believe that Greece may have to exit the Euro Zone, but in that event, the Euro bank deposits will have to be protected (if the Greeks reintroduce the drachma), to avoid the market attacking other countries and result in depositors withdrawing funds from banks in say Italy, Spain and Ireland, for example;

The Greek Parliament will pass yet more (fictional) austerity measures this week, which will be ignored, as all the previous others have;

It is almost certain that the previous (21%) haircut negotiated with financial institutions re Greek bonds will be re negotiated – reports suggest that the haircut will be increased to around 60%. However, as the Troika report was delayed, the deal on the haircuts may not be agreed this weekend. Oh dear. The banks are balking, but quite frankly the politicians are ignoring them – quite rightly. After all, if Greek bonds are marked to market, a write off of 60%+ will be required, in any event, given current market prices;

Based on the above and given that there are only a few days left till the 23rd October EU heads of State meeting, it is unlikely that all the outstanding issues will be resolved and that the Euro Zone will (yet again) disappoint. However, the real key dates are the G20 Heads of State meeting on 3rd/4th November. Personally, I believe they cannot deliver the (over ambitious) market expectations, but something will be cobbled together, with the need to do more and more in due course – in other words, the 3rd/4th November deadline is unlikely to be the deadline for a comprehensive fix;

I believe that Europe cannot resolve this issue unaided. For that reason, I believe that the only credible organisation that can make a difference is the IMF. The IMF clearly understand the problems only too well (and the potential contagion effects, globally). In addition, they have far more experience. The EU is, by contrast, clueless. For that reason, I believe some involvement by the IMF is more than likely. Furthermore, the IMF understands only too well the contagion effects for the global economy. There was a brief report (not followed
up) quite some time ago, suggesting that the IMF would raise US$/E300bn, (the financing coming from existing members and/or EM’s, in particular, given their reserves) which would be deployed to help the Euro Zone credit crisis – no reports have emerged since;

EM’s are certainly extremely concerned about a potential failure in Europe. For example, Europe is China’s largest trading partner and China does not need any more problems at present – it has enough of its own. In addition, their is to be a major change in the leadership, next year – the Chinese are therefore desperate for stability to ensure a smooth handover from the current regime. As a result, it is in China’s and other EM’s self interest to stabilise Europe. It is also in the US’s interest that Europe does not implode.
As a result, I would argue that the necessary financing can be arranged, though some may argue that politically, it will be difficult for the US to contribute, given the views by the Republicans/Tea party. However, I believe the funding is available;

Essentially countries lend to the IMF, which then on lends to relevant Euro Zone countries. The IMF (through the IFC) could also play a part in the recap of European banks, though I accept a number of technical issues will need to be resolved. However, an IMF involvement is a 75% probability and positive for markets, given the shambles in the Euro Zone;

All of the above will take time and is impossible to be sorted out by the 23rd October EU heads of State meeting, indeed also by the G20 meeting. The Germans have warned as much. However, unlike the EU/ECB/Euro Zone, the IMF retains credibility and their involvement will be viewed positively and will buy more time;

There are numerous other issues, including fast deteriorating fiscal positions in Spain and Portugal – both will miss their targets.
Furthermore, German growth will decline (significantly?) in the 4th Q 2011/ 1st Q 2012 – the Germans have been extremely cautious recently and the Finance Ministry/Economic institutes are cutting their forecasts for this Q and next year aggressively – the Germans have just announced that 2012 GDP will be just +1.0%, down from +1.8% a few months ago – basically Germany needs a fix as much as everyone else.
Self interest will drive them to deliver in due course;

Summary

I can go on, and on and…… However, the bottom line, in my humble view, is that:

There will be no resolution of this crisis by the EU heads of State meeting on 23rd October – virtual certainty;

The earliest date for any solution will be the G20 Heads of State meeting on 3rd/4th November, though a comprehensive fix by that date is also unlikely;

Without IMF involvement, this is going to be a fiasco and very bad for markets, given that the Euro Zone will not deliver as much as was/still is expected – however, I believe the IMF will get involved;

The Euro Zone will start introducing fiscal measures, together with verification, which (ultimately) will be positive and enable the issue of Euro Bonds – indeed, I would argue that Euro bonds already exist – after all, the EFSF is raising funding through the issue of bonds, guaranteed by the Euro Zone countries – I accept its not a joint and several guarantee, however;

The key for the Euro Zone is to implement measures to stimulate growth
– unfortunately, everything they are doing is the complete opposite;

The ECB is relaxing its collateral requirements even more – they are currently accepting used toilet paper, so I’m not sure what this means. Furthermore, the ECB will reduce rates by at least 50bps shortly – they should never have raised them in the 1st place and having made that mistake, should have corrected it by now – However, as usual, Trichet was more concerned about his reputation/legacy;

As stated above, in due course (earlier than people think, in my humble view), Euro Zone countries will issue Euro Bonds, (through an Euro Zone Debt Management Agency) to ensure appropriate fiscal control, together with constant verification. This will be a game changer for the global economy. Personally, there is a possibility that after all the pain, the Euro Zone will emerge from this much stronger and fiscally much better positioned – though that’s some time in the future;

I’ll leave you with this – Mrs Merkel reported last Tuesday that it was time to take “unconventional measures” – what can she mean – surely not QE !!!!. In my opinion, Euro Zone QE is a very strong possibility, in spite of the very real objections/opposition at present, particularly from the Germans/ECB.

Whilst the situation looks bleak, indeed dreadful, the Euro Zone has, in the past, come up with the goods when their feet are placed firmly in front of the fire. I, on balance, believe this will happen again, but I’m really counting on the IMF.

However, this is a truly dangerous game.

Be very, very careful.

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A qualified UK accountant, Kiron joined the M&A dept of N M Rothschild in London. He was then appointed head of M&A of Rothschild (Hong Kong). On his return to the UK, he was a founding member of the Rothschild international privatisation team. Subsequently headed up the Central and Eastern European (“CEE”) team – rated No 1 in 4 out of 5 years (Privatisation International).

Kiron has acted as a lead adviser in respect of over US$150bn of deals and has worked globally in both developed and emerging markets.