Investment - Articles - When it comes to bailout funds – size matters


 Carl Astorri, Global Head of Economics and Asset Strategy, Coutts
 As anticipated in our daily theme of 12 July “Europe getting closer to choosing systemic solution over chronic fatigue” European leaders Thursday 18th July announced a comprehensive range of measures aimed at stopping the euro-zone debt crisis before it kills the euro project and tips the global economy back into recession.
 The initial reaction of markets to the package has been positive, but it seems likely that it will be viewed less favourably over time. As explained in yesterday’s Daily Theme previewing Thursday’s EU Summit, the way to judge this package is on the extent to which it will bring down the debt service costs of the three little PIGs - Portugal, Ireland and Greece - and stop the spread of contagion to the larger PIGS of Spain and Italy. Although the package contains the right sort of tools to do this, it does not have the fire power to deploy those tools convincingly – size matters.
 
 The package aims to reduce the Net Present Value of Greece’s outstanding debt by around 20% via “burden sharing” with private-sector bondholders. Given that Greece’s net debt to GDP ratio for 2012 is forecast to be 157%, even after a 20% haircut Greece’s debt would still be 126% of its GDP. That is a crushing burden, even at the bailout package’s new reduced interest rate of 3.5%.
 Is the bailout fund big enough to lend Greece an amount equivalent to all of its outstanding debt? In short, yes. The fund has enough fire power to take on all of Greece’s debt once a haircut of 20% is applied – around €290bn.
 
 Where does that leave Portugal and Ireland? Officially private sector holders of Portuguese and Irish debt are not going to be encouraged to take a haircut on their debt. However, given their crushing debt burdens – at current market rates they would cost a fifth of their respective annual GDP to service – this is not credible.
 Consequently, it seems sensible to assume that Portugal and Ireland will eventually get the same support from other euro-zone countries that Greece has had. The combined cost of supporting Portugal and Ireland along with Greece, assuming a 20% haircut to bondholders, is just over €500bn. This is more than the €440bn the European Financial Stability Facility (EFSF) has available. To make matters worse, the fund also stands ready to put money into euro-zone banks and offer emergency credit lines to Italy and Spain, which between them owe more than three times the amount that Greece, Ireland and Portugal do. The EFSF just does not have enough money to do everything it needs to.
 
 The bill will keep getting bigger
 The bottom line is that at some point the size of the fund will need to be increased, and that will be politically unpopular in Germany, Finland and Holland, who will foot the bill. It will also put the credit ratings of these countries at risk, or the extent of the private sector participation via loses to bond holders will have to be increased.
 
 Specific assistance measures from Thursday’s package…
 For the financial sector:
 The EFSF can now lend euro-zone governments money to re-capitalise their banks.
 
 For Greece:
 The maturity of EFSF loans was extended from 7.5 years to 15 years, and the interest rate on these loans was cut to 3.5%.
 A menu of bond exchanges, rollovers and buybacks have been offered to private-sector creditors, with the aim of cutting the amount of Greek debt outstanding by 20%.
 
 For Portugal and Ireland:
 No bond exchange, rollover or buyback as yet.
 The maturity of EFSF loans was increased from 7.5 years to 15 years, and the interest-rate cut to 3.5%.
 
 For Italy and Spain:
 These countries are now eligible for emergency lines of credit from the EFSF.
 
 For the European Central Bank:
 Credit guarantees have been given on Greek debt to enable the ECB to keep taking Greek bonds as collateral after Greece is downgraded to default by credit-rating agencies. This will enable Greek banks to continue receiving funds from the ECB and keep the banking system functioning.
 
 For CDS sellers
 Despite the likely downgrade of Greek bonds to default, due to private sector participation, the International Swaps and Derivatives Association has ruled that this is not a ‘credit event’ and thus will not trigger any payment on credit default swaps (CDS). This will benefit US and UK banks that have sold CDS.
 
  

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