Reflections on Europe's New Initative

Currency in Crisis

After staring into the abyss, and reducing risk, investors anticipating a new European initiative spent most of last week putting risk back on.  The details of the European initiative were less important in the first instance than the fact that a new initiative was to be taken.

My general sense is that European officials have bought some time, but the sense of closure is unlikely to last until the end of the quarter.

There are two key elements.  One is about Greece and the other is about the new flexibility of the EFSF.

Greece:  Lots of Movement, Little Real Debt Relief

Greek's debt burden will be reduced by a little more than 26 bln euros from what was projected if all goes according to plan, but Greece's debt to GDP will remain well above 100%.  And that is if sweeteners for private sector participation is sufficient to achieve a 90% participation rate.  This seems to be more than a little exaggerated, but we'll see.    A selected defaulted now may release some steam from the pressure cooker, but it will not preclude a larger default/haircut later.  

Of the 109 bln euro Greek 2.0 package, only about 34 bln euros will be in the traditional form, like its first package and the Irish and Portuguese packages.  The other 75 bln euros will be used to induce price sector participation.  Roughly 20 bln euros will be loaned to buy back Greek bonds in the open market.  It has roughly 350 bln euros of debt and counting. 

Another 35 bln euros will be lent to Greece for a complicated bond swap and roll-over to delay an estimated 54 bln euro bond payments due 2011-2014.  It reduces the current value of Greek debt by an estimated 14 bln euros.  

The last 20 bln euros appears aimed at recapitalizing Greek banks.  The bond buy backs, swaps and rollover schemes means that bonds holders get less than originally promised.  Greek banks are large holder of Greece sovereign bonds.  

Lastly, euro zone governments will guarantee 35 bln euros to permit Greek banks access to ECB liquidity in the eventuality of the default, assumed to be limited in scope and time (selective default).  

It would seem to take Greece out of the capital markets for the better part of the next decade.  

EFSF: Pregnant with Possibilities

The EFSF is to be infused with fresh life, reanimated as it were.  It will be able to buy distressed debt.  The ECB has not bought any for several months.  It can also offer lines of credit preemptively.  It has been embraced by French President Sarkozy.  "We have agreed," he was quoted in the press," to create the beginnings of a European Monetary Fund."  Merkel also acknowledged that "one could draw such a comparison" to the IMF.    Some pundits suggested that this new EFSF addresses the flaw at the heart of EMU--monetary union  without fiscal union.  

Such euphoric assessments are understandable, but faulty.  Surely no one really believes that the IMF is the basis for fiscal union in the world.  Then why should we believe that a European Monetary Fund is the beginnings of fiscal union in Europe ?  

Moreover, the new EFSF powers will be terrible constrained.  There appears to be two conditions to the EFSF to exercise its new powers.  First, the ECB must identify a country as being in an extreme debt predicament.  This sounds simple enough, but it suggests a process that moves considerably slower than the markets.  Yet it is the second condition that is more problematic.  All euro zone members must approve of the bond purchases.  This will politicize the process as well as slow it down.  Unanimity in decision making will take time and will require trading of political chits.  

Some suggest that the deal worked out between Sarkozy and Merkel a day before the summit was the traditional compromise between the two pillars of Europe.  Sarkozy has been pushing for increased flexibility of the EFSF for some time.  Merkel has been insisting on private sector participation.    Merkel has a veto over the implementation of the EFSF's new flexibility.  Sarkozy tried to set the terms of the private sector participation, with the French plan, but it was ultimately diluted.  

Trichet's ECB got some of what it wanted as well.  The ECB is unlikely to buy any more sovereign bonds. The EFSF is more flexible, which Trichet also has favored.  It softened its objections to private sector participation, but apparently on terms that would limit it to Greece and not be extended to Ireland and Portugal.  It did soften its refusal to accept defaulted instruments as collateral by accepting the euro zone government's guarantee.  

Going Forward

If I am right, the markets' euphoria will soon pass.  There are a number of issues that remain troublesome.  First, the EFSF funding was not increased and this will limit its ability to exercise its new flexibility.  Second, all the euro zone members have to ratify the agreement and this may take the better part of the next couple of months.   It is not a done deal.   

My guess is that Germany will approve as the opposition SPD will likely support the government on this. Merkel did appear to overstep the (nonbinding) resolution by the Bundestag to limit the drift toward what some consider a transfer union.    France will ratify.  My concerns would be in Finland, Austria, maybe the Netherlands, and not sure if Belgium will have a government (it has only been more than a year since the election, though there have been more promising noises lately.

At this juncture, my best guess is that the typical pattern will hold"  summit, institutional changes, eases tensions, only for them to rebuild again.    I am concerned that the Greek 2.0 package, like the Greek 1.0 package is not scale-able for Ireland and Portugal.  While they will be getting lower interest rates from the EFSF and longer maturities, it does not address the debt levels themselves.  

Europe, as I have argued, remains a project under construction.  It is evolving.  It is being forged in the furnace of the crisis.  There is though not teleological end point.  The Greece 2.0 package and the new flexibility of the EFSF in theory, does not put the experiment on much firmer footing.  The speculative market, judging from the IMM net speculative position, went into last week with among its smallest net long euro position since January.  This would suggest that market positioning favors additional euro gains, as the market chases the euro higher.  At the same time, with data suggesting the euro zone is losing economic momentum, real fund managers may not be following the currency speculators in size.