Hope. Sarkozy and Merkel raised expectations two weeks ago when announcing a comprehensive plan to address the debt crisis by the 23 October summit. As we discussed at the time, while we think this is credible in terms of substance, we always worried about the time line. Ultimately, the G20 summit on 3 November is the real deadline. However, on present information, a decision should be announced this Wednesday.
Package. Otherwise, disappointment will be writ large, and probably not only on financial markets. Alongside the release of the sixth tranche of aid to Greece and institutional changes, we expect a comprehensive 3-point “roadmap out of the crisis” (pages 2-3):
Greece. It is now clear that even the second Greek bailout package will prove inadequate. It will have to be expanded considerably to EUR 175bn (pages 5-8). That is not possible without a stronger involvement of private creditors (bigger haircuts/longer maturities).
Banks. That highlights the recapitalization requirement of banks in Europe. They will be required to raise adequate capital from shareholders and financial investors. Otherwise, the respective governments or ultimately the EFSF will have to step in. But capital without liquidity or interbank guarantees would be unlikely to put things to rest.
EFSF. As important as ratification of the expanded rescue fund was, its ”firepower” must be increased via deleveraging. The French want the EFSF to have access to the ECB, the Germans want to limit the leverage to what they can achieve via guarantees.
Risks. If, however, the EU summits again ”come up short“, the fallout would be severe. New shock waves on financial markets could harm already rather weak economic activity. But the heads of states and governments are certainly aware of this.
– Weekly Comment: Lots of noise (page 2).
– Economic outlook: Fine-tuning (pages 9, 12, 15 & 17).
– Data outlook: Sentiment indicators to deteriorate further (page 20).
– Market outlook: Euro under the spell of the EU summits (page 24).
Lots of Noise
It has been a pretty noisy week here in Europe, but if you bother to look through the fog and pay attention to the numbers and (only) to the policy makers who actually matter, it's all okay. Yesterday, there were rumors of the EU summit being postponed. But now France and Germany agreed to get the whole package reviewed in detail at this Sunday's EU summit, which could then be decided upon by the heads of states and governments at a second summit next Wednesday. This is not really a big concern, I'll deal with it below. First two quick – and important – notes on data:
I suggested last week that we'll have to revise our 3Q and 4Q GDP forecasts a tad – nothing dramatic, but we are publishing some small adjustments (see the following Research Notes). It's clear that 3Q will not have turned out nearly as bad as most people (including ourselves) expected. Hard numbers for July and August showed that, and yesterday we got the first European hard number for September, namely the Polish industrial production number, and it was up a whopping 1.9% mom, following a 2.2% gain in August. Given the correlation between European growth numbers, this may suggest a pretty strong ending to 3Q for more European countries. Today, we also got the first indications for 4Q: the German Ifo index eased further to 106.4 (from 107.4) and in the French INSEE to 97 (from 99). Weakness yes, and probably a slight contraction this quarter, but no recession.
Professor, you are wrong!
