EuroTARP or Euro-trip?

In the wee hours of Thursday morning, European leaders agreed on a plan to shore up the continent’s banking system and stem the contagion affecting sovereign borrowing costs in every country from Greece to France. The plan has three parts: the European Financial Stability Facility will be expanded to about 1 trillion euros, Greek bonds held by private banks will be “volunarily” exchanged for new bonds worth half as much, and the banks most affected will get about 100 billion euros to strengthen their capital positions.

It sounds impressive. Two indicators will show whether it is enough: the spread between Italian and German borrowing costs and the share prices of French banks. So far, neither has meaningfully improved—with good reason. The “plan” has not really been finalized. More worryingly, even if it is implemented in full it would fail to address the fundamental problems plaguing the financial system.

The least complicated part of the bailout is the so-called “private sector initiative” to reduce the debt burden of the Greek government. And yet:

Officials said that at its most basic the Greek haircuts will work like this: someone owning a €100 bond will trade it for a bond with a face value of €50. But the real value of the new bonds will be highly dependent on their annual interest rates – or so-called “coupons”– and how long it takes for the €50 to be paid back – known as maturities.

By adjusting coupons and maturities and taking into account other “sweeteners” already agreed by European officials – such as the €30bn ($42bn) in collateral they will provide to back the new bonds – the pain on bondholders could be lessened considerably.

“Here’s where you may be a little bit surprised, but this is where we decided to end last night: the specific elements of the deal, that is to say the structure of the new claim on Greece, remains to be negotiated,” said Charles Dallara, managing director of the Institute of International Finance, the consortium of banks that negotiated on behalf of Greek bondholders.

One economist who has advised European governments estimated that the net present value of the new bonds – the measure of what they are worth when the coupons and maturities are taken into consideration – could come close to bonds that were supposed to be offered after July’s aborted Greek bail-out. Those bonds were estimated to have just a 21 per cent reduction in net present value.

By cutting in half the face value of the estimated €200bn in Greek bonds in  private hands, officials have taken a far more aggressive stance in reducing Greece’s overall debt levels than they did three months ago, a move long called for by outside analysts. But such swingeing cuts are also dependent on almost all Greek bondholders agreeing to participate in the plan. Unlike the July deal, which set a target at 90 per cent participation, Thursday’s plan includes no such target.

There is another wrinkle. Only a little more than half of Greece’s total debt would be eligible for a write-down. The rest is owed to the European Central Bank and the IMF. UBS provided a good summary of the problem, via Alphaville:

In short, as shown in the above chart, a 50% haircut effectively equates to a 22% reduction in existing debt once the [Greek] banks have been recapitalised. This is far from enough. Or, to put it another way, to achieve an actual 50% reduction in the debt, Greece would need to implement a 100% haircut, i.e. repudiate its debt totally.

Nor is the current plan is considered credible by the markets. As Zero Hedge noted:

While bonds maturing around 1 year from now have since jumped to just shy of the 50 cent on the dollar haircut level, bonds further down the curve are just not buying it and continue to trade in the 30s…Those who believe that the ECB will go ahead and carry through on its promise of a 50% haircut and no further, should be buying up the entire curve which trades below 50…Judging by prevalent values, even assuming some modest accrued interest, the bond market is expecting a final haircut of about 62%.

Charting cash prices of Greek bonds vs maturity:

So much for that.

The second major pillar of the “plan” was to expand the European Financial Stability Facility by about a factor of 4. One small problem:

It is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn.

All of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.

There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised.

China has been approached for some money, although it is not clear why this would help. The most they might offer would be 100 billion euros. The conditions, meanwhile, would be quite severe:

“It is in China’s long-term and intrinsic interest to help Europe because they are our biggest trading partner but the chief concern of the Chinese government is how to explain this decision to our own people,” said Professor Li. “The last thing China wants is to throw away the country’s wealth and be seen as just a source of dumb money.”

He added that Beijing might also ask European leaders to refrain from criticising China’s currency policy, a frequent source of tension with trade partners.

