Billionaire financier George Soros last week branded the "comprehensive package" to rescue the euro a failure -- and he is by no means alone in his views. Speaking at a dinner organized by Pi Capital in London on October 27, the Hungarian-born Soros said the eurozone rescue package:
"Will bring relief partly because the markets were so obsessed by the lack of leadership. The mere fact that something was achieved was a major relief and it will be good for any time from one day to three months.”
While it contains sensible measures, including banning banks from paying bonuses or dividends unless they can demonstrate an ability to meet the EBA's raised capital requirements by June 2012, there are plenty of reasons to be skeptical about the grand bargain cobbled together by European leaders at 4am on October 27.
The package of measures, whose details remain sketchy in the extreme, was initially met with euphoria by the markets. But this was probably because the politicians had - for the first time since the onset of the crisis in October 2008 - done something to address the underlying problem of unrepayable debt. The trouble with this deal, however, is that it only papers over the yawning structural gaps and fiscal imbalances that make the single European currency unsustainable.
Here's my list of some of some of the flaws in this deal, together with a description of some of its unintended consquences:
(1) The deal changes the rulebook on sovereign debt. The “voluntary” 50% haircuts imposed on Greece’s creditors (a ruse to ensure credit default swaps were not triggered via a "credit event") change the rule-book for fixed-income investors. Since Greece has been permitted to renege on a portion of its debt with limited penalties, investors will increasingly wonder whether the bonds of other heavily-geared countries are as safe as US credit ratings agencies would have us believe. The overall effect may, perversely, be to further raise the cost of sovereign borrowing.
(2) The deal was supposed to create a “firewall” around Italy and Spain, reassuring investors that these countries were different from Greece and that they are not going to default. However, the expanded European Financial Stability Facility (EFSF), even with €1 trillion in firepower, provides insufficient reassurance. Andrew Bosomworth, a portfolio manager at Pimco wrote:
“As contagion spreads, markets care less about the size of Greece’s haircut and more about whether Spain, Italy and the French banking system are solvent. Italy and Spain’s governments need to raise some €325 billion next year and Europe’s banks need two-thirds as much again to reach a 9% core tier 1 capital ratio, sums that will quickly exhaust the EFSF's lending capacity."
(3) The EFSF jeopardizes France’s AAA credit rating. If France were to be downgraded, which is near-inevitable if the French government is forced to bail-out its own banks, the EFSF would be even more lacking in credibility.
(4) As a highly-leveraged special purpose vehicle (or ‘SPV’) the EFSF uses the same sort of opaque, debt-piled-on-debt financial engineering as the alphabet soup of toxic instruments (CDOs, CDO-squareds, CPDOs etc.) that originally caused the crisis in October 2008. Writing in The Wall Street Journal, Francesco Guerrera pointed out the irony of this:
“After spending the aftermath of the financial crisis hogging the moral high ground and criticizing "Anglo-Saxon capitalism" for its penchant for financial engineering and excessive leverage, European Union leaders employed some of the same devices for Greece.”
(5) The deal requires European leaders to go cap in hand to China for financial support. As Jeremy Warner explained in The Telegraph, the Chinese political leadership will almost certainly demand a quid pro quo:
"The Chinese threaten to extract a high price; security for their money, open access to European markets and freedom to buy advanced technologies (and there I was thinking they'd already stolen it all). They might also demand that Europeans cease all open criticism of Chinese mercantilism, human rights abuse and anything else that tends to concern us over China's ever onwards and upwards rise to superpower status."
(6) The position regarding credit default swaps on developed-world sovereign debt is fluid (some argue if such CDS have effectively been killed off as a result of their failure to cover losses on the Greek "haircut", it would be a good thing since such swaps are one financial 'innovation' that is of little social use (see Reuters 'Global Investing' blog by Mike Dolan). However, this thesis is strongly disputed by, among others, Reuters blogger Felix Salmon, who argues that it's way too early to write the obituary of the sovereign CDS, especially when you consider what they are mainly used for. If Salmon is wrong and sovereign CDSs are now worthless, the euro package would further inflate countries' cost of borrowing, since holders of hedged sovereign bonds would find they are not, in fact, hedged after all.
(7) The euro package is likely to further restrict bank lending across the EU. Banks are more than likely to shrink their balance sheets, as opposed to raising new capital, in their bid to reach the new 9% core tier one capital ratios, which the EBA expects them to do by June 2012. (For a broader analysis of the problems facing Europe's banks read 'Europe's dying bank model' by Gene Frieda).
(8) There are reasons to doubt whether Italian prime minister Silvio Berlusconi will deliver his side of the bargain -- a credible plan to boost growth and cut Italy's €1.9 trillion debt pile. As Hugo Dixon wrote in BreakingViews the danger is that Berlusconi’s government will limp along until January 2012, and then collapse under the weight of its own incompetence, having achieved precisely nothing. "[Italy] is still the bête noire of the whole eurozone problem," says Monument Securities strategist Marc Oswald.
(9) There's nothing in the euro package to address the eurozone’s anaemic growth. Prof Edward Altman of the Stern School of Business and New York University told the Financial Times that "news of deteriorating economic statistics, if they occur, will nullify what has been the best effort, so far, from the euro countries’ leadership.”
(10) The European Central Bank, where Frenchman Jean Claude Trichet today hands over as president to Italian Mario Draghi, seems to remain a bystander in all this. It could do so much more. As Paul Krugman wrote in his New York Times blog: "the ECB’s refusal to provide either the lender of last resort facility or the monetary expansion the eurozone needs is creating a vicious circle of self-reinforcing austerity."
Overall, one has to conclude that, while it is certainly more impressive than any of the EU’s earlier efforts to salvage the euro, this emergency package is just another example of 'kicking the can further down the road' (apologies for the cliché). Jonathan Loynes, the chief European economist at Capital Economics told Bloomberg that:
“The very best you can hope for is it buys you time. It avoids an imminent catastrophe and means Greece should be able to meet its obligations in the near future, and it may restore a bit of confidence. But it won’t prevent the debt crisis overall from rambling on and indeed escalating.”
Further reading on the European sovereign debt crisis and attempts to ensure the euro survives:
- To ensure the euro's survival, eurozone leaders must become more radical by Ian Fraser
- Some tough love for the eurozone leaders by Bearemy Glaser
- Does China want to save the Eurozone? by Anthony Harrington
Tags: Angela Merkel , bonuses , Breaking Views , capital buffers , capital raisings , CDS , China , Communist Party of China , credit default swaps , credit event , default , deleveraging , ECB , EFSF , European Banking Authority , European banks , European Financial Stability Facility , european sovereign debt crisis , Felix , Financial Times , French banks , Gene Frieda , George Soros , government bonds , Greek default , Hugo Dixon , Jeremy Warner , Jonathan Loynes , Marc Oswald , Paul Krugman , PIIGS , Reuters , Silvio Berlusconi , sovereign bond market