What Happened at the EU Council Meeting?
The EU meeting of heads of state and government revealed very few surprises compared to the mid-March agreements (see A Small Positive Step, But Still No Step-Change, March 14, 2011). But, if anything, the new information on some details of the agreement reached at the summit disappointed us and the markets. For several reasons:
First, the full lending capabilities of the ESM might only be reached somewhat later after it was agreed - on Germany's initiative - that there will be no upfront payment of half of the ESM's €80 billion in paid-in capital in 2013, but a five-year, pro-rata phase-in period. Hence, the full amount of paid-in capital would only be available in 2017. Depending on how the rating agencies judge this delay in capital commitments, it might limit the ESM's effective lending capabilities in the first years.
Second, with respect to increasing the effective lending capability of the current EFSF, the decision on the increase in the EFSF guarantee pool has been postponed until June. The picture here now looks a bit more uncertain too, given that its expansion to an effective lending capacity of €440 billion requires unanimous approval by all guarantors. For the time being, this approval is not possible in Finland, as the parliament has been dissolved ahead of the April 17 general elections. It might also prove difficult after the election, if the euro-sceptic True Finns are part of the next government.
Third, Ireland did not get the 100bp reduction in the interest rate on its emergency loans that Greece already secured in mid-March. This standstill is actually due to the Irish government asking for a postponement of the discussions on the interest rate and the demands by some European countries for the Irish government to review its corporate tax regime in exchange for an interest rate reduction until after the bank stress results are released on March 31 and also the talks on the restructuring and recapitalization of the Irish banking system are concluded.
Fourth, market expectations that Portugal would apply for a rescue programme around the summit proved false when, rather than moving forward towards a resolution of the country's funding situation, the Portuguese Prime Minister announced late last week that he would step down after losing a vote in parliament on the additional austerity measures pledged by Portugal ahead of the mid-March EMU summit. This decision leaves Portugal in a state of political limbo, which could last as long as two months before a general election can be held and a new government can be formed.
Our initial reaction to the summit outcome: While governments agreed on a broad-based and widely expected reform package - notably with respect to economic governance of the euro area - the agreement does not constitute a silver bullet to end the euro area sovereign debt crisis. As we had feared, the measures taken mainly provide additional liquidity within the euro area rather than improving solvency meaningfully (see Sovereign Debt Crisis - A Roadmap for Investors, February 7, 2011).
At the time of writing, there is still no clarity on a number of key issues regarding the permanent ESM mechanism. These important details include, for instance, how exactly the debt sustainability test that will precede all ESM emergency lending post mid-2013 will be conducted and who will have the final decision on whether a debt restructuring is necessary before the ESM can provide emergency loans. The decision mechanism is crucial, given that involvement of private sector investors in the event of a debt restructuring will be on a case-by-case basis. Hopefully, some more details on the ESM will be revealed over the coming days and weeks.
As expected, the reform package agreed at the summit includes:
1. Reform of the current rescue fund, which will be operational until June 2013 (EFSF), to increase the lending capabilities to €440 billion.
2. Creation of a permanent rescue/restructuring fund, which will be operational post June 2013 (ESM) and have lending capacity of €500 billion.
3. Reform of the Stability and Growth Pact (the so-called economic governance package) to introduce semi-automatic sanctions.
4. Measures to increase economic policy coordination within the euro area (the so-called Euro Plus Pact as a number of EMU out countries have also joined).
What's Changed from the EMU Summit in Mid-March?
Most of the above-mentioned innovations had already been pre-announced at the policy gathering in mid March (see A Small Positive Step, But Still No Step-Change, March 14, 2011). Back then the EU leaders had already signaled their intention:
- to endow the ESM with actual lending capabilities of €500 billion from 2013 onwards.
- to increase the EFSF's effective lending power from about €250 billion to €440 billion.
- to reduce the interest on the loans to Greece by 100bp and extends its maturity to 7.5 years.
- to allow purchases of government bonds in the primary market for countries under an EFSF adjustment programme.
The latter point, however, has more to do with liquidity support, rather than market support. Indeed, bond purchases will only be allowed in exceptional cases; in general, the funding would be provided via loans. This means that in the current situation the EFSF would be allowed to buy Greece or Ireland, but not Portugal or Spain. In our view, these purchases are intended to pave the return of programme countries to the market.
