The latest EU Summit has produced lots of positive words, with 23 of the 27 countries agreeing on a new fiscal ‘compact’ (compact seems to have replaced ‘consolidation’ – genius work by some spin doctor!). Does this mean the Eurozone is out of the woods?
Not quite yet.
The pressure on Eurozone banks has eased with the European Central Bank announcing a 0.25% rate cut and, more importantly, the commencement of two 3 year long-term refinancing operations (LTROs) of unlimited size and full allotment – these replace current 1 year LTROs. ECB also reduced the quality of collateral it will accept in these operations, whilst adding bank loans to the accepted list of ‘things we don’t mind holding because we do not mark-to-market.’
So European banks should have ample access to euro and dollar liquidity and also be able to offload enough credit-un-worthy assets to survive further economic turbulence. An agreement to increase funds available to the IMF provides extra security to sovereign bondholders, although they’ll move down the pecking order of who is repaid first in the event of default (assuming the country taps into the IMF credit line).
The big question mark which remains relates to solvency of both banks and governments:
– Banks: Can they raise capital required to meet 9% Tier 1 requirements whilst maintaining revenues/profits?
– Governments: Can fiscal compact/austerity measures be fully implemented and still deliver growth required to repay creditors?
Good news on solvency = Agreement being reached on fiscal issues should encourage the ECB to open up its balance sheet and increase purchases of troubled governments’ bonds. As daylight breaks through the dark tunnel of fiscal
consolidation compact, Mario Draghi and the ECB Board are warming to the idea of a financial ‘bazooka’ to end this crisis. They’re still not quite convinced but certainly more convinced than they were at the beginning of the week.
Bad news on solvency = The deal involves governments agreeing to keep structural budget deficits below 0.5% of GDP. This will require severe austerity measures or a sharp rise in GDP, it remains to be seen whether the former hinders the latter.
After months of holding EU summits with more bark than bite, it’s great to see positive words from policymakers and I hope they can turn these words into signatures. It will take time to draft the new rules and have them signed off but the key players are at least moving in the same direction. When all is signed and done, the Eurozone may end up with a much stronger financial system than we can currently dream of.
In the meantime, it’s worth keeping your seatbelt tightened and listening out for policymakers’ announcements.