Europe has an impossible dream

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Expectation levels have certainly been raised by last weekend’s declaration at the G20 meeting that Europe needs to present a comprehensive plan for resolving its sovereign debt and banking crisis at this weekend’s EU Summit. Since that time, Germany has attempted to water down the “dreams” that many appear to harbour of what can realistically be achieved by Sunday. In contrast, French President Sarkozy emphasised yesterday that “an unprecedented financial crisis will lead us to take important, very important decisions in coming days”.

As so often happens when weighty matters are being debated by the current German and French leaders, Angela is again playing for time while Nicolas is essentially saying that there is no time. Raising the stakes, Sarkozy claimed that the destruction of the euro risked the destruction of Europe. The French President is absolutely right – it is five minutes to midnight for Europe and still the German Chancellor says she wants to think about it. Can Sarkozy convince Merkel to save Europe? Because if he cannot, then France could sink as well.

Guest post by FxPro

With so much riding on Sunday’s outcome, it is worth exploring what can reasonably be expected. First, on Greek debt, despite the protestations of France, the ECB and bond-holders, it is abundantly clear that the private sector needs to shoulder a much greater burden, and accept that, without a much larger haircut, Greece has nil chance of repaying its loans. Moreover, the longer it takes for the private sector to accept a bigger haircut, the increased likelihood that the amount it will ultimately receive will be much lower. It is becoming untenable to argue for anything other than a significant debt write-down in Greece.
Second, on bank recapitalisation, Europe’s banks may be screaming blue murder, but frankly their time is up as well. Claims that they can make sufficient adjustments to their balance sheets by culling assets and lowering their lending are not just unlikely, but also counter-cyclical. It would merely reinforce the huge tightening in financial and credit conditions already underway. Furthermore, the deleveraging that banks represent they are prepared to undertake to avoid public funding is significantly below what is required. Most of Europe’s banks have little choice – they will be forced to accept recapitalisation, and it will almost exclusively be public money because the private sector will be very reluctant.
The problem is that pouring substantial public money into the banks only exacerbates the mountain of future liabilities many European nations have already saddled themselves with. France, for instance, is expected to record a public debt-to-GDP ratio by year-end of 87%, but will also need to factor in the cost of bailing out the French lending arm of Dexia and the commitment to the EFSF of EUR158bln in guarantees. Sizeable banking recapitalisation is a minimum requirement at this point but may not be enough given the ongoing deterioration on the assets side of the vast majority of these banks.
Third, there is the suggestion that the EFSF’s firepower could be raised from EUR 440bln to EUR 2trln by providing insurance for a portion of new borrowings by Europe’s fiscal miscreants. If Europe’s leaders believe that investors will be reassured by this über-basic financial alchemy, then they are incredibly naive. Apart from Germany and its northern European friends, there just isn’t the fiscal leg-room to make further substantive commitments to the EFSF. Without the participation of the ECB, leveraging the EFSF will just not fly. The insurance proposal has merit, but is incredibly risky and, on its own, will not be enough.
So, what can Europe realistically deliver this weekend? On Greek debt, it may well agree that private bond-holders ought to accept a haircut of at least 50%, but it cannot impose the outcome because to do so would trigger a default. And moreover, achieving a voluntary agreement amongst bond-holders of such a large haircut looks unlikely at this stage. On bank recapitalisation, there may be acceptance amongst politicians that banks need to be recapitalised, but as yet there does not appear to be the recognition that the various states need to jump in with both feet and stump up the necessary capital. And on the EFSF, if the insurance proposal as is being currently touted is the best that Europe can do, this will also not be sufficiently convincing.
As always with these, by now, regular weekend meetings of European leaders, there is plenty of room for disappointment. This one is unlikely to be the exception.

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