Europe Bolsters Crisis-Fighting Tools

By James G. Neuger and Simon Kennedy - Oct 27, 2011 10:35 PM GMT+0700

European leaders bolstered their crisis-fighting toolbox with a plan that may generate only limited relief for stressed sovereigns unless it can be fleshed- out within weeks.

“It remains a deal long on intentions and short on details,” said Jens Larsen, chief European economist at RBC Capital Markets in London. “Until we know how the mechanisms will work, it will be hard to judge whether this will be sufficient to entice investors to provide support to European governments.”

Europe’s currency, stocks and bonds rose after 10 hours of talks ended in Brussels with governments boosting the heft of their rescue fund to 1 trillion euros ($1.4 trillion) and persuading bondholders to take 50 percent losses on Greek debt. Measures also included a recapitalization of European banks and a potentially bigger role for the International Monetary Fund in strengthening the bailout fund.

Still to be worked out in negotiations, which may fall prey to fresh bouts of political infighting and investor revolt, is just how the firepower of the 440 billion-euro rescue facility will be leveraged and what banks will get in return for accepting the Greek haircut. As next week’s Group of 20 summit looms, nations from Greece to Italy remain under pressure to restore fiscal order and the onus is on a Mario Draghi-run European Central Bank to keep buying bonds.

Buying Time

“The announcement is enough to buy some time,” said Charles Diebel, head of market strategy at Lloyds Banking Group Plc in London. “Officials have certainly come up with a comprehensive list of actions, but we are certainly still a long way from all the process parts being in place.”

The euro rose as much as 2 percent to $1.4181, the highest since July 1. Yields on Italian and Spanish 10-year bonds fell and the Stoxx Europe 600 Index surged 3.5 percent to the highest since Aug. 3.

There have been false dawns before in the two years since Greece first revised its budget math. Policy makers initially underestimated the threat posed by the Mediterranean nation and then repeatedly failed to muster the financial firepower to prevent it from engulfing Portugal and Ireland before tainting Italy and Spain. Leaders had already declared victory after July talks which featured a 21 percent Greek writedown.

Italian Auction

“Markets now appear to be resigned to tardiness on the part of policy makers and grudgingly prepared to accept that resolution will not be achieved in a single step,” Goldman Sachs Group Inc. strategists said in a note to clients.

An early test of Europe’s latest initiative comes tomorrow when Italy auctions as much as 8.5 billion euros of bonds. The euro-area’s third-largest economy has become a focal point as investors question whether authorities can ring fence the country’s 1.9 trillion euros of borrowing, the euro-region’s second-biggest debt burden in nominal terms after Germany.

Italian Prime Minister Silvio Berlusconi heard demands from EU allies at the summit to present a comprehensive plan to speed debt reduction by spurring economic growth that has lagged behind the EU average for more than a decade. Weeks of bickering within his ruling coalition made it impossible for Berlusconi to pass new measures and he instead offered a 14-page blueprint for reforms that pledged action on asset sales, easing of labor laws and raising the retirement age.

Recession Threat

The summit was the second in four days and the 14th in the 21 months since Europe pledged solidarity with Greece. It came amid mounting global pressure for the euro-area to quarantine Greece and prevent speculation against Italy, Spain and France from ravaging its economy and triggering the second global recession in three years.

“The world’s attention was on these talks,” German Chancellor Angela Merkel told reporters after the summit concluded at about 4:15 a.m. today. “We Europeans showed tonight that we reached the right conclusions.”

Banks bowed to pressure from leaders as their negotiator agreed to higher “voluntary losses” to smooth a second bailout for Greece, which will now include 130 billion euros of official aid, up from 109 billion euros envisioned in July. Just hours before the accord, Institute of International Finance Managing Director Charles Dallara said “there is no agreement,” before he received a rare invite to join the talks.

Greek Haircut

The banks’ resistance was broken by a threat “to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks,” Luxembourg Prime Minister Jean-Claude Juncker said.

