The French word dénouement connotes a form of final resolution of a problem or an issue. In fiction, it comes after the climax and brings clarification. In war, it is often the decisive turn in a battle that sets the stage for the war’s end – whoever the ultimate victor may be. We may be approaching such an end point in the European debt crisis. After repeated bailouts of debt-ridden countries through the imposition of austerity and adding to debt levels – actions which only worsened the countries’ debt ratios – European leaders are discussing seriously, for the first time, the possibility of significant haircuts for creditors. “Kicking the can down the road,” the trite phrase used to describe the European policy reaction, may no longer be the path for debt-ridden economies. Reduction of debt to levels that countries can reasonably be expected to service would be the first step toward ending the crisis. Also causing optimism about a resolution over the next several months is the sense of urgency that both the Obama administration and European leaders are exhibiting at arriving at a permanent solution.

Approach of dénouement would probably not end the recent market volatility. Major measures to be undertaken by European officials and banks may well add to the nervousness among market players who were able to downplay the importance of macroeconomic factors before the events of 2008.

I have repeatedly suggested since the first Greek bailout of May 2010 that the European debt crisis was going to get worse and, even now, there may be one more leg down before we all decide to put the issue on the backburner. Or, if you prefer a baseball analogy, it looks like we are at the top of the eighth inning – the game is not over yet, but you have only a couple of innings to go.

Europe: Metamorphosis of Sovereign Debt Problem

The beginnings of the European debt crisis can be traced to late 2009 and early 2010 when Greece admitted to having falsified its fiscal accounts, with the budget shortfall in 2009 really 15.4% of GDP rather than the 3.7% that the then government had originally announced! Rather than let Greece default or exit the Eurozone, the European Union arranged a €110 billion rescue program in May 2010, announcing that this would enable Greece to enter the private markets on its own. The “rescue” resulted instead in a deterioration of debt ratios and a fall in GDP, and Greece is nowhere near accessing private credit markets – its two- year debt is trading at a 66% yield today, and ten-year obligations at 22%. You can buy a Greek obligation due August 2013 for only 43 cents on the euro.

bailed out in November 2010 with a €85 billion program. Portuguese debt came under speculative attack because of its debt-GDP ratio at a dangerously high 93%, and it needed a €78 billion program in May this year.

The crisis took a new, and dangerous, turn July 8 when Italy’s debt came under speculative pressure for the first time. Italy is the world’s third largest debtor and Europe’s largest. Its €1.9 trillion public debt is the equivalent of 120% of GDP, the second highest in Europe after Greece’s 150%. Simply put, if Italy had to be bailed out, it would irreparably damage the finances of even Germany, the largest European country and the strongest in terms of credit standing. And despite repeated efforts by the European Central Bank to buy Italian debt, the yield continues to be under pressure (chart).

European Banking Authority and Sovereign Default

While markets were increasingly worried about the contagion reaching Italy, and about an imminent Greek sovereign default, the European Banking Authority tried to calm investors by declaring on July 15 that most banks had passed the stress test it conducted. Furthermore, the EBA emphasized that the “approach followed in the stress test...is also in line with the commitment of the European Union to prevent one of its Member States from defaulting on its liabilities.” Less than a week after the publication of the report, the EU announced that creditors would be required to take a 21% haircut in connection with a new bailout of the Greek government! And Wolfgang Schaeuble, the German Finance Minister, suggested last week that the haircut may have to be bigger than 21% in order to reduce the eventual burden that would be placed on a bailout fund.

Realization that the debt contagion had not been tamed and was spreading to bigger countries, especially to Spain and Italy, put pressure on the share prices of European banks believed to have major exposure to the troubled sovereigns. The STOXX Europe Bank price index lost about 35% of its value between early July and the end of September. So what had been a peripheral country sovereign problem has come to core Europe – Italy – and threatens the solvency of some of the largest banks in the region.

Berlin Summit and its Aftermath

Deteriorating conditions in Europe, daily swings in U.S. financial markets based on what European authorities may or may not accomplish, and slower growth forecasts even for emerging markets, formed the background for the meeting that German Chancellor Angela Merkel and French President Nicolas Sarkozy had in Berlin last Sunday.

The two leaders went into the session with a deep chasm separating them on what needed to be done. The French side, encountering worldwide doubts about the solvency of its banking system, asked for the EFSF to be substantially increased in size – up to €2 trillion has been rumored in the press and in financial circles. The sum would be used to recapitalize European banks as well as to bail out sovereigns, even assuming a worsening of the contagion. According to the French proposal, individual countries would be able to borrow from the enhanced fund to recapitalize their banks. On the other hand, since Germany would be the major contributor to the fund, Chancellor Merkel is believed to have suggested that each country attempt to recapitalize its own banks and only subsequently, draw down from the fund.

Not surprisingly, the announcement after the meeting said that an agreement had been reached but was short on details. After all, how do you bridge a €2 trillion gap over a weekend? I expect the eventual resolution to be close to the German position – that each European government work with its own banking system. Why? To raise a figure close to €2 trillion in capital markets for an enhanced EFSF would result in a many-notch downgrade of not only France’s sovereign rating, but Germany’s as well. In so doing, Europe’s major powers would be inflicting damage on the EFSF itself since the currently AAA-rated entity would get downgraded if it were not backed by AAA sovereign credits. In short, in enhancing the size of the EFSF, its ultimate lending capacity may be much reduced!

Inflation: The Ultimate Savior

If there will never be a €2 trillion EFSF, how does the dénouement of the debt crisis come about? I see it occurring through a combination of several other developments:

1. EU leaders will have to take the official position that significant haircuts need to be imposed, not only on creditors to Greece, but on lenders to other European debtor nations as well. At the current time, senior officials like Mr. Schaeuble from Germany have suggested it but it is not yet the common EU position. Europe needs to undergo massive deleveraging, and creditor haircuts will be one way the debt burden will be reduced.

2. To offset the adverse impact of haircuts on banks’ capital adequacy ratios, the European banking system will have to go through a major recapitalization through private capital markets amounting up to the €200 billion figure that the IMF has at the top of its estimated range. This would involve a significant dilution of existing shareholders who, in this manner, would bear a part of the burden of the deleveraging process.

3. In exchange for debt reduction, debtor nations will be required to introduce debt-equity conversion programs providing new investors with profitable opportunities. Debt prices would rise in secondary markets as a result of these moves and, therefore, will be welcomed by creditors. Sovereign wealth funds are likely to be significant players in this process. In other words, China is not going to simply buy Spanish or Italian paper but would be interested in significant direct investment opportunities.

4. A major role will be played by inflation. I expect that even Germany would ultimately agree to faster money creation by the ECB in a tacit acceptance of a higher inflation target than the current “just under 2%.” Higher inflation would be a hidden path toward debt reduction. It would also be a politically more palatable way to impose a portion of the deleveraging burden on German taxpayers than through the creation of a massive new bailout fund. Expect Eurozone inflation to rise to a 4-5% pace in order to make a serious dent on the countries’ debt payment capacity.

 

 

(c) TCW Asset Management

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