Promising or Just Promises?

Europe appears to be finally gaining momentum in its long and slow struggle towards a solution to the sovereign debt and banking crisis that is threatening its very existence. France and Germany have promised to produce a “comprehensive plan” to end the crisis at this weekend’s European summit on 23-Oct and will present it at the G-20 ministerial meeting on 3-Nov. The plan is expected to encompass three crucial elements: deeper haircut on Greek debt; recapitalisation of European banks; and an increase in the firepower of its bailout fund to prevent contagion to other countries.

Sounds familiar? Sure. The markets have been demanding these actions for some time while politicians were dithering. What is new now and certainly out of character is that a definitive timeframe has been fixed and one that is rather aggressive too. All of a sudden, policymakers in the euro-zone find themselves surfing right up to the curve as markets turned decidedly exuberant in anticipation of a resolution.

Is this the real deal? This is a tough call. That Germany and France have promised to act within such a tight deadline is promising. And markets have rewarded such a bold move with the EUR trading at a 1-month high and equities up more than 10% in the past two weeks. But the devil is in the details and the proof of the pudding is in the execution.

Regarding the amount of haircut, there is still disagreement amongst various countries to accept deeper losses. It was only three months ago that private creditors agreed to a 21% haircut. Germany now wants a 50%-60% write-down while France is resisting because French banks, being one of the largest holders of Greek debt in the region, will be hardest hit. What should the amount be? Too little and the markets will be disappointed. Too much and it will encourage Ireland and Portugal to backslide on their reforms and clamour for a haircut too.

On recapitalisation, what is clear is that banks need more capital. Besides that, little else is clear. There will be new stress tests to determine the extent of additional capital the banking system needs. The stress test scenarios have to be tough enough to be credible but yet at the same time not so demanding that the capital needed to fill the gap is unachievable and risk sending the markets into another tailspin. According to sources, EU leaders are working on a plan to raise anywhere between EUR100 billion and northwards of EUR300 billion. Meanwhile, banks are reluctant to raise capital when their shares are trading at fractions of book value, existing shareholders are resisting calls to pump more capital and governments are weary about using more taxpayers’ money to bail out banks. It is also unclear whether the recapitalisation will be a piecemeal effort on a national basis or a concerted pan-European execution in one go. Germany has stressed that individual countries should take care of its own but France is opposed to that because it could jeopardise its triple-A rating. 

And on more firepower to the EFSF bailout fund, one can only hope that they have achieved a consensus. It is only after a prolonged struggle did the German parliament finally ratified the expansion of the EFSF to EUR440 billion and allowed it to buy bonds in the secondary market as well as to offer credit lines to governments. The same can be said for Finland, the Netherlands and Slovakia. If the EFSF is to be sufficient to backstop the liquidity of the periphery countries including Spain and Italy, it would need to grow to a size of at least EUR2 trillion. And EUR2 trillion implies a coverage ratio of only just about 50%. European officials have to find ways to scale up the fund without requiring another round of voting. They could either turn the EFSF into a “bank” allowing it to leverage up its equity of EUR440 billion through a credit line with the ECB, or alternatively, it could act as an insurer to protect the first 20%-30% of the value of affected sovereign bonds. It is unclear how they will proceed.

One week is a rather short time to manage all these challenges. But then again, this crisis has been brewing for more than a year and a half. With pressure mounting, time running out, European politicians have no more excuses. For once, they have the chance to get ahead of the curve. They should grab it. 

The big question is will they succeed in convincing the markets, or will they disappoint yet again. If the latter, then markets could easily give back all the gains and more, but if the former, then the question is how much more upside can there be. Going by the previous experience in the US in 2009, it can be substantial. In March-2009, US Treasury Secretary Tim Geithner expanded the TARP program to announce a public-private initiative to buy toxic assets from banks paving the way for the banks to be recapitalised. That turned out to be the turning point in the risk markets and equities powered ahead for the next 12 months by more than 80%.

I’m not suggesting we’ll get a similar magnitude of response. For one, while the TARP in 2009 may have removed the systemic risk threatening the banks, the real lifting of financial markets was attributable to the combined global firepower in fiscal and monetary stimulus and quantitative easing.

The world is a much different place now. Governments in the developed world are on an austerity mode even while their economies are moving along stall speed, and central banks do not have much room for manoeuvre with rates already at or near historic lows. The experiment with unconventional policy such as quantitative easing have not yielded much in terms of economic growth but have definitely bloated up the balance sheets of these central banks. And more importantly, investors are less naive. They now know better that you can’t solve a debt problem with more debt. It only comes back to roost at a later time.

For the record, I’m not a pessimist. In fact, as an equity fund manager, my pre-disposition is normally optimistic. I believe we’ll get a strong rebound when we get the resolution. But given the reality, I’m just not as convinced about the sustainability. For me, the best case scenario is that the European crisis is stabilised, developed markets manage a 1-3% annual growth while finding a way to reduce their debts over the medium term without harming the economy too much. But the odds are not high and hence we need to be prepared for a “new normal” in the financial markets with higher volatility and lower returns. This will have strong implications on asset allocation in the next few years. In a high risk-low return environment, the sweet spot in terms of risk profile is skewed towards the conservative. But for now, even though we are cautiously optimistic, prudence would dictate that we change our allocations only when we get more clarity on 23-October.