Still to be decided are the finer points of the write-off such as the collateral banks will be given in return and whether future bank debt is backed by a national or European guarantee. Banks and insurers will be asked to accept a writedown of half the nominal value of their Greek bonds.

That “haircut” aims to reduce the country’s debt level to 120 percent of gross domestic product in 2020, still twice the EU limit, though down from the 162 percent forecast for this year. Dallara said in Brussels today that he was confident the participation rate would “very, very high.”

The writedown will make Greece’s debt more sustainable though “this position is fragile and dependent on a set of rather optimistic macro assumptions,” said Nicola Mai, an economist at JPMorgan Chase & Co. If the country’s economy fails to rebound more debt restructuring may be needed, he said.

Leveraging EFSF

Leaders backed two ways of leveraging up the European Financial Stability Facility, which is too small to defend countries such as Italy, which has a debt of more than three times the EFSF.

Under plans to be spelled out in November, the fund will be used to partly insure bond sales and a special investment vehicle will be created that would court outside money from public and private financial institutions and investors to further boost its muscle.

French President Nicolas Sarkozy spoke today with Chinese President Hu Jintao to try to tap support from the country with the world’s largest currency reserves. Hu hopes that the measures will help to stabilize markets, state-owned China Central Television reported after the call. Japan plans to support the increase, and is waiting to hear from European officials on details for the program, according to a person familiar with the matter.

Two-Tier Market

The insurance scheme may still fail to draw investors amid concern its sponsors won’t honor their commitments and questions over the timeframe and amount of guarantees on offer, said Karen Ward, an economist at HSBC Holdings Plc. It could also create a two-tier bond market as investors shy away from the previously- issued unprotected debt, she said.

Economists at Royal Bank of Scotland Group Plc said the 1 trillion-euro goal still falls short of what’s necessary to truly defend Spain and Italy, while warning the special investment vehicle may struggle to issue enough cheap debt to lure outside investors.

The very use of leverage drew criticism from the Bundesbank with President Jens Weidmann saying the “instruments that have been tabled are similar in their design to those that helped to cause the crisis.”

Europe also struck a bank-recapitalization accord, setting a June 30, 2012, deadline for lenders to reach core capital reserves of 9 percent after first writing down their sovereign- debt holdings. Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

Bank Capital

The challenges to overcome on that front include deciding which assets banks can count as capital and how financial institutions will raise it given their reluctance to seek cash from shareholders. The European Banking Authority estimated banks’ capital needs at 106 billion euros, with Spanish banks requiring 26.2 billion euros and Italian banks 14.8 billion euros.

The figure is “at the low end of expectations,” said Philippe Bodereau, head of credit research at Pacific Investment Management Co. in a telephone interview. “It would be positive if we saw banks launching rights issues, but most will try to get there by selling businesses, retaining earnings, cutting dividends and deleveraging.”

ECB Role

Leaders tiptoed around the broader role of the politically independent ECB in keeping the euro sound, making no mention of its bond-purchase program in a 15-page statement. The Frankfurt- based central bank was said to be purchasing Italian debt today and Holger Schmieding of Joh. Berenberg Gossler & Co. said it will likely have to keep doing so as policy makers round off their plan. Incoming ECB President Draghi yesterday indicated the policy will continue.

“Without ECB support, the chances of this deal putting an end to the euro debt crisis are now probably below 50 percent,” said Schmieding, Berenberg’s chief economist.

The pact received conditional support from abroad as leaders prepare for the Nov. 3-4 G-20 summit in Cannes, France, which had been set as a deadline for a new European plan and may pave the way for more international assistance. The U.S. Treasury had no immediate comment on the European agreement.

“They need to keep up momentum and urgently to fill in the elements” of the package, said U.K. Prime Minister David Cameron. Canadian Prime Minister Stephen Harper called the agreement “grounds for cautious optimism,” which now needs to be detailed and implemented.

To contact the reporters on this story: James G. Neuger in Brussels at jneuger@bloomberg.net; Simon Kennedy in London at skennedy4@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net