What's more, the EU Council reiterated that it will press ahead with the ESM's debt restructuring model post mid-2013 as envisaged in a meeting back in December, notably haircuts for private sector investors in cases of a country unexpectedly having not just a liquidity problem but also a solvency one. Importantly, however, the involvement of private sector investors will not be obligatory but on a case-by-case basis.
Although the initial announcement in mid-March signalled a somewhat stronger unity and political commitment than seemed to be the case beforehand, the late-March EU Council appears to have fallen behind initial expectations in several respects:
1. The signing off on EFSF reform and the ESM has been postponed to "before the end of June 2011".
2. As regards the ESM:
(i) phasing-in: period for capital contributions by Member States to be phased in over a longer period (five equal installments, instead of three) which seemed to be the option favoured by Germany;
(ii) "adequate and proportionate form of private-sector involvement will be expected on a case by case basis where financial assistance is received by the beneficiary State".
In their statement on November 28, 2010 the Finance Ministers of the euro group initially said that "for countries considered solvent, on the basis of the debt sustainability analysis conducted by the Commission and the IMF, in liaison with the ECB, the private sector creditors would be encouraged to maintain their exposure according to international rules and fully in line with the IMF practices. In the unexpected event that a country would appear to be insolvent, the Member State has to negotiate a comprehensive restructuring plan with its private sector creditors, in line with IMF practices with a view to restoring debt sustainability. If debt sustainability can be reached through these measures, the ESM may provide liquidity assistance". Already at the press conference following the EU Council in mid December, President Van Rompuy stressed that private sector involvement would be on a case-by-case basis, in line with international practices of the IMF and would not require private sector involvement as a precondition for support under the ESM (see Fast Track or Slow Motion to Fiscal Federation? December 17, 2010).
Portugal - Thoughts on the Government Crisis
What happened: Portugal's centre-left Prime Minister José Socrates, resigned on Wednesday night after the parliament rejected his government's latest package of austerity measures, the fourth such package in 12 months.
What happens next: The government will remain fully functional until Portugal's centre-right president, Aníbal Cavaco Silva, accepts the resignation. Consultations with the various political parties seem to have started already last Friday and will probably continue for a few more days.
According to the constitutional procedures, the president could invite all the six parties represented in the parliament to form a coalition government, which would avoid snap elections in the near term. In this scenario, the current government would stay in power as a caretaker government until a ballot.
However, its functions would be confined to "acts strictly necessary to ensure the management of public business", according to the constitution. While the scope of these powers is widely debated, quite a few commentators seem to think that they do not go as far as granting the power to request/negotiate a bailout.
Without agreement the parliament is to be dissolved with snap elections to take place more or less two months later. In this scenario, the president will consult with the political parties and with the Council of State (which is an advisory panel) before fixing an election date no earlier than 55 days away.
What it means for the possibility of an EFSF bailout: Our core view has been that, abstracting from the marginal buyer (the ECB), funding has dried up to such an extent that outside help might be necessary at some point. Several government officials and opposition members of parliament too have mentioned on various occasions that after the rejection of the austerity measures the risk of outside financial help might have increased, or that such help was needed anyway.
The timing of a Portuguese application to the EFSF is uncertain, for two reasons. First, the fact that Portugal so far has not applied for an EU-IMF programme suggests to us that so far Europe has not had an incentive to push strongly for such a step. The question though is whether this could change in future, for example, because of concerns about contagion from the uncertain political situation in Portugal.
Second, there are a number of issues of legitimacy for a government that has been defeated in a confidence vote (resulting in the resignation of the prime minister) when negotiating an adjustment programme with the IMF/EU authorities. Indeed, another key issue is whether a government can approve a request for outside financial help and/or deliver on the measures mapped out in the loan agreement. This largely comes down to the political stability and the parliamentary strength of the incumbent government.
The IMF has encountered many situations in emerging markets where the Fund was ready to provide funding (against strong conditionality) but had difficulties in finding a political counterparty in the country that had a sufficiently strong mandate to negotiate an adjustment programme.
The upshot is that, unless a new coalition government is formed within the next few days, the chances are that a Portuguese bailout, should it happen, will have to wait until a new government is fully operational, probably no earlier than June though.
Could Funding Become an Issue?
