Last month I argued that Greece would be forced to reschedule its debt. Nothing that has happened since has caused me to change my mind – indeed nearly 75 per cent of those responding to a recent Bloomberg survey agree with me.
I have changed my mind, however, about how events in the eurozone will play out: what started as a sovereign debt crisis in one country is turning into a debt crisis for eurozone banks. The restructuring of Greece’s debt will be delayed because it has become a sideshow in a larger eurozone financial drama.
Below I spell out how I think this crisis will unfold and what implications it has for investors in the emerging markets.
The “shock and awe” initiative launched by the eurozone leaders on 10 May was recently given an institutional shape via the European Financial Stability Facility (EFSF). The EFSF is designed to assist sovereigns who are unable to issue debt on acceptable terms in the markets, in effect providing a safety net for Greece and other eurozone countries that may need it.
By establishing this facility and backing it with some €750 billion (including the IMF’s contribution) its creators believe they have effectively lessened the risk of sovereign default. They also believe that combining the EFSF with a renewed commitment to fiscal austerity will restore economic stability.
The EFSF totals €440 billion and is being subscribed to on a pro rata basis by all the eurozone countries except Greece. Additional funds are being provided from other sources: €60 billion has been committed from the existing European Stabilization Mechanism and the European Central Bank (ECB) is purchasing eurozone government bonds - €40 billion in purchases were completed as of early June. With a total commitment of some €250 billion, the IMF is also expected to become active in lending to eurozone countries that request its help.
Little is known about how the EFSF will operate. It plans to raise funding by issuing bonds that would receive an AAA rating by virtue of the facility’s sovereign backing – Germany and France are both AAA rated and will subscribe up to 49 per cent of the facility. It appears the EFSF will buy sovereign debt rather than private bonds issued by eurozone banks.
I have a different perspective on what this initiative will accomplish. By focusing solely on sovereign debt, eurozone leaders have unwittingly set the stage for a significant contraction in credit to the private sector, above all to and by eurozone banks. Government austerity measures and a simultaneous contraction in credit to businesses and banks will weaken the current economic recovery and push the region towards deflation.
All the numbers on credit exposure to the Club Med countries (Greece, Spain and Portugal) tell the same story: their debts are huge. The latest quarterly report from the Bank for International Settlements (BIS) shows that German and French banks have claims on the Club Med countries of nearly €1 trillion. There is little doubt that lenders and investors will seek to reduce cross-border credit exposure to these countries. By providing a massive bailout to sovereign bondholders, the EFSF makes it a certainty that private institutions will bear the bulk of the burden of debt reduction efforts by these investors.
A typical bank creditor would reason along the following lines:
I need to reduce my institution’s overall credit exposure to the Club Med countries. I can sell the sovereign bonds we hold in our portfolio at a modest loss. But since these will almost surely be paid at par on maturity – thanks to the EFSF – it makes more sense just to let them run off and reduce my sovereign exposure gradually.
However, I still need to convince the markets that we are actively reducing our risk in these countries. This means we will have to cut our credit lines to private borrowers and banks and try to get as many private loans repaid as possible. Unfortunately these repayments will come mostly from the most creditworthy borrowers because lesser credits are strapped for cash. But this will help reduce our loan-to-deposit ratio, help our chances of securing funding to meet our ongoing needs and please investors in our stock.
This logic helps explain two phenomena that have puzzled observers:
Investors should not be fooled by the seeming stability in the government bond markets for Club Med countries. The sovereign risk associated with these bonds will gradually migrate from private to official creditors, both the EFSF and the ECB. French and German banks which have pledged to maintain exposures to Greece will presumably reinvest sums received from maturing bonds (having committed to do so under political pressure) but other lenders, including important non-bank creditors such as insurance companies and mutual funds, will simply take the repayments and reinvest them elsewhere.
Private holdings of Club Med sovereign bonds will thus be subject to a gradual rundown. A bigger drama will be played out in the eurozone banking sector. Here the overriding issues are funding and credit risk: where will banks secure stable sources of funding and how will their efforts to control credit risk affect their lending activity?