In practice, this means that Chinese funding will have to be guaranteed by European taxpayers. If the bailout goes bad, it will be European citizens footing the bill, not the Chinese. This does not seem that helpful relative to the price.

But there is another cost. Michael Pettis, a scholar based at Peking University, has argued quite persausively that Chinese “aid” would actually be counterproductive:

More foreign investment will not help Europe…Any net increase in foreign purchases of euro-denominated local government bonds has an impact far beyond the short term funding impact. It also affects the trade environment.

This impact is an automatic consequence of the way the balance of payments works. Today Europe runs a current account surplus. By definition this means that far from being starved of capital, European savings exceed European investment, and it exports the excess to the rest of the world.

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack of credibility.

Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

How would this happen? There are many ways, but the most obvious is that as foreign central banks sell large amounts of dollars to buy euros, the euro strengthens against the dollar. As this happens, European manufacturers become less competitive globally and their exports drop.

This would cause a rise in European unemployment as those manufacturers are forced to fire workers. It would also cause total European savings to decline as total production drops more quickly than consumption. Remember that savings is simply the difference between production and consumption. In other words as more foreign savings enter Europe, one consequence might simply be less European savings, which is hardly likely to resolve the solvency problem.

Of course there are other ways Europe could adjust. Europe could prevent a rise in unemployment if all of the new foreign funding was used to fund direct investment. Every dollar given to Spain by the BRICs, in other words, would have to be matched by a one-dollar increase in Spanish infrastructure spending. Might this happen? Of course not. Given the need for transfer and welfare payments, it is very unlikely that Spain in this example would transfer the additional money to a new investment project, and anyway if it did it would not solve the original problem of selling bonds to finance its day-to-day needs.

There is a third way. As workers are fired because the European manufacturing sector becomes less competitive, European governments could borrow even more money to cover the transfer payments or otherwise give them jobs. This is really just a variation on the above, but the conclusion is a little different. It suggests that any net increase in foreign purchases of European bonds will be met by a more-or-less equivalent increase in the amount of government bonds issued. This, of course, does not help Europe in the aggregate, although it may temporarily help the governments issuing those bonds.

As the above cases show, the increase in foreign investment would simply be matched either by an equivalent reduction in domestic savings or an equivalent increase in domestic debt to counteract the rise in unemployment. Rather than ease the burden, in other words, foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt. The BRICs, in other won’t help Europe by buying Italian bonds. They will simply help the Italian government at the expense of Europe generally.

So far, it appears that two of the three pillars of the vaunted “plan” are made of sand.

What about the plan to recapitalize Europe’s troubled banks? About 100 billion euros have been dedicated to the task. This is almost certainly inadequate, but don’t take my word for it: Thomson-Reuters created a handy web tool that allows anyone to run their own stress tests on the continent’s banking system.

Using some reasonable assumptions, I concluded that it would take a minimum of 600 billion euros to stabilize the banks. When a noted finance scholar presented at a think tank in town, he thought that the true figure was about 1.3 trillion euros. Either way, the latest plan is far too small to repair the financial system.

One final note: the bailout does nothing to address the fundamental imbalances between the surplus and deficit countries that created the crisis. Martin Wolf pointed this out back in May, 2010 when the EFSF was first created to fight the initial uptick in Greek borrowing costs. As he wrote back then:

The story of the eurozone economy has, in consequence, been one of divergence, not convergence. The rough external balance masked the emergence of countries with huge current account surpluses and corresponding exports of capital, notably Germany, and of others with the opposite condition, notably Spain. In countries with weak domestic demand and low inflation, real interest rates were high; in countries with strong demand and higher inflation, the reverse was true. The result is not just huge fiscal deficits, now that private-sector spending has collapsed, but a need to regain lost competitiveness. But, inside the eurozone, this is possible only with falling wages, higher productivity growth than in Germany (and so soaring unemployment), or both.

So nothing meaningful has been accomplished. The market action reflects this, even if stock markets are up a few percentage points. Expect far more euro-bailouts in the near future.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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