12 October 2011

Simon Nixon: Is it a euro bazooka or a damp squib?

The new 'Grand Plan' hatched by Merkel and Sarkozy will aim to address at one stroke the inter-related problems of sovereign debt, bank capital and bank funding—what UK Prime Minister David Cameron has dubbed the big bazooka. What could possibly go wrong?

Despite the market's initial enthusiastic response to news that this secret deal has been reached, plenty of pitfalls lie ahead. The first task is to secure a comprehensive solution to Greece's problems. To put Greece's debt back on a sustainable footing, necessary to retain IMF support, it is likely that much more debt relief will be needed than is currently on offer. Many argue that most of any further debt relief should come from the private sector... but it is hard to see how this can be done on a voluntary basis. A coercive deal would trigger credit-default-swap contracts with unknowable consequences.

The alternative to unleashing a "Lehman moment" on global markets would be for eurozone leaders to agree substantial forgiveness of official loans via further maturity extensions and interest rate cuts. This would have the added virtue of lifting some of the cloud over sovereign bond markets and easing the pressure on banks. But this solution would require political courage so far lacking from eurozone leaders.

That points to the second challenge: To recapitalise Europe's banks to withstand further losses on government debt. Top ECB officials believe it may be sufficient to re-run this summer's doomed stress tests allowing for any increased haircut on Greek government bonds and setting a higher pass-mark of 7 per cent core Tier 1 capital ratio rather than 5 per cent, according to someone familiar with their thinking.

If the eurozone sets the bar too low, the markets will not be convinced, funding markets will remain closed and banks will continue to speed up their deleveraging plans. But setting the bar too high risks spooking the markets: investors may interpret a stress test that included a haircut on Italian debt as a signal that Italian debt was also at risk of default—a potentially catastrophic scenario for which no realistic amount of new equity would be sufficient. Another risk is that if capital levels are set too high, banks will further accelerate deleveraging to boost returns on equity.

The third challenge is therefore to convince markets the challenge facing Italy and Spain is one of liquidity, not solvency. That in turn means arming the European Financial Stability Facility with sufficient firepower to reduce both countries' borrowing costs. But a worry is that any new EFSF guidelines would still require a separate vote in the Bundestag.

That leads to the final vital element of the Grand Plan: Agreement on EU institutional and governance reforms necessary to convince countries such as Germany that the rest of the plan is worth supporting. These reforms would be sure to include much tougher EU oversight for national fiscal policies, particularly countries that draw on eurozone funds, and would almost certainly require treaty changes. Given the difficulty the eurozone is facing securing support for the expansion of the EFSF, securing political agreement for the transfer of yet more powers to Brussels could be difficult.

Ms Merkel and Mr Sarkozy have promised to reveal the full details of their great undertaking in four weeks. If they pull it off, it will certainly be an achievement of great advantage. It will also be little short of a miracle.

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