Deal or No Deal? (What is Going on in Europe?)

(Beware of Greeks bearing debts)

The big news last week for the markets was that European leaders arrived at a bailout package for Greece. Equity markets breathed a big sigh of relief (at least for a few days) that a full-blown banking crisis affecting the private sector, similar to Lehman Brothers in 2008, has been avoided. But the bailout package still has left a lot of unanswered questions, since it was short on a lot of the key details of the plan.

First, let’s discuss the key points surrounding this deal. Essentially, Europe’s bailout fund, the European Financial Stability Facility (EFSF) has been increased from €440 billion (about $600 billion U.S.) to €1 trillion (around $1.36 trillion US dollars). The fund will be used to insure the first 20% of losses on new bonds issued by Italy, Spain and other financially troubled European countries. This is very similar to the US TARP program of 2008. The source of the new money is still a mystery. There is speculation that the International Monetary Fund (IMF), China, Japan, Russia, a Eurozone bond issue, or a combination of all of these could be used to provide the funding needed. So far the European Central Bank (ECB) has not been mentioned as a participant, but it is starting to become apparent that the ECB will have to be involved in some way to make this work. China is likely to negotiate a deal strongly in China’s favor, so it would likely be very expensive to involve them.

Next, European banks were asked to “voluntarily” accept about a 50% write-down on their Greek government bonds they are holding. This is theoretically a voluntary restructuring and is not technically labeled a default. This is done to give Greece some debt relief. The plan is to get Greece’s debt down to 120% of Gross Domestic Product (GDP) by 2020 versus a forecast of 170% of GDP in 2012. This would be partially accomplished by exchanging the current Greek debt they hold for new debt to be issued by Greece. The European Banking Authority (EBA) has told 90 banks that they must add capital by next June to give them some space for the write-downs of the Greek Debt. Because of these write-downs, the banks that cannot raise the cash from profits will be forced to raise capital either from shareholders and/or state funds.

The 50% “haircut” on Greek debt would also have to be accompanied by more austerity in Greece and this is likely to be a major problem. The austerity plan would involve more tax increases and continued pay cuts and layoffs for public employees. The plan has not been received well by the Greek people, and just 4 days after it was announced Greek Prime Minister George Papandreou announced a referendum would be held as to whether Greece should accept the package and stay in the Euro-zone. The Greek citizens do not want to continue to make concessions in their standard of living to just to preserve the European Union (EU). Also, substantial reductions in Government spending will likely hamper economic growth for the foreseeable future. Since the plans to get the debt under control are dependent on moderate growth over the next decade it becomes a vicious circle. If the Greek people vote the referendum down (60% are against it) there is a good chance Greece would leave the EU. An “involuntary” default could then occur which could accelerate problems in countries such as Italy, Portugal and Spain. Obviously, the Greek referendum, if it does indeed happen, will be watched by the markets very closely.

The whole European debt crisis has demonstrated the restrictions of euro membership for the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain) that have had trouble controlling their spending. Since they have the Euro as the common currency they no longer have control over the currency and are unable to devalue their own currencies to gain competitiveness on their exports. The EU membership is also forcing austerity measures when their economies need more spending to get them going. The more fiscally responsible countries such as Germany and the Netherlands have been able to compete better and increase exports to bring in revenues and have done a better job controlling spending and so are not facing the same problems. France is probably somewhere in between.

The plan also calls for a commitment from Italy to do more to reduce its debt. Italy has committed to achieve a balanced budget by 2013, and a surplus by 2014 as well as reducing its debt load to 113% of GDP by 2014 (It is currently over 120% and rising). These are bold targets for Italy, and eerily similar to targets that the Greeks have been setting for years now but to no avail. The stock market may be buying the new bailout package, but the bond market doesn’t seem to be biting. The yields of 10 year Italian government bonds have risen to over 6% (current yields on 10 year U.S. Treasury bonds are about 2.1%). This could be the “canary in the coalmine” signaling possible trouble ahead. The bond market is saying that they are becoming more and more concerned about Italian debt, and are thus requiring a higher rate of return. The stock markets are acting like the problem is solved while the bond markets are saying wait a minute! Time will tell as to who is correct.

So the devil is really in the details and there are plenty of unanswered questions before we declare victory. Plus what about the following:

• Will other countries seek similar deals? Italy, Spain and Portugal, whose economies are much larger than Greece, might be next in line. The plan does not appear large enough to handle too many more bailouts should some of these countries have their hand out in the near future.
• How will the “insurance” element of the EFSF work?
• The plan is dependent on affected countries getting their fiscal house in order over the next several years, despite economies that will continue to be hampered by continuing austerity measures. How is this going to work out? Greece has already shown it is much easier said than done.
• A true solution probably involves a fiscal union which includes a central treasury, a more powerful central Bank and the issuance of Eurobonds predicated on this fiscal union. Unfortunately, getting all the EU countries to agree on this is not likely at this time.

All in all, it is a good first step that the powers that be in Europe are trying to get something done to avoid a full blown crisis. At least it looks like there is a rough framework in place, but they are going to have to provide more details soon, or markets may get very nervous again. Also, the whole plan doesn’t appear to be a permanent solution, but may buy some time until a permanent fix is available. So, for the time being it appears to be another instance of kicking the can down the road. The problem is that this can is getting bigger and bigger, and we may still be talking about these same issues a year or two from now. So, depending on the outcome of the Greek referendum, it looks like it is “Deal? Or No Deal?”