Markets Hail Eurozone Debt Deal, But Analysts Unimpressed

ANALYSIS

 @Gooch700 on October 27 2011 8:27 AM
Luxembourg's Prime Minister Juncker France's President Sarkozy and Germany's Chancellor Merkel attend an European Union summit in Brussels
Luxembourg's Prime Minister Juncker France's President Sarkozy and Germany's Chancellor Merkel attend an European Union summit in Brussels Reuters

Late Wednesday night and into early Thursday morning, bleary-eyed leaders of European nations hammered out a deal to try to quell the Eurozone debt crisis.

Among other measures, the senior government officials who attended the emergency summit in Brussels, said that private banks holding Greek debt will have to accept a 50 percent loss (“haircut”); the rescue bailout fund -- European Financial Stability Facility (EFSF) will be boosted to 1 trillion euros ($1.4 trillion); while European banks will have to raise about 106 billion euros ($148 billion) by June of next year in order to protect from losses arising from sovereign defaults.

Separately, Italy’s Prime Minister Silvio Berlusconi has vowed to balance his country’s budget and enact reforms to reduce Rome’s 1.0 trillion euro ($2.7 trillion) of debt.

European leaders roundly hailed all the agreements.

Greek Prime Minister George Papandreou celebrated: We can claim that a new day has come for Greece, and not only for Greece but also for Europe.

The Eurozone has adopted a credible and ambitious response to the debt crisis, French President Nicolas Sarkozy said at a news conference.

Europe is closer to resolving its financial and economic crisis, Jose Manuel Barroso, president of the European Commission, said in a statement.

We are showing that we can unite in the most difficult of times. The package that we have agreed tonight, a comprehensive package, confirms that Europe will do what it takes to safeguard financial stability.”

German Chancellor Angela Merkel said: I think we were able to meet expectations and we have done what needed doing for the euro.

While European stock markets have responded favorably to the deal – major indices are up as much as 5.50 percent in Thursday trading – not everyone was impressed with the agreements and exercised caution about its efficacy.

 “Many crucial details are missing and the test of this deal lies in the weeks ahead,” wrote Gavin Hewitt, BBC’s European editor.

“Greece has been given a chance to escape its debt trap but long years of austerity lie ahead and its economy is still shrinking. The 1 trillion-euro bailout fund will be lower than some people think necessary to protect big economies like Italy and Spain. The test will be whether it lowers their borrowing costs.”

Hewitt added that “with this deal some time has been bought. Some of the crucial details of how, for instance, the rescue fund will work, will not be hammered out until November. Hanging over all of this is the question of growth. All of these calculations, commitments and expressions of determination can be dismissed if Europe's weakest countries do not return to growth.”

Even George Osborne, the British Chancellor of the Exchequer, warned that while the rescue plan was a “good package” in principle, it lacks detail and leaves several “very important questions” unanswered.

“The Eurozone leaders have grasped the seriousness of the situation,” he told BBC Radio.

“Now we have got to maintain the pressure to put the package into place to actually fill in the blank spaces that remain and get the Eurozone into a much more stable position.”

Osborne added: “I think they’ve made very good progress on the key issues they needed to make progress on – capitalizing the banks, reinforcing the firewall and resolving the Greek situation. Of course, we’ve now got to get the detail – there’s still quite a lot of detail to be filled in. The crucial thing is to maintain the momentum to ensure that we don’t see what happened back in July when they agreed another package, then it took months to get into place. We’ve got to turn what is a good package into something that’s actually got all the detail and is going to work in practice. There are very important questions to be resolved – whether China is going to be involved, exactly how they’re going to operate this new firewall, whether all the private sector are going to be involved in the Greek write down of debt.”

Jonathan Loynes, chief European economist at Capital Economics in London, was also unimpressed.

“The plans announced by Eurozone policymakers overnight look more like a peashooter than the ‘bazooka’ previously promised to tackle the region’s problems,” he wrote.

“We have not altered our view that the crisis will deepen over the coming quarters, ultimately resulting in some form of break-up of the currency union.”

Loynes indicated that each element of the deal will be insufficient to address the crisis.

“The 50 percent Greek haircut, for example, is expected to bring the ratio of debt-to-GDP down from current levels of around 165 percent to 120 percent by 2020,” he said.

“But even if investors fully sign up to the plan, this would still be an unsustainably high level of debt, equal to that of Italy. What’s more, the debt ratio in 2020 will depend very heavily on the course of the economy between now and then. If Greece remains in recession, as we expect, debt will no doubt by much higher than 120 percent of GDP. Accordingly, further Greek restructurings or defaults seem very likely in the future.

He also lamented that the leveraging of the EFSE up to the 1 trillion euro figure was at the low end of prior expectations.

”Therefore [it] seems unlikely [it can] bring an end to contagion effects on other economies,” he noted. “Admittedly, 1 trillion euros would just about cover Italy and Spain’s financing needs over the next three years. However, with a significant portion of fund’s original 440 billion euros already used in bail-outs for Portugal, Ireland and Greece, the EFSF will need to be “leveraged” four or five times to reach that amount. Accordingly, it can be used to guarantee or insure only 20 percent to 25 percent of private sector exposures. As such, there are major doubts over whether investors, such as China, will find the idea of buying peripheral sovereign bonds… very attractive.”

The plan to recapitalize European banks also disappointed Loynes.

“[It is] unlikely to guarantee the stability of the Eurozone banking sector,” he stated. “The increase in core tier one capital ratios to 9 percent - expected to require an injection of some 106 billion euros -- is much more stringent than the 5 percent minimum specified by the summer’s bank stress tests. What’s more, unlike the stress tests, the figures partly allow for the effects of a sovereign default by marking to market securities held on both trading books and banking books.”

He cautions: “However, this means that the plans make little or no allowance for sovereign defaults in Italy and Spain - whose bonds are not far below par. And yet the current political turmoil in Italy casts further doubt on its ability to implement the austerity measures needed to improve its fiscal outlook. Likewise, they make no allowance for the erosion of capital ratios likely to result from general economic weakness.”

Loynes concluded: “We still expect the crisis to prompt a prolonged recession in the euro-zone, further turmoil in global financial markets and, at some point, the end of the euro itself in its current form.”

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