Harbour Commentary: Holes in the lifeboat

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The European sovereign debt crisis remained the main driver of global fixed income markets during the course of October, continuing the theme that dominated markets over September.

Wednesday, November 2nd 2011, 2:25PM

by Harbour Asset Management

• The European sovereign debt crisis has dominated financial markets again this month.
• At the end of October, the market took a huge sigh of relief when European leaders announced their latest rescue package.
• However, the plan lacks key details and faces significant implementation challenges, including a possible Greek referendum.
• Italy and Spain, in particular, face the greatest threat of contagion if the crisis spreads.
• It will be some time before concerns about Europe subside for good.
• In the meantime, Europe looks set to be a drag on global growth, helping to underpin the relatively low level of interest rates in core developed markets like New Zealand.

The European sovereign debt crisis remained the main driver of global fixed income markets during the course of October, continuing the theme that dominated markets over September. After experiencing the depths of pessimism following the IMF/G20 meetings in September, there was a strong sense of anticipation over the first half of October as optimism grew that European policy makers had grasped the severity of the crisis and would deliver a comprehensive rescue package.

The Lifeboat has arrived!

There was a huge sigh of relief from markets when a rescue package was announced on 27 October, after European leaders worked into the small hours of the morning to finalise the deal. And there were certainly plenty of positive elements to cheer about.

• European leaders had set aside their internal squabbles and met their self-imposed deadline ahead of the November G20 summit.
• The larger haircut on Greek debt of 50% was a step in the right direction to put it on a sounder footing. And the two largest vulnerable European countries, Spain and Italy, committed to improving their debt positions through structural reforms.
• The firepower of the European Financial Stability Facility was increased from Euro 440 billion to Euro 1 trillion providing more resources to address the crisis. And importantly, bringing the IMF and other countries like China into the rescue fund acknowledged the size of the problem - it is a global problem - that requires a global solution.
• Finally, there was a plan for recapitalising banks to the order of Euro 109bn, detailed down to individual banks. It highlighted that those banks that needed to raise capital were largely contained to Greece, Italy and Spain - with less needed in France than expected, and UK banks requiring no more capital.

Holes in the Lifeboat

As the sigh of relief passed, it become increasingly clear that the package was missing key details and faced some tough implementation challenges.In short, there were visible holes in the lifeboat.

• The EFSF increasing to Euro 1 trillion is less than the Euro 2-3 trillion that would drawn a more definitely line under the European sovereign crisis. Indeed, the details on how the Fund will be leveraged to Euro 1 trillion remain sketchy. And although China and others were named as potential sources of funds, they have yet to sign up.
• The 50% haircut on Greek debt does not include holdings by the ECB or IMF, who now hold a vast chuck of their outstanding government bonds. Furthermore, this private sector haircut is "voluntary" so there is a risk that this part of the agreement unravels. The 21% haircut in the July rescue package was also voluntary and took considerable time and effort to receive private sector backing.
• The package is forecast to have the effect of bringing Greek debt to GDP to 120%. This is still very high by international standards - in the same ballpark of other vulnerable European periphery countries - and at risk of missing this forecast if Greece remains in its economic slump of the past 3 years as GDP shrinks.
• In containing the European sovereign crisis, much hangs on the ability of Spain and Italy to implement structural reforms that will improve their debt dynamics, and restore market confidence. If either of these countries fell victim to a loss of market confidence, it would propel the European crisis into a completely larger scale. Since the package, the reaction in the government bond markets of Spain and Italy has been lukewarm at best.
• It is still unclear how the European banks will be able to implement their recapitalisation plans - whether they will be able to raise these funds in the private sector. Rather than increasing capital, it looks increasingly like they will attempt to improve their capitalisation ratios by shrinking assets and cutting loan growth, which would hurt economic growth.

The biggest challenge for the package came just days after the announcement when Greek Prime Minister George Papandreou stunned financial markets (and his own parliamentary colleagues) by announcing a referendum allowing Greek voters to decide whether to accept the bailout package. The Financial Times in London reported one European diplomat as saying that the decision was "the political equivalent of smashing rare and expensive plates at a restaurant when one is happy: the meaning of this eludes everyone."

Struggling Back to Shore

Much of the initial euphoric reaction to the European package has now been unwound.

That said, the risks of an imminent disaster out of Europe has been reduced, and this has been reflected in an easing of funding pressures on global banks.

Indeed, Australasian banks look in resilient shape compared to their European counterparts, with less need for immediate funding, stronger balance sheets, and a firmer economic backdrop. This relative strength, and eased concerns over funding costs, may be one factor that provided New Zealand banks the confidence to pass on these lower funding costs to their customers by lowering their fixed mortgage rates.

Looking forward, we expect the outlook for Australasian banks to be linked to the domestic economic cycle and prospects for China, where we expect the market to continue focusing on both the property cycle and the prospect for monetary easing.

Regardless of the success of this European rescue package (or the next!), the backdrop in Europe is likely to be relatively slow economic growth in the coming years, as the region deals with the constraints of high debt and low productivity growth. Once added to the patchy economic recovering occurring in the United State, this adds up to an environment where interest rates in core developed countries, like New Zealand, look set to stay relatively low for a while yet.

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