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A trader's guide to assessing the European crisis plan

CMC Markets

The European announcement on proposals to deal with its sovereign debt problems looms as a possible game changer for world markets so I've tried to get together a brief framework of how to assess it from a trader's or investor's point of view.

My list of thoughts follows but I'd very much appreciate any other contributions readers are generous enough to make. You can do this by leaving a comment below.

My first point of focus is that the plan will be mainly about managing the consequences of the debt problem rather than fixing the problem itself.  Removing the debt problem is likely to be a long term process (unless the radical solutions of default or currency devaluation are employed). This means that sovereign debt will remain as an element of risk for some time to come especially if economic growth is weak in the vulnerable nations.

To satisfy investors that the consequences of sovereign debt default can be managed well enough to completely remove the risk premium that has been built into markets since May last year the plan would need to:

  • Carry enough fire power to rule out any question of a "run" on Italian or Spanish bonds. Both these too big to fail nations are vulnerable to a situation where their bond rates rise above about 6% for any period of time. They may have difficulty servicing their debt at these prices
  • Prevent a situation where a Greek default gets out of control and causes the situation to unravel, leading to a major crisis of confidence in world markets.

So how effective would the sort of measures that have been discussed in recent weeks be in dealing with these 2 problems. This is my list:

Requiring European Banks to increase their capital by €100bn.

  • This amount would be largely irrelevant in the event of a default by Italy or Spain whose combined public debt is around €2,500 bn
  • It is not necessary for banks to deal with the mooted increase in the level of Greek default but it would create a strong security buffer against a Greek default next year
  • As an aside, raising capital will be much more expensive for banks now that their share price has plummeted than had it occurred in less of a crisis management mode earlier in the year

Increasing the rate of default on Greek bonds from 21 to 50%

  • While this may be a fairer allocation of losses between investors and taxpayers, it won't be a complete solution for Greece. The increased haircut is estimated to reduce their debt to GDP ratio from 180 to 140%. Most analysts reckon this ratio needs to get down to around 90% to get the country's finances back onto a sustainable footing for the long term

Increasing the European Financial Stability Fund from €440bn to €1000bn

  • € 1000 bn won't be enough to contain a situation involving Italy or Spain. Estimates for the total required to deal with this seem to be more in the range of €2-3,500 bn
  • A key thing, I'll be looking for is how definite and certain funding proposals for the EFSF are. Plans to talk to sovereign wealth funds or explore insurance alternatives would be too indefinite to make much difference to markets

So in general the sorts of proposals that have been mentioned in recent weeks look to me at best like an incremental improvement but well short of the sorts of measures that would remove European sovereign debt as a risk issue altogether.

A good package of "incremental" improvements may reduce the problem of an immediate crisis due to uncontrolled unravelling of the Greek situation. That might justify markets returning to the sort of area we saw back around March/April this year but it wouldn't justify removing risk premiums back to pre GFC levels.

AND announcement of a good package of incremental improvements is by no means a sure thing

Cheers

Ric


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