On The European Deal…

Looking at the main points of the debt crisis deal released earlier doesn’t shock me, as it is just another can kicking exercise by policymakers. It is not a solution. Nothing – apart from the honest restructuring of sovereign debt, the consequences to be borne by the creditors and the creditors only – can be. While traders and financial media will undoubtedly be in party mode over this, remember that their outlook generally doesn’t extend beyond 4PM EST. From this perspective, the deal has been overwhelmingly positive and a success, given the reaction in the various markets. ‘Risk on’ is back – for now. It isn’t surprising either. As bearish as I am, if you’ve been reading my Market Observations, you’ll note that I have been looking for a short term levitation in risk assets. And we’re getting it. But will it last? Let’s go through the main points the Telegraph has laid out:

The €440bn European Financial Stability Facility (EFSF) – often referred to as the rescue or bail-out fund – will have between €250bn and €275bn available after providing aid to Greece, Ireland and Portugal.

Right away you can see that between €250-275 billion won’t come anywhere near enough to fund the likes of Italy and Spain for any substantial period of time. So it has to be leveraged:

 The eurozone leaders say the fund’s firepower could be quadrupled to around €1 trillion to create a “firewall” against contagion from the debt crisis. It will be leverage through the use of a combination of a special purpose investment vehicle and a debt-insurance scheme.

Even this  €1 trillion figure doesn’t do much to cover Spain and Italy for much longer than two years, if that. Also, should another country run into trouble, the funds will be depleted further and take even less time to run out. This merely confirms the can kicking nature of it all. The real issue though is the manner of leveraging. The debt-leveraging scheme would work as follows:

 A state-sponsored insurance scheme would ensure a buyer of, for example, Italian bonds, would get a payout if Italy were to default – the size of the payout is still to be negotiated but there have been suggestions of the first 20pc of any loss. Eurozone leaders this guarantee will encourage otherwise reluctant investors to buy government bonds. The wording seems to suggest investors will have to pay for this insurance.

In other words, the EFSF will be offering CDS style protection up to 20% of any loss. The existing CDS market, that would be dealing with this under normal circumstances, has been dealt a blow by the International Swaps and Derivatives Association (ISDA), who deemed that the 50% haircut on Greek debt that is also part of this deal will not be deemed a ‘credit event,’ as it is a voluntary haircut.

This sort of thing renders the CDS contracts on Greek debt almost worthless, which is what the policymakers intend, in hopes to curtail the ‘evil speculation’ in CDS markets that is always a scapegoat in these crises. All this will do however, is lessen the appetite for private consumption of public debt, given that a method to hedge against losses incurred (CDS), has already been proven to be unreliable. If policymakers can just snap their fingers and render such insurance policies to be worthless, then why are investors going to load up on more public debt with no means of protecting themselves? In the event that losses are incurred on these new bonds, are the policymakers going to declare such haircuts ‘voluntary,’ and thus not pay out those insurance claims as well?

The bottom line is that there stands to be very little in the way of private appetite for new issuances of debt. The ‘Special Prupose Investment Vehicle’ also relies on investors, mainly foreign investors from China and the Middle East. Again there is nothing in the way of concrete support for these plans from either player, and it is unlikely to surface at any point in the future.

Ultimately, this is just a vague, patchwork plan that will yet again kick the can down the road and distort markets further. There will be increased pressure on the ECB to start monetizing the debt, but this isn’t a solution either, despite what Martin Wolf or Paul Krugman will tell you. This is because the bad sovereign debts will be paid for by the average European via inflation. Should the ECB capitulate and start printing money in the manner the Federal Reserve or Bank of England have, it will be the last straw for the Germans in my view. I can’t see them sticking around to endure the results of a fresh attempt by another Central Bank to inflate the problems away. Should it get to that point, I think we would see a real push to return to the D-Mark.


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