Tuesday, March 15, 2011

Europe: progress being made

The news out of the weekend’s Eurozone leader summit was lost in the coverage of the devastating earthquake in Japan. The good news is some progress was made.

In our view, Europe’s woes run far deeper than just the sustainability or otherwise of high sovereign debt levels. The broader issue is the lack of macro-economic policy co-ordination across a region that has one exchange rate and a single central bank.

We were therefore pleased to see some progress made on the terms of a “Pact for the Euro”, which was borne out of the initial “Pact for Competitiveness” proposed by France and Germany. At this point, however, there is only agreement in principle that commits to closer economic co-ordination and a range of austerity measures. These include caps on government spending (the “debt brake” in the earlier proposal), close monitoring of pension schemes and limits on public sector wage increases.

The bit we don’t know yet is how these measures will be enforced, or in other words, what happens if you break the rules. No doubt it is this sort of issue that will be discussed and hopefully decided on at the March 24&25 Summit.

The Leaders have bought themselves some time by dealing with some of the more short-term issues that debt markets have been fretting about. The main point is that the European Financial Stability Facility (EFSF) is now able to lend up it its full €440b face value. Previously the EFSF has only been able to lend up to €250b given the need to keep cash on hand to preserve its AAA credit rating.

This has been made possible by a combination of guarantees from the AAA countries and callable or “paid in” capital from the weaker rated countries.

This has led some commentators to speculate this may result in the establishment of a two-tier sovereign debt market made up of highly-rated (AAA) Europe bonds and bonds issued by individual sovereign countries that could be lesser quality (lower rating, higher yield). Seems to me the closest we are ever likely to get to the concept of European fiscal federalism.

The €440b available through the EFSF is available until mid-2013, at which point the EFSF is replaced by the European Stability Mechanism (ESM) which will have €500b at its disposal.
As part of the weekend negotiations the two countries already with bailouts, Greece and Ireland, were offered an easing in the terms of their bailout package in exchange for further austerity measures.

Greece took the deal. The Government has agreed to sell €50b in government assets in exchange for which it will get a 1 percentage point reduction in the interest rate on its €110b bailout. It will also now have 7.5 years to pay this back rather than the original 4.5 years.

Ireland rejected the deal put to them. In exchange for a 1 percentage point reduction in its 6% bailout loan, the Irish Government was asked to give up its 12.5% corporate tax rate. That deal was not acceptable to the new Irish Prime Minister.

The lesson for Portugal in all of this is that should it go down the path of a bailout, there will be tough conditions to implement.

Importantly, progress continue to be made on the broader issue of European macro-economic c0-ordination. In many important regards, the rubber is still yet to hit the road in terms of how any of this will actually work. Political compromise was never going to be easy – everybody has to go home with a win. We look forward to further progress later this month. In the meantime, authorities are just doing enough to keep up with market concerns.