Herman van Rompuy, the European Council president, was keen to manage expectations on Thursday morning, saying that the agreement thrashed out by eurozone leaders overnight is far from the end of the single currency area’s problems.
European leaders agreed on a 50% write down on Greek debt, an increase in size of the European Financial Stability Facility (EFSF) to more than €1tr (£876bn), a new bailout package for Greece and a recapitalisation of the European banking sector.
A meeting that Deutsche Bank economist Gilles Moec said had: “slightly exceed[ed] the diminished expectations of last week.”
”On balance we think that the package should be seen as progress in the resolution of the Euro crisis, even if the final outcome crucially depends on the capacity to attract potential non-European investors and a full finalization of deal with the private sector on Greek debt with an acceptable level of participation.”
Banks were major gainers as European stock markets rose to hit three month highs on Thursday. The Dow Jones Stoxx Banks index, which aggregates the performance of European banks, was up nearly 5% in early trade. The German Dax and French CAC40 rose by 3.8% and 3.6% respectively after the open, and extended gains to 4.46% and 5.14% by midday.
Banks will need to increase their core tier one capital ratio – a measure of their stability – to 9%, up from the 5% required in the last round of stress tests conducted by the European Banking Authority (EBA).
The EBA estimates that €106bn is needed across the continent to hit this target by the deadline of June 30 2012, with the majority of additional capital needed in Spain, France and Italy, although some German banks will also need to improve their capital ratios. George Osborne confirmed to the House of Commons today that no British bank would need to take on additional capital.
Fears that banks would prefer to sell off assets, rather than take on public funding, do not seem to have been realised.
Clarity over the size of the haircut was the bare minimum that the market needed. Uncertainty over the exposure of the banking industry to Greek debt has undermined confidence across Europe.
Banks will be hit by the 50% write downs, but the combination of additional capitalisation from the EU and the fact that the market has expected a deep haircut for some time means that the damage has either already been priced in, or will not be as significant as many feared.
“The agreement reached on key parameters for private sector involvement is of the utmost importance to improve debt sustainability. It is based on a realistic assessment of the Greek economy and an appropriate burden-sharing between the private and official sectors.”
By Thursday morning, some holes in the grand plan were already being picked at by analysts.
Firstly, the private sector’s 50% write down will only bring Greece’s debt back to 120% of its gross domestic product by 2020, because the country has a large stock of loans from public bodies. This number is hardly within the definition of sustainability, particularly as economists are predicting years of slow growth in the country.
The Greek government has also agreed to find another €15bn on top of a €50bn privatisation programme that has already failed to catch light.
There is also a potential conflict brewing over payouts from credit default swaps (CDS), effectively a bet against a bond which pays out when the issuer defaults,
Many CDS are held by buyers of the underlying bond in order to limit losses in the event of the issuer’s failure. However, some hedge funds hold them as assets in their own right, effectively taking large bets against a sovereign or company. In the case of Greece, it is unclear how many of the CDS currently held are “naked” in this way.
The consensus at the moment is that as the haircut is ostensibly voluntary and does not apply to all creditors equally, it does not constitute a default and should not trigger a payout, but the risk of pressure or even legal action on that decision remains.
The European Financial Stability Facility’s additional firepower should see it with €1tr in deployable capital. Some in the markets are already saying that the “bazooka” is not big enough, and noting that the creation of “special purpose vehicles“ to be used to shore up sovereign debt, is contingent on finding funding from cash rich sovereign investors in emerging markets. Nicholas Sarkozy is understood to be speaking to his counterpart in China on Thursday, and Klaus Regling, head of the EFSF, is due to head to Beijing.
The G20 has previously rejected calls to back further European bailouts, so it remains to be seen whether bilateral talks can bear fruit.
The technicalities and legalities are still set to be debated, and with 17 states in the currency area with their own sovereignty issues to consider, and with serious concerns still circulating over the Italian government’s commitment to reform, it could be that today’s market rally is short-lived.
As Charles Jenkins, an economist at the Economist Intelligence Unit, said: “It is possible that the series of agreements reached by euro zone leaders last night will come to be seen as a turning point in the struggle to prevent the disintegration of the euro zone and a new banking sector crisis. However at the moment there are far too many uncertainties to make any such assertion.”
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