But here is what really bent me out of shape this past week: Friends of mine – important investors – called me from Chicago after having listened to a speech Tuesday night by professor Ken Rogoff, the co-author of that great book on the history of financial crises – and therefore, naturally, someone people like to listen to. Having long predicted disaster in Europe (mostly on the back of his assessments of European politicians' reaction function), Rogoff now apparently returned to his specialty of data and economics to report that the end is near because – he claimed – of outflows of deposits from Italian banks. Unless he was misquoted, it leaves me bewildered because – as even a casual observer would have noted – the opposite is true. Here is what is happening to Italian deposits: During a two year period, until about a year ago, the Italian non-financial private sector (i.e. households and businesses) worried about the crisis like everyone else and they therefore increased their savings, specifically by increasing their deposits in the banking system by 8%-9% yoy. These strong increases have been easing this year because the level of savings is high and because higher inflation has eroded real income. During 1Q, deposits were flat yoy, and then – maybe what caught the eye of some – they declined by 1.0%-1.5% yoy during May-July, after which they stabilized in August (last observation) at a high base. More importantly, however, throughout this period, time deposits have been increasing (while sight deposits have been declining), and – as I am sure professor Rogoff knows – Italian savers traditionally hold savings also in the form of bank bonds (i.e. uninsured exposure to the banks). And this category of savings (not included in the deposits numbers) has been increasing by 4%-5% yoy in recent months. In other words, Italians continue to put an increasing amount of their savings into the Italian banking system – but, of course, at a slower growth rate than at the height of the crisis two years ago. There is nothing strange about this. Indeed, all that's happening in Italy on that front is that households are protecting some of their real consumption (running at a modest growth rate of 1% yoy) from the slightly higher inflation by lowering the growth rate of savings. Meanwhile, they are allocating more of their savings pot (not less) to the Italian banks. It may be difficult to understand European developments from afar, but a proper look at the data makes it all pretty clear!
The EU summits
Despite the speculation surrounding the upcoming EU summit(s) on Sunday and Wednesday, we see no reason to change our expectations. As I discussed last week, the important deadline is the G-20 meeting on 3 November, and we always knew that there are some tough issues to be sorted out between Germany and France (hence, the need for Sarkozy to leave his wife and newborn child to travel to Frankfurt for a meeting with Merkel and Trichet). Let me summarize again the three components: ring fencing Greece; recap the banks; and the EFSF:
On Greece, it is clear that the amount required to build an effective ring fence is considerably larger than expected in July. In our note, we estimate that we'll need EUR 170- 175bn, which means that the haircut will almost certainly be bigger as well. The Greek press reports possible haircuts of 39%-60%. I would not be surprised to see a number in the high end of that range. The Troika's report is presented to the Eurogroup today, but the final decision on the haircut will not be decided until very late in the game.
On the banks, the "news" is that the shortfall may be only EUR 90bn. This really isn't a surprise given the talk of 9% Tier-1 capital and the IMF number of an EUR 200bn loss. Unfortunately, even EUR 90bn (less than 1% of GDP) might be difficult to raise in this environment; so unless things improve significantly, the reported June deadline will be a real constraint. Therefore, the risk here is that banks will engage in substantial balance sheet reduction with potentially severe consequences for the real sector. As I have argued before, liquidity is critical, and the ECB is not right in claiming that EUR 5 trillion in eligible collateral is sitting readily available on the sidelines. Two years ago, when the UK government and the Bank of England rescued the UK banking system, it provided GBP 50bn in capital, GBP 200bn in liquidity and GBP 250bn in interbank guarantees. If the eurozone were to apply the same ratio; i.e. EUR 90-100bn in capital, EUR 400bn in liquidity (let's call it a "liquidity TARP" in which the ECB forces the banks to take the money) and half a trillion in interbank guarantees, then I think we all would start to believe that we might have turned the corner. Unfortunately, I am not optimistic here. I hope policymakers appreciate that capital without liquidity or interbank guarantees would be unlikely to put things to rest.
On the EFSF, it's all about leverage because of the need to generate some serious firepower. I have heard silly ideas of EUR 2 trillion (and even more), but the number is unlikely to exceed EUR 1 trillion, with EUR 750-800bn being more realistic. On top of that, the IMF has USD 400bn readily available. This is not quite a bazooka, but neither is it just a water pistol. Between the EFSF and the IMF, they could easily take both Italy and Spain out of the market for two years (some EUR 620bn, excluding the rollover of T-bills), and with the right communication policy, I remain completely confident that much less would do. The German and French so far couldn't agree on leverage mechanism for the EFSF. The French want it to have access to the ECB, the Germans want to limit the leverage to what they can achieve via guarantees. We expect the comprehensive 3-point “roadmap out of the crisis” to be agreed upon next Wednesday (with the G-20 meeting on 3 November as the ultimate deadline).