At the moment eurozone banks are increasingly dependent on the ECB for short-term liquidity management. Banks have put over €360 billion in the ECB’s overnight deposit facility, more than at the time of the Lehman Brothers default. Banks unable to secure interbank funding will remain regular borrowers of short-term cash from the institution. A report in the “Financial Times” on Wednesday said that Spanish banks were borrowing record amounts from the ECB. All of these are signs of mounting distress with bank funding.
These developments put into doubt the viability of BIS guidelines whereby the banks should increase their long-term funding. Morgan Stanley’s Huw van Steenis estimates that eurozone banks face a funding gap of €1.5 trillion; an alternate estimate by the Institute of International Finance in Washington DC puts the gap at €2.1 trillion. The “Financial Times” reported on Tuesday that business leaders in France and Germany are lobbying against the BIS guidelines, arguing that they would be “catastrophic” for the financing of European companies.
The combination of unprecedented funding requirements and increasing scarcity of such funding raises a fundamental question: how can eurozone banks survive without access to substantial amounts of capital to recapitalize their operations? This in turn raises questions about which eurozone institutions could provide the resources on the scale that will be needed.
The ECB immediately comes to mind as a possible solution to this dilemma. But the ECB has its hands full with its liquidity management activities and in any case it is not structured to play a role in bailing out and restructuring banks. This role is best filled by national banking authorities. But this means the affected countries will need additional financing to provide banks with both longer-term funding and injections of new equity.
Eurozone policymakers have thrown all their available money at bailing out sovereign creditors. This has left them without a programme or the money to recapitalize their banks. It looks as if the EFSF will have to be used to bail out both sovereign and private bank creditors. The IMF will also have to step in to help. The potential scope of such bailouts would be truly unprecedented.
Attempts by eurozone policymakers to address the worsening economic situation have been late in coming, are typically short on detail and often merely set in motion unintended harmful reactions:
What is missing is a set of measures that could break the downward spiral of growing market pessimism. The ECB appears reluctant to carry out its role in purchasing eurozone sovereign debt and a lingering sense of policy disagreements among its key members undercuts market confidence.
The belated decision by the European Union summit on Thursday to publish details of stress tests of 25 top EU banks is welcome but market participants still sense that governments are hiding something. The problems are likely to be concentrated among medium and smaller-sized banks, not the biggest banks. Markets want to hear what governments are planning to do to bolster these banks’ capital positions, not that the governments think the market views of risk are irrational. At this stage the market is facing more questions than it can find answers for.
In my view, it would be wrong to expect the eurozone’s commitment to greater transparency to be a “game changer” for the evolution of this crisis. It could forestall any cataclysmic turn of events but the problems facing the region are too complex and the degree of policy coordination too fragmented to permit an easy resolution. The base case remains: There will be continued erosion in market support for Club Med sovereign debt and in credit to the private sector.
How should investors in BRIC equities play these developments?
One of the puzzling facts of this crisis is that European stocks have outperformed both US and BRIC equities since the beginning of April (Chart 1). This trend implies that there is significant upside to BRIC equities since the BRIC countries are relatively less affected by the crisis.
It is not surprising that BRIC equities have lagged so far during this crisis. As high-beta instruments BRIC equities display more volatility on the downside as well as the upside. The question for investors is whether this is the time to step up commitments in BRIC equities – anticipating outperformance on the upside - or whether it is more prudent to wait.
My view is that investors should wait or hedge any new positions established in BRIC equities. Under my base case scenario there will be a steady erosion of credit both to sovereign and private obligors in the eurozone – certainly not a welcome development, but not a sign of a more serious deterioration of eurozone banks. Nonetheless there is a risk that the evolution of this crisis will lead to more serious repercussions despite the optimism that seems to hold in the markets at the moment.
I think the event that would send investors a buy signal would be the introduction of credible programmes to recapitalize the large number of affected banks not only in the Club Med countries but also in Germany and France. We are not at that point yet despite media spin that the eurozone crisis has been averted.
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