Many market participants are now asking whether Portugal is reasonably funded to take care of sizeable redemptions in April (about €4.5 billion) and June (€5 billion). The funding situation is not that clear-cut for outside observers. How much cash a government has is confidential, and the Treasury does not disclose this information. So one can only try to ‘guesstimate' the broad magnitudes involved, bearing in mind that the purpose is just to get an idea and that many caveats apply. The government has raised €12 billion in bonds and T-bills over the year to date (YTD), plus another €1.3 billion in privately placed notes. However, this compares with €10.8 billion in T-bill redemptions YTD. This means that, looking at funding-related cash flows, only €2.5 billion or so is currently available.
Naturally, it is very likely that they government has started the year with cash in the public purse. However, this number too is kept confidential by the Treasury. One could perhaps use the financial national accounts ("flow of funds") as a proxy, bearing in mind that national accounts are different from cash numbers in several ways and that these figures are only available up to 3Q10. For Portugal, the financial national accounts do not have a separate figure for central government's transferable deposits, but only one for total deposits and currency of the general government.
These numbers include social security and local governments, so they probably overstate the amount of cash available. Given the six-month lag between the information published and the current date, one can only infer what the amount could have been at year-end by looking at the average of the past several years, which is about €7 billion.
Finally, one would have to project monthly budget deficit numbers, perhaps by looking at their typical monthly distribution (i.e., their seasonality). This exercise is subject to considerable uncertainty, and we would caution against following it too literally, for several reasons. First, the recent fiscal austerity almost surely affected the ‘typical' pattern of revenue-raising and spending activities. Second, the ‘all else being equal' clause - which one would have to assume in these calculations - rarely holds in practice.
For example, the Portuguese government might try to save cash by paying its suppliers later than usual, or could slightly postpone payments within the public sector. What's more, a loan from the domestic banks could be available, or the ECB might step up its SMP and buy in the secondary market on the day before a crucial auction or private placement, in order to make room for private sector investors to take that new supply. And even Greece runs a modest T-Bill issuance programme.
The upshot is that the considerable uncertainty around Portugal's funding situation is unlikely to disappear any time soon. While there are reasons to believe that countries have a lot more room to manoeuvre than firms to deal with payment deadlines, the chances are that investors will try to come up with rough estimates along the lines described above. So, assuming that no further cash is raised going forward, concerns that the coupon and redemption payments, especially those due in June, might prove challenging for Portugal will probably continue to linger.
What Are the Implications for Spain?
We think that Spain is in a different league relative to, say, the small EMU peripherals. This is because even under very negative assumptions about the additional capital needs of the Spanish banks and about the near-term growth outlook, the Spanish debt/GDP ratio will not rise meaningfully above the euro area average.
Our base case assumes real GDP growth of 1% this year, 1.5% in 2012 and a similar pace of expansion on average between 2013 and 2017. After this year's expected inflation spike of 2.9%, we forecast a deceleration to 1.8% from 2012 onwards. Moreover, we predict a decline in the primary budget deficit to below 3% by 2014 and a surplus of 1% three years down the line - as well as rising interest rates to around 5% on average in 2017. Under these assumptions - which we deem to be rather conservative - we find that Spain's debt would stabilise at around 80% of GDP in 2014 before slowly starting to decline again in the following years.
Alternatively, assuming no progress in terms of deficit reduction for the next five years and a double-dip over the period 2011-12, Spain's debt/GDP ratio would stabilise at around 95% in 2018. This would not make Spain's bear case that different from that of other euro area countries' base case, such as Italy or France. What's more, the size of potential further write-downs in the Spanish banking sector is a key risk and adds considerable uncertainty around the debt trajectory. This concern is well founded, but the scenarios illustrated above implicitly allow for a significant additional bailout of the Spanish banks by the government - if needed. For example, our bear case encompasses additional spending close to €100 billion relative to the fiscal consolidation path envisaged by the government.
Naturally, as long as it is still dealing with balance-sheet repair, the Spanish economy is likely to stay weak. But the policy landscape has significantly shifted for the better (see Spain: On the Mend, March 7, 2011). We are fundamentally more constructive on Spain's ability to set itself apart from the smaller peripherals because we think that, unlike Portugal and Greece, Spain should continue to grow - but at a subdued pace; what's more, the labour market, pension and banking sector reforms are a key step in the right direction; and Spain's competitive position looks more favourable than that of most other southern European countries, while a controlled deleveraging is necessary, welcome and now happening.
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