The euphoric reaction from markets to the recent Eurozone summit would suggest that finally the policy makers have made substantial progress towards finding a solution to the three year old debt crisis. As we have seen several times before the initial verdict of markets has been mistaken and certainly much of the subsequent optimism was due to the low expectations ahead of the meeting. The political leaders had given the impression that there were irreconcilable differences, especially between Germany, the main creditor nation of the currency union, and the periphery countries.
To assess the impact of the summit it is necessary to answer two important questions. Firstly, will the measures that have been agreed provide the basis for a solution to the crisis or at the very least go a significant way to alleviating the stress in the Eurozone? Secondly, even if it does not yield a solution is there enough in the summit to galvanise a sustained rally in risk assets before further intervention is needed by the policy makers. In this respect, the Lon-Term Refinancing Operation (LTRO) programme announced by the ECB last December is a relevant analogy. While the provision of liquidity to banks has not made a material difference to resolving the underlying issues of the debt crisis, it had a significant effect on investor sentiment that resulted in a three month and 20% rally in equities. Could this scenario be repeated now?
This note seeks to answer these questions by reflecting on the various measures that have been agreed and their likely long-term impact.
The EU Summit of June 28-29th 2012
It is worth reminding ourselves of the major decisions that were taken at the summit. These can summarised as follows:
■■ A compact for jobs and growth worth a reported $120bn
■■ A new supervisory body for Eurozone banks involving the ECB to be
in place by December
■■ The ESM to have the ability to inject capital into banks directly rather
than via the sovereign, as had been the case for Spain’s bank bailout
■■ Financial assistance for Spanish banks to be provided by the
European Financial Stability Fund (EFSF) (the current bail out fund)
and then by the European Stability Mechanism when it is active
■■ The seniority status of ESM loans to be removed
■■ A commitment for the EFSF/ESM to buy sovereign bonds in the
primary or secondary market
■■ A ‘roadmap’ is to be drawn up by the leading EU institutions (ECB,
European Commission, European Council and Euro Group) for a
‘genuine economic and monetary union’. They will present an interim
report by October and a final report by the end of the year
■■ A promise to examine the financial situation in Ireland with the view
of relieving the public debt burden
Broadly, the measures agreed at the summit fall into three categories:
growth, enhancement of the ESM and moves towards a banking union.
These will be considered in turn.
A commitment to increase economic growth in the Eurozone was the least surprising part of the summit agreement. There had been increased political momentum within the currency union to introduce measures designed to help growth and increase employment, as it became clear that the policy of fiscal austerity was having the opposite effect. The election of Francois Hollande as President of France added a powerful voice to the pro-growth lobby and his election campaign was partly based on adding a growth element to the Eurozone strategy for dealing with the debt crisis.
The €120bn growth package that has been ratified at the summit was in line with expectations. It does not reflect a wholesale change in direction by the policy makers but is designed to complement the existing strategy of austerity and structural reform to improve public finances.
The details include extending the capacity of the European Investment Bank (EIB), which is responsible for providing finance of growth projects, allocating structural funds to specific projects and pilot programmes for project bonds. Given the size of the programme (€120bn) and the piecemeal nature of the investments it is unlikely to make much of a difference to the Eurozone economy, even within some of the underperforming periphery nations. There may be some jobs created in areas where the projects are targeted but the benefits will remain localised. Apparently, the net spending will be much less than €120bn as much of the money is being redirected. It does allow President Hollande to say that he has fulfilled his election promise and other leading politicians, such as President Monti of Italy, will also be pleased about the change of direction but the change is largely symbolic.
If growth continues to deteriorate (as recent PMI readings suggest) it will be interesting to see if the policy makers implement further and more meaningful growth measures or if they rely on the ECB to provide the necessary stimulus to the flagging economies.
The European Stability Mechanism (ESM)
The ESM is not due to become active until 9 July and is still to be ratified by some of the Eurozone Parliaments. It was designed to supersede the current bailout fund, the EFSF, with greater resources and more flexibility. Following the bailout of the Spanish banks in June there was some uncertainty which fund would be used to inject the necessary capital. This was important because as it stood at the time loans issued by the EFSF ranked pari passu with those from the private sector whereas loans made by the ESM were going to have senior status. The subordination of private sector debt contributed to a major sell-off of Spanish government bonds following the bank bailout and one of the positive surprises of the summit was that the ESM will now also rank pari passu with the private sector.
A second major change was the decision to allow the ESM to fund the banks directly rather than via the sovereign. This is important because by lending the money to the Spanish government it added to the public debt burden and would have increased the debt/GDP ratio by up to 10%. What is not clear is whether this treatment only applies to the Spanish banking sector following the recent bailout or to other countries that may have similar problems in the future. There are also other unanswered questions that will have a material effect on the sovereign, banks and stakeholders in the banks. These include what form the capital injections will take, the financial terms of the loans, how to treat equity investors and other creditors (are shareholders and bond holders going to take a haircut, especially the former) and will the banks be monitored following the provision of capital.
