Given both the multitude and the complexities of the issues that Europe needs to address, expecting that all could be resolved by today was always an impossibility. Of course, the task has been made much harder by the exceptional financial constraints faced by most of the eurozone’s sovereigns and Europe’s clunky governance structure which significantly prolongs decision-making.
As such, we can expect to be disappointed tomorrow. That said, it must also be conceded that steady and deliberate progress is being made on a number of fronts. On the EFSF, the proposal whereby the facility would set up a fund to guarantee bond-holder losses on new sovereign issuance appears to have gained sufficient acceptance, but as we have suggested previously, this is no more than simple financial alchemy.
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Critically, even if European leaders announce that the EFSF’s capacity has been raised to, say, EUR 1trln, no European sovereign is being asked to contribute extra money in the near term. Another EFSF proposal that was circulating in Brussels last week was bringing forward the timetable for the temporary (EFSF) and permanent (ESM) rescue facilities to mid-next year. Discussion on this idea seems to have gone quiet and not surprisingly given that most of Europe’s largest sovereigns simply will not have the cash to contribute fresh and hefty sums to the ESM by then.
On the subject of potential non-European contributions to the EFSF from the likes of the IMF and the BRIC nations, this remains under discussion, although it is too soon to expect a definitive announcement on this today. Firstly, a number of the IMF’s heavyweights, such as the US, Japan and the UK, pushed back against a suggestion two weeks ago that their contributions be lifted significantly in the short term.
Secondly, the IMF would be extremely reticent about providing loans to sovereigns where they did not have preferred creditor status. And finally, the IMF would probably want a great deal of say in how the money was spent; if not, then it would certainly impose strict conditionality on how the funds were disbursed. A lot of water will need to pass under the bridge before this one is resolved.
On Greek debt haircuts, reports suggest that the two sides are still far apart. European negotiators are attempting to convince the consortium of bondholders to accept a haircut to face value of 60%, which equates to a reduction in net present value (NPV) of over 75%. However, negotiators from the Institute of International Finance (charged with representing the bondholders) have offered a ‘voluntary’ reduction in NPV of 40%, up from 21% at the time of the July deal. On banking recapitalisation, it has been agreed that European banks needs to raise more than EUR 100bn of new capital, but there is likely to be little detail over who will provide this capital, because surely it will be very expensive and the private sector will be reluctant. With so many of these issues still in flux, Europe will try to talk up its response today in front of the assembled international media but unfortunately the substance will be lacking.
Commentary
UK rebalancing is working. Against the backdrop of very high inflation, falling living standards, unprecedented fiscal austerity and an economy flirting once more with recession, it is little wonder that the prognosis on the UK economy has been so relentlessly negative this year. But finally, there are some signs emerging that all of this pain and suffering is producing results. In the second quarter, the current account deficit narrowed to an eight year low of just GBP 2bn, well below expectations and down substantially from the previous quarter (originally reported as a deficit of GBP 9.4bn, now revised down to GBP 4.1bn). To put this into context, the average current account deficit over the past decade has been GBP 7bn. Over recent quarters, the narrower external deficit reflects both a reduction in the size of the trade deficit and a significant increase in investment income from overseas. Relative to GDP, the current account deficit is now just 0.5%, a thirteen year low. Separately, household-sector saving jumped to 7.4% of disposable income in the second quarter, up from 5.9% in the March quarter. For the Chancellor, he ought to be rejoicing. Net borrowing by the public sector (on a national accounts basis) has fallen consistently over recent quarters, from a peak of GBP 42bn back in Q1 of last year to GBP 33.5bn in Q2. This has been almost exactly offset by a reduction in foreign borrowing, a necessary but hitherto largely neglected aspect of the whole adjustment process. Households have been less successful in recent quarters in terms of saving, reflecting the enormous squeeze on real incomes, although there was some partial relief in the second quarter. For sterling, the news that the current account deficit has narrowed substantially, public sector borrowing has fallen significantly, and the household sector is replenishing saving is unambiguously positive.
Equities unnoticed amidst euro-focus. Such is the understandable focus on Europe right now that almost unnoticed this month has been the very powerful improvement in global equity markets. Just as well, it could be argued, after a dreadful August/September when the investment skies were so dark that Armageddon loomed. Since the end of last month, the major bourses in both Europe and the US are up by 8-10%. For the year thus far, US equities are little changed, the FTSE is down 6%, the DAX has dropped 13% and the CAC-40 has fallen 17%. The dramatic recovery reflects a number of factors. Firstly, both traders and investors became über-bearish, so there has been a degree of short-covering that has propelled the rally. Also, some savvy investors who had spare cash recognised that the equity risk premium became so elevated that equities represented exceptional value. The more constructive mood has definitely been aided by European leaders displaying greater urgency in dealing with their sovereign debt and banking crisis. Additionally, the American economy seems to be chugging along again, with FedEx last night claiming that the US outlook was looking healthier – back in the summer, recession seemed around the corner. The Fed has implemented a twist, with some speculation that it might opt for more quantitative easing over coming months; the ECB looks set to cut rates before too long and the BoE implemented significant additional asset purchases. Corporate earnings in the US for Q3 have been healthy. Interestingly, volume throughout this relief rally has been light, implying that participation has been low. The perky performance in stocks coincides with a powerful jump in high-beta currencies. For instance, the Aussie is up 8% month-to-date, the BRL 7%, and the Norwegian krone 6.3%.
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