Europe – Finally, light at the end of the tunnel?

The recent European Union (“EU”) Summit has been hailed as the most important event in years. Preceding this EU Summit, there are experts who stated in late November and early December that the European Currency (“euro”) has at most 10 days to survive. For example, EU Monetary Affairs Commissioner Olli Rehn commented on late November that “they are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union”. French President also commented before the EU Summit that failure to reach an agreement is a luxury that they cannot afford. He added that EU would not get a second chance. The monumental EU Summit has finally come to pass. So what is the verdict?

Some key developments from EU Summit

First steps to fiscal union via “fiscal compact”

European leaders established tougher budget rules in a separate euro- area treaty excluding Britain. It would restrict structural deficits at 0.5% of GDP. Governments should also set up an “automatic correction mechanism” to reduce their deficits if they exceeded the target. In addition, there would be more intrusive control of taxing and spending by governments which exceed the deficit limit of 3% of GDP.

Putting their own money on the line

Euro EU states and non-euro EU states are lending EUR150b and EUR50b respectively to the International Monetary Fund’s (“IMF”) general resources.

Sped up the setting of European Stability Mechanism (“ESM”)

European governments agreed to bring forward the establishment of the ESM to July 2012, a year ahead of schedule.

Diluted the demand that bondholders share losses in future bailouts

Germany who initially championed for bondholders to share the burden of future bailouts has backed down as such demand had an adverse impact on the debt market.

How did U.S. markets perform right after the EU Summit?

U.S. markets soared after the EU Summit. Some would ask whether we are finally seeing the light at the end of the tunnel. I hope so but I doubt it.

Here are some worrisome signs that investors have to take note

EUR2t up for refinancing next year

According to Bloomberg, Europe governments have to refinance more than EUR1.1t of debt in 2012 with about EUR519b of Italian, French and German debt maturing in the first half alone.

Besides government debt, European banks are also vying for debt refinancing. According to Dealogic data, European banks need to refinance US$665b of debt in 1H2012 and US$370b in 2H2012. Furthermore, banks may face funding squeeze due to the competition for their deposits. For example, clients withdrew funds from stressed countries’ banks, resulting in the loss of as much as EUR14b for the Greek lenders in the two months to the end of October.

Banks still reluctant to lend to one another

With reference to Chart 1 below, Euribor-OIS spread (a widely touted indicator which signifies the banks’ reluctance to lend to one another) has been trending sharply higher since June and at this level of 96.4bp, it is already higher than the time that Bear Stearns collapsed and is almost at the highest level since Mar 2009. This does not bode well for the financial system.

Chart 1: Euribor-OIS spread

Source: Bloomberg as at 12 Dec 11

Avalanche of refinancing in the next two months

There is significant amount of debt to be refinanced in the next two months. Just to put this in perspective, Italy’s Nov 29 auction which was widely reported only saw a total of EUR7.5b refinanced at a yield greater than 7%. However, Italy has to refinance EUR320b of debt in 2012 with about a third of the debt due for refinancing in 1Q2012 alone. (This is how significant it is and it’s only from Italy…)

Wild card – response from credit rating agencies

Last week, Standard & Poor (“S&P”) put 15 out of 17 Eurozone countries on negative outlook. (For readers who are curious to know why the other two Eurozone countries are not placed on negative outlook à this is because Greece already has a junk CC-rating and Cyprus was already on downgrade watch!) The response from S&P and other rating agencies remain a wild card as ratings downgrade remain possible. At the time of writing on Monday, there is a rumour floating around that S&P may downgrade Europe later in the day at the earliest. In addition, Moody’s Investors Service said today that last week’s EU Summit provided few new measures and it is still doing a review on all European Union sovereign credit in 1Q2012.

Implementation is key

Europe has announced several comprehensive plans before but it almost always falters when it comes to implementation. More details have to be ironed out on the implementation on the fiscal compact. Firstly, it is uncertain how binding the fiscal compact will be for the member countries. Secondly, who has the rights to enforce the measures remains a question mark. Thirdly, as the above details are ironed out, it may be possible that countries which initially accepted the fiscal compact may have second thoughts of joining (this “back and forth” is not unheard of in Europe). In addition, although it is reported that Britain has wielded its veto, the other three countries Hungary, Sweden and Czech Republic will be consulting their parliaments, thus it is not a given that they will definitely accept the fiscal compact. Once the fiscal compact is finalised by Mar 2012, it has to be ratified by all participating countries. Given the various uncertainties, the timeline does sound ambitious.

Secondly, according to Citigroup research, to ensure the smoothness of the ESM, they believe that Article 136 of the EU treaty may have to be changed to align to German constitutional court but this change has to be ratified by all 27 EU member countries. In addition, all the 17 euro members have to ratify the ESM framework agreement and 90% of the EMS’s capital have to be committed. Given the “slow response time” of the Euro members, ESM may not be up and coming by mid 2012.

Despite the concerns, the EU Summit may spark aid from G20 through IMF

The move (European leaders making bilateral loans to IMF) may raise the probability of obtaining aid from Group of 20 (“G20”) nations. Previously, G20 nations were reluctant to help Europe as they felt that Europe was not doing enough to resolve their own debt problems. According to Brazilian Finance Minister Guido Mantega, Brazil may arrange something with Russia, India and China to aid Europe. Mexican central bank Governor Agustin Carstens also offered their aid.

Conclusion: Europe crisis may worsen first before it ameliorates

In the near term, it is likely that the ECB may have to step up its bond buying program perhaps in 1Q2012. This is because notwithstanding the