The highly anticipated EU crisis summit has delivered headline agreements in the three key areas: a Greek bailout, bank recapitalisations and an expansion of the rescue fund. Agreements were reached between EU leaders at around 4am on Thursday morning Brussels time, 11 hours after the summit began. European equities rose strongly and the spreads on Spanish and Italian government bonds tightened relative to German bunds.
In terms of helping Greece, the summit agreed on a new 130 billion euro bailout for the troubled southern European country. Of this, 100 billion euros will come from the European Financial Stability Fund (EFSF) and 30 billion euros from the IMF. Private bond-holders of Greek debt have decided to take a voluntary 50% writedown on Greek government bonds. The writedown is expected to see Greek government debt fall to 120% of GDP by 2020, from a forecast of about 170% of GDP next year if no debt was written off.
For the banks, agreement was reached that they need to raise 106 billion euros to boost core tier-1 ratios to 9% by June 2012. The Euro Banking Association has suggested several ways to raise new capital: going to private markets; retaining profits and withholding discretionary payments; and substituting existing hybrid instruments with higher quality capital instruments. The 9% tier-1 ratio target exceeds the 7% level that world leaders have agreed to phase-in from 2013. Banks have until the end of the year to tell supervisors how they will make up the capital shortfall by the June 2012 deadline.
Leaders decided that the EFSF is to be leveraged and will provide “risk insurance” for new bonds issued by struggling eurozone economies. It could be leveraged “four or five” times, suggesting a capacity of about 1 trillion euros.
What does it mean?
While headline agreements have been reached, much of the details of implementation are still to be worked out. The impact of a voluntary 50% writedown on Greek government bonds on credit-default swaps that protect against outright or technical default is unclear. If these contracts are not triggered, many investors might view them as worthless. If they are, it could help to spread contagion. Although exposures are known and are thought to be relatively limited, the ECB would ultimately act as lender of last resort.
The focus of attention is moving to Italy where the debt-to-GDP ratio is 121%. EU leaders have been pushing Italy’s Prime Minister Silvio Berlusconi hard to deliver concrete austerity measures. Berlusconi’s hastily-put-together plans are focused on raising the retirement age and accelerating the program to privatise state assets. Investors will monitor progress on these plans in coming weeks. Beyond revealing plans for the EFSF bailout fund to be extended, it remains to be seen exactly how this will be implemented.
Dominic Rossi, Global CIO equities at Fidelity says that while financial markets have reacted positively to the intent shown by policymakers, the deal is not the game changer investors are looking for. “Italy's 120% debt-to-GDP doesn't look any more sustainable today than yesterday,” Dominic says. “Europe is destined for a multi-year workout during where economic growth will be very restrained and equities are likely to remain cheap. The path of equities will therefore require better news else where. Earnings growth in the US continues to surprise on the upside and we may be approaching a policy shift in China. The catalyst for higher equity values lies outside Europe rather than within.”
Trevor Greetham, Asset Allocation Director at Fidelity, says the EU leaders surprised positively after the squabbling of recent days but were low on detail on the critical point of leverage for the bail out fund to backstop Spain and Italy. “We may have to wait until November for specifics of possible BRIC/IMF involvement alongside a partial insurance scheme for primary issuance,” Trevor says. “The critical test will be what happens to the Eurozone economy. Provision of liquidity goes hand in hand with further austerity in the periphery with Italy now the focus. Meanwhile, if the UK experience is any guide it will be hard for national regulators to prevent banks deleveraging their balance sheets now forced public capital injections are threatened.”