The EUR has rallied on the news and CDS for all of Europe has fallen significantly. Italy and Spain had been close to reaching the key 400 level in CDS on Monday, but now have fallen back to 260 and 310 respectively. Stock markets in Europe are rallying on the news.
Similar to the U.S. "Gang of Six" debt ceiling plan, the devil is in the details on the new scope of the European Financial Stability Fund, and many questions remain over the ultimate impact it will have on the peripheral countries' debt. The biggest positive is the ability of the fund to ease the terms of Greek loans by extending the length from 7.5 years to 15 years and reduce the interest rate on those loans. Next, the fund appears to have the authority to buy debt in the secondary market, and could purchase debt under the auspices of the European Central Bank. Finally, the fund will be able to make loans to governments to enable states to recapitalize financial institutions including non-programme countries. Like TARP, the mere announcement of the changes to the fund has changed the outlook of the market towards the periphery and financial institutions.
As noted, the initial market reaction has been very positive, as the use of the EFSF is seen as a solution to the acute European debt crisis. However, the plan raises concerns regarding several functions that now it has the power to use. First, the fund is created by member country contributions, and new loans from the fund to Greece have the de facto mechanism of redistributing Greek debt to the members. This is done without the legal ability to not only constrain Greek spending, but also without the ability to force asset sales for raising euros to pay off debt. This was the major German and Finnish concern. At this time, I'm also not certain whether the EFSF can engage in the new functions without all participating countries putting their plans to a vote. I'm not sure how politicians in either country will view this development, but the reaction will likely be negative.
The backing of the member nations (especially Germany) is critical as it provides both the funding and the AAA rating. As for that rating, if the EFSF provides loans to member nations for bank recapitalizations, this takes the fund into new credit territory. Granted, the loans are made to the country and not the banks, but the link to a much lower-quality entity remains. Will a member country make the fund whole should one of their financial institutions go bankrupt? What if this occurs in a crisis environment when the nation is going under as well? What happens if one of the nations that are supposed to fund the fund goes into default and can't make its contribution?
Lastly, the new plan provides three options to the private sector on what to do with their Greek bonds. They include a debt buyback, a rollover or a swap into new bonds. The buyback assumes a private bondholder wants to sell bonds at current market prices with an approximate 40% loss. The rollover plan assumes a private bondholder wants to maintain exposure to Greece as the debt matures. Finally, the swap assumes both conditions (depending on the terms). I think all of these are incorrect assumptions. Also, the private bondholder will not likely sell now especially if he/she believes that European governments will eventually buy back the debt at face value. And there is the distinct possibility that all of these options will trigger the ratings agencies to declare a default.
By the way, the new plan makes no determination over what level of debt the periphery countries can support. Barron's has aninterview with Seth Egan of Egan-Jones Ratingswhich details the ability of these nations to support the debt they have with the tax receipts they receive. Here's the data:
- Greece Debt E330b/Tax Revenue E46b
- Ireland Debt E200b/Tax Revenue E34b
- Italy Debt E1.843t/Tax Revenue E445b
- Portugal Debt E160b/Tax Revenue E38b
- Spain Debt E639b/Tax Revenue E211b
The conclusion one draws is that these nations can't support their debt under almost any interest rate.
For now, the markets continue to express relief over the new agreement to assist the European periphery via the EFSF. The hope is that the new plan will help Greece, Ireland and Portugal gain time to restructure their finances and ease the burden of their debt. The spreading of periphery debt responsibility out to the rest of Europe will provide a short term solution to the acute debt crisis issue. However, the stark fact remains that these countries can't support their current debt loads due to the lack of tax revenues.
Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a contributor to CNBC's Money in Motion Currency Trading.You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.
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