The other major announcement regarding the ESM is that it would purchase sovereign bonds in the primary and/or secondary market. The objective is to help reduce the yields of the periphery countries following a sharp increase in the cost of debt for Italy and Spain in recent weeks which threatened to remove their ability to finance themselves in the debt market. Mr Monti had been especially insistent that something should be done to relieve the public funding requirements with several auctions due over the rest of this year. Together with PM Rajoy of Spain he refused to endorse the Compact for Growth unless Germany conceded that on measures to help the periphery bond markets and the ambush proved successful as Mrs. Merkel gave in.
The decision to give the green light for the ESM to buy bonds was not as great a surprise has been made out because both the EFSF and the ESM are permitted to by sovereign bonds as agreed in the original treaties. The facility had never been used or even seriously discussed partly because the ECB had undertaken the role through its Securities Market Programme (SMP). Since the SMP was started early last year the ECB has purchased over €200bn of bonds in the secondary market but, despite the worsening of the crisis in recent months, has suspended the programme. There has been some conjecture as to why the ECB has not stepped up its buying as Spanish and Italian bond yields rose sharply but the central bank has always been a reluctant buyer and regarded the policy as outside its core competence area.
Furthermore, despite the size of its purchases it has not prevented stress being reflected in peripheral bond markets. The ESM is likely to be more committed to limiting the rise in yields and the fact that it is now prepared to intervene may by itself provide a cap on the cost of debt in the short term. The decision, however, is a controversial one.
Not only has Merkel attracted criticism for capitulating to Monti and Rajoy but since the summit ended both Finland and Holland have indicated they may try and block bond purchases by the ESM.
The major drawback for the ESM is not the continuing discord among the Eurozone members about what it should or should not do but the limited resources currently available to the fund given its new responsibilities. At present, it has €500bn of available funds but there was no hint that this would be topped up. This is clearly not enough to provide funding for sovereign bailouts, bank bailouts and sovereign bond purchases. To be credible with the markets it is necessary to have not just enough but more than enough or sooner rather than later the ESM’s viability is likely to be tested. With a possible Spanish bailout looming as well as a third Greek bailout the fund would need probably three times its existing capacity to reassure markets it was adequately funded.
Alternatively, the ESM could leverage itself by getting a banking licence and conducting repo operations with the ECB. This would be the preferred option but Germany would not sanction this, especially as it conceded more than Mrs. Merkel originally intended coming into the summit.
The Eurozone banking sector
The area where the summit made most progress was in the commitment towards creating a banking union. In the weeks preceding the summit there had been a lot of speculation about how far the policy makers would go in this regard. Following the Spanish bailout it was evident the nature of the crisis was as much about the banks as the sovereigns themselves with the pair locked in a deathly embrace. In the words of the EC President after the summit one of the primary objectives was to ‘‘break the vicious circle between the banks and sovereigns’’.
As mentioned in the previous section, the ESM bailout fund will now invest directly into the banks instead via the sovereign. This is certainly the case for Spain and will presumably act as a precedent for other countries. Also, the debt of Ireland that has seen its own national debt rise well above 100% as a result of rescuing its own banks is likely to benefit from revised and improved terms that will mirror the Spanish bank bailout. The importance of this is not only that it will not add to the overall debt burden of the sovereign but also it will transfer the liability of the bailout from the national tax payer to the Eurozone tax payer, a clear step towards a European banking union.
Another major development will be the creation of a single bank supervisory body that will involve the ECB. This will have to be functioning before the ESM can transmit the funds to banks requiring bailouts so there is likely to be several months of delay before Spanish banks receive the funds. The new supervisory body will greatly increase the responsibility of the ECB in its relationship with the banking sector.
Although these measures are far reaching and significant they do, however, fall some way short of a full banking union. Firstly, there is no mention of a Bank Resolution body for the Eurozone. This is the creation of a set of procedures taken by the common authority to solve the situation of an unviable bank (of which there have been several in the Eurozone). For an effective bank union there needs to be a framework to facilitate an efficient bank resolution process. Secondly, and related to the creation of a bank resolution scheme, is the lack of a common deposit insurance scheme. In the period leading up to the summit there were significant withdrawals of deposits from banks in Spain and, especially, Greece. Usually, the national central bank guarantees deposits up to a certain level but the uncertainty surrounding this may not prevent a ‘bank run’, as happened in the UK with Northern Rock in the summer of 2008.
With Greece, the threat of a withdrawal of the Eurozone meant there was a currency risk as well. If depositors left their money in the banks their funds would be redenominated in new Drachma following the exit resulting in a probable loss of value of at least 50% against the Euro.
Overall, the measures taken towards a European bank union were more than the market expected and represent considerable progress to severing the ‘’vicious circle between banks and sovereigns’’. However, it is not enough without the creation of a bank resolution scheme and pan-euro deposit insurance. Bank shares, which have been battered by the markets, rose strongly following the summit and the banks have sensibly used the window of opportunity to raise debt in the markets to strengthen their balance sheets. The honeymoon is unlikely to last while the link remains, albeit less tightly, between the banks and sovereigns.
The delay in putting the machinery in place for the ESM to recapitalise banks until the supervisory body has been established is also unfortunate because further stress within the sector is likely to emerge before then.
Ted Scott, Director Global Strategy, F&C