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New bailout deal is not a solution
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Spain, Italy and Belgium will be downgraded by the end of the summer
"John Maynard Keynes noted that politicians are slaves to defunct economic theories. Europe's sovereign debt crisis suggests that this should be paraphrased to European politicians are slaves to defunct economies. The focus on Greece represents the old magicians' trick of deflection - the crisis has moved beyond the insolvent troika of Greece, Ireland and Portugal to focus on the lack of growth in Italy and Spain.
"Italian yields above 6% provided the catalyst for European politicians to surpass admittedly minimal expectations with a second bailout package for Greece. The latest package ticks a number of boxes including substantial additional funds, lower interest rate, maturity extension and a smorgasbord of options for private sector involvement. Moreover, the lower interest rate and extended loan terms will also be offered to both Portugal and Ireland. The European Financial Stability Fund's remit will be extended to include secondary market purchases under extraordinary circumstances as well as potential to lend funds to governments, which are not participating in the bailout program, to help recapitalise their banking systems.
"The plan provides a great deal of sound and fury, but falls significantly short of delivering a solution. We believe that adding more debt on top of debt is ultimately unsustainable and the continued insistence that Greece is solvent is just not credible. More importantly, in order to prevent systemic risk and contagion politicians have created a Debt Reduction Mechanism. The DRM is the inevitable successor to the Exchange Rate Mechanism. In the absence of currency devaluations, debt devaluations are inevitable. Europe's politicians emphasise that Greece is unique, but methinks they doth protest too much. They have a created a mechanism that will allow regular debt devaluations across the whole of the periphery and semi-core economies.
"We expect Spain, Italy and Belgium to be downgraded by the end of the summer. The missing link in the Greek package is any focus on growth. The reduction in Greek, Irish and Portuguese borrowing costs is welcome, albeit at the expense of moral hazard, but the severe fiscal austerity suggests that these economies will not achieve nominal growth targets of 4%. Likewise, we expect growth in both Italy and Spain to dip back into mild recession during the second half of the year. Last week's flash PMI surveys for France and Germany showed sharper than expected deterioration in confidence during July. More importantly, the preliminary composite index for the Eurozone was only just above 50 in the month, suggesting that confidence amongst the periphery has fallen further below zero.
"The core economies will garner some relief from the rebound in global inventories during the fourth quarter, but underlying demand has deteriorated since the start of the year. As liquidity contracts, the outlook for 2012 is for the major industrialised economies to remain mired in a growth-recession. The European Sovereign Debt crisis is manageable as long as activity in core Europe and the rest of the world remains strong, but if as we expect, their growth slows, the crisis will move into a more dangerous phase.
"The Greek package, if believed, should dampen volatility and enable peripheral debt to outperform over the summer. However, trust is in short supply in Europe and there are many unanswered questions over the extend of private sector participation in the Greek bailout. Given the response of the German Constitutional Court to the collectivisation of risks through a series of loan guarantees and weaker growth in the periphery, we expect peripheral spreads to widen over the summer."
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