Economists agree that, for now at least, the plans are sketchy. “Very light on detail” says Gary Jenkins at Evolution Securities. “Painfully slow” steps says Barclays’ Capital’s Frank Engels. “Long on intentions, short on details” says Jens Larsen at RBC Capital Markets.
There are three particular concerns.
First, has enough been done to reduce Greek debt? Private sector investors will take a 50 per cent “voluntary” loss on their bond holdings, and the country will get another €100bn support from the EU and IMF. However, the summit envisages that, even after all this, and current austerity, Greek public debt will be equal to 120 per cent of GDP by 2020.
In a slow-growing economy, this is burdensome. For example, to stabilize this ratio with real interest rates of three per cent and GDP growth of one per cent a year requires a primary budget surplus of 2.4 per cent of GDP a year. And this is not just for one year, but always. By comparison, the UK government thinks its austerity programme will be finished when the primary budget surplus hits 1.3 per cent of GDP.
Unsurprisingly, then, some economists doubt that this is the final word. “Growth is the necessary condition for countries to escape from a debt trap” says Jamie Dannhauser at Lombard Street Research. And with growth lacking, he says, this week’s plan is “doomed to ultimate failure.”
Secondly, how exactly will the European Financial Stability Facility work? The summit says this will be leveraged up to provide a fund of €1 trillion. It hopes this will allow the EFSF to act like a monoline insurer, offering protection to investors against the first portion of any losses on government debt. But as we discovered in 2008, such insurance is only as good as the credit quality of the insurer. This means that any worries about the quality of the debt of, say, the French government (one of the backers of the EFSF) would undermine the value of the insurance. And, remember, even €1 trillion is less than half the combined debt of Italy and Spain.
Norbert Aul at RBC Capital Markets thinks the EFSF’s new powers will reduce Spanish and Italian bond yields by only around half a percentage point. Whilst helpful, this is not enough on its own to solve their problem. And perhaps the summit realizes this. It promised “an unequivocal commitment to ensure fiscal discipline.” But this is not good for growth.
Thirdly, how will banks recapitalize themselves? The summit calls for them to have core tier one capital ratios of nine per cent. The European Banking Authority estimates that this requires €106.5bn of additional capital. The summit says that “banks should first use private sources of capital.” But will investors really want to put so much cash – the equivalent of the entire market capitalization of BP – into poor quality assets? If they don’t, the summit says that national governments should chivvy up. But these are the same governments that are struggling to cut debt.
This leaves two alternatives. One is that banks raise their capital ratios by cutting their lending. But the summit says “National supervisors must ensure that banks' recapitalisation plans do not lead to excess deleveraging.” The other is that the EFSF will end up investing in banks. But this will reduce its ability to guarantee governments’ debts.
Given these problems, summiteers have more work to do in the next few months. Mr Jenkins says: “The true success of the agreement will be seen in Italian bond yields six months down the line.”
