We’ve seen major upheavals in Europe over the past week.Two prime ministers have been unseated and yields on bonds are skyrocketing for Italy, Spain, and France.
More and more, Italy looks like the big problem at the heart of this crisis. But despite PM Silvio Berlusconi’s recent ouster, there’s not much hope that Italy can turn itself around anytime soon.
In the craziness over bond yields, however, let’s not forget the major issues that are at stake right now.
A resignation offer from PM Silvio Berlusconi yesterday hit markets by storm. Now yields on Italian bonds are shooting through the roof, following in the footsteps of Portugal, Ireland, and Greece. In fact, Italy looks a lot like Greece, except on a much bigger scale.
Now the government is faced with getting itself in order sufficiently to pass a 2012 budget and a new reform package. No one knows exactly how that will play out.
With Italy likely too big to fail and too big to rescue, the onus is on Italian politicians to get the country's finances in order--unless they decide to bail first.
While concerns about a referendum and government collapse in Greece last week were ultimately unfounded, they nonetheless bely greater political instability in Greece.
That instability has been compounded by the government's failure to decide upon a new prime minister. They've been delaying a final decision on that all week.
Protests and riots have raged virtually without interruption for the last few months, and a shakeup of the Greek military -- though seemingly harmless -- implies that the government is facing severe political pressure.
Clearly, changes need to be made in the eurozone to better manage and prevent crisis and public spending problems.
Herman van Rompuy told reporters that euro area leaders have recently made a LOT of progress on this issue. However, the progress made by EU leaders at their second summit Wednesday was disappointing -- while EU leaders spoke vaguely of changes, no tangible proposals were made.
In reality, we won't see major amendments to EU governance anytime soon. Merkel told reporters after the summit Wednesday that a final roadmap of treaty changes won't be decided upon until March 2012.
In addition to the political controversy such amendments will generate within EU states after those measures are agreed upon, non-euro countries might oppose measures that further distinguish them from euro area states.
Amendments to the euro area that would make it smaller and sleeker could provide an endgame for the euro crisis--but not without significant expense.
Such an alternative would require changes to the current EU treaties that allowed countries to be ejected from the euro currency, not to mention stronger fiscal integration. It would also leave the countries kicked out of the currency at a significant disadvantage, and they would quickly become the targets of speculators.
Intensifying arguments between EU states that use the euro and those which do not comprised some of the biggest news to come out of the EU summit last weekend.
Of particular note was a choice statement by French President Nicolas Sarkozy, who told U.K. PM David Cameron, 'You have lost a good opportunity to shut up...We are sick of you criticising us and telling us what to do. You say you hate the euro and now you want to interfere in our meetings.'
But it looks like euro and non-euro states might have made peace after all 27 EU leaders agreed on the program to recapitalize European banks and news surfaced that EU treaty changes are not an immediate concern.
However, divisions could heat up once again as eurozone leaders debate changes to EU treaties that could change the relationship of states that use the euro. This is probably a long-term issue, however, as a final roadmap on those changes won't see publication until March 2012.
Eurozone leaders and Charles Dallara, the managing director of the Institute of International Finance and representative of the banks at the negotiations, struck a deal on 50% 'voluntary' haircuts on Greek bonds at the big EU summit two weeks ago.
The size of these write downs could cripple the banking sector despite bank recapitalization, which has already suffered significant stress with the current writedowns (remember Dexia?). On the other hand, bigger haircuts seem like the only way to make Greek debt sustainable.
While an agreement may have been reached on private sector losses, it doesn't mean bondholders are going to go for it voluntarily.
Bondholders must participate voluntarily to avoid provoking a credit event, in which credit default swap insurance against Greek debt gets paid out.
The deal reportedly includes lots of attractive 'sweeteners' for banks, however considering that at maximum 85% of bondholders showed interest in a 21% haircut, we're sceptical that nearly as many are going to voluntarily take losses of nearly double.
That suspicion is bolstered by announcements from Greek lawmakers last week that they expected 100% participation in the swap -- something that realistically will only be achieved through coercion.
The ramifications of a credit event could be disastrous. The size of the CDS market is a bit of an unknown, so the shocks caused by CDS payouts could be far-reaching and incredibly damaging.
On the other hand, Citi's Willem Buiter argues that a credit event caused by coercion might not actually be such a bad thing. The size of the Greek sovereign CDS market is small and better regulations are in place now to control contagion than were in the Lehman days.
This is likely to become the biggest topic of conversation in the coming weeks.
The European Banking Authority alleged that banks will probably need about €106 billion ($147 billion) in capital to meet a new 9% core capital requirement. They'll have 8 months to meet this goal.
But they'll probably receive less funding than this number implies from national authorities and the EFSF. Banks will be asked to seek funding on their own before turning to national governments for capital. Only if governments are incapable of meeting these capital needs on their own will banks receive funding from the EFSF.
There are problems with this plan, however.
The size of these recapitalizations will probably still be too small to calm markets. Further, it will bar fragile banks in core European countries like France from EFSF funds, placing more stress on the French government -- and thus France's credit rating.
Finally, there is some concern that countries like Italy and Spain will wage a campaign to taint the 9% capital requirements and allow banks to use riskier, hybrid capital to meet the agreed-upon core ratio.
EU leaders are considering two plans to leverage the European Financial Stability Facility up to €1 trillion ($1.4 trillion). It will probably be able to use both plans simultaneously, although they still haven't set out a coherent plan:
Guaranteeing first losses on sovereign bonds:
- This plan would likely insure 20-30% of bondholders losses on sovereign debt holdings, with the aim of inducing them to purchase bonds of struggling sovereigns like Italy and Spain.
- We're sceptical that such a plan would work. 20-30% guarantees will probably be too insignificant to convince investors to continue purchasing bonds.
Using an SPIV funded by the IMF and private investors:
- An SPIV would be used to induce investors like the IMF and China to purchase sovereign bonds on the primary and secondary markets. The IMF could also be included in this plan.
- This SPIV will probably take weeks to create, according to Reuters columnist Paul Taylor. Further, it essentially amounts to the rest of the world bailing out Europe, particularly if private investors aren't so keen on buying sovereign bonds. It would also likely require the IMF to boost its resources.
- However, an IMF backstop to the eurozone as a whole is an attractive proposition, as it implies that the fund will do what is necessary to support a euro rescue. The IMF can act more quickly than the EU and with much less fanfare.
China is a wildcard in the eurozone crisis. While there have long been rumours about Chinese involvement in the bailout, this time that now looks more likely than ever.
This series of rumours started when EFSF head Klaus Regling suddenly flew to China. Then French President Nicolas Sarkozy announced that he would welcome Chinese interest in helping out. He spoke with Chinese Premier Hu Jintao the next day.
However, it seems the International Monetary Fund will be key to organising a coordinated, global response to the crisis. Failure to reach a deal on IMF backing of the EFSF at the G20 summit last week and continued U.S. opposition to involvement suggests that there are more battles to come on this matter.
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