Positions in Europe: Long Germany (EWG); Short Spain (EWP)
The initial report of results from the EU Summit on Competitiveness on Friday and into the weekend suggests that: (1) far more was agreed upon at the Summit than advertised, and (2) in aggregate, most of the agreements leaned dovish, meaning leaders elected to throw more monies and more generous loan terms at the region’s sovereign debt issues. Again, we contend that over the intermediate to long-term, policy that facilitates piling more debt-upon-debt only increases the inevitability of another crash.
The main Summit agreements include:
On Temporary vs Permanent Bailout Structures
-The temporary European Financial Stability Facility (EFSF) will be able to access its full funding (from the member states) of €440 Billion, versus the approximately €250 Billion previously available.
-Agreement was reached to let the EFSF buy bonds directly from governments; however, the EFSF is not authorized to buy bonds in the secondary market or finance debt buybacks by governments. Ahead of the Summit, the EFSF was only authorized to loan funds to governments. Therefore, under this agreement, credit risk for primary bond purchases will move onto the EFSF (taxpayer) balance sheet.
-Funding for the permanent bailout fund, the European Stability Mechanism, starting mid-2013, is pegged at €500 Billion.
On Existing Loans
-European leaders agreed to lower Greece’s bailout interest rates of about 5% by 100 bps, and extend the repayment period of the loans to 7 1/2 years from 3 years. (Greek PM George Papandreou estimates the moves would save about €6 billion over the life of the loans.)
-Ireland did not receive its request to have the interest rate on its bailout loan (~5.8%) reduced by 100bps, as Irish PM Enda Kenny refused to raise the country’s 12.5% company tax rate, which compares to the EU corporate tax rate average of 23%, or Germany at 30% and France at 34%.
Overall, the agreements reached at the Summit far exceeded the syllabus, with the gravitas expected to come at the EU Summit for a Comprehensive Package on March 24-5. In particular, the more hawkish stance of Germany (via Chancellor Merkel) going into the Summit was lost over the weekend, namely that government bonds could not be bought directly by the EFSF and that funding for the facility would not be increased. The only point that Merkel (and Sarkozy) stood strong on was maintaining that Ireland could not receive more favorable loan terms unless it raised the country’s corporate tax rate, an issue that’s very contentious and one that the Irish refuse to budge on.
In any case, the market response to the weekend is clear: bond yields from the PIIGS have come in, notably the Greek 10YR yield was down as much as -50bps d/d and the equity market (Athex) closed up a monster +5.2% today (see first chart below). The results of the weekend also alleviate the pressure that major compromise has to be met at the second Summit, which should tone down the recent return of sovereign debt fears.
We are by no means of the camp that this news is positive for the health of the region. On the contrary, we see Europe’s action as confirmation that it will choose to kick the can of debt further down the road. In this light, the European Commission forecasts Greek public debt will reach 159% of GDP in 2012!
And while the expansion of the EFSF and talk of funding for the European Stability Mechanism will instill a level of confidence in the market and common currency, the underlying issue is not if there exists adequate funds to bail out the next overly indebted country, but should be enacting policy measures to more properly incentivize or punish countries that exceed debt and deficit levels. This will better direct the region’s future economic growth. Further, simply loosening debt payback terms sends the wrong message to countries, namely that mismanagement is permissible and the union will always be around as a backstop/crutch.
And to the point of more favorable loan terms for Ireland, we believe the island nation is going to have to play ball: it’s not going to be able to have its cake (an extremely low corporate tax rate) and eat it too (have its bailout loan more generously restructured).
What’s also clear from this weekend is that the ECB will continue to play a role as buyer of government bonds in the secondary market, currently at €77 Billion since May 2010.
We’ll get the final approval for the agreements reached this weekend at the March 24-5 Summit. While we could very well see stability in European markets and the common currency over the short run as optimism surrounds the Summit meetings, over the longer term our concern remains grounded that Europe is simply pushing its sovereign debt imbalances further out on the curve. At the very least, we’d expect the PIIGS, some of the best equity market performers year-to-date, to mean revert over the coming weeks (see second chart below). We’ll continue to manage risk on a day-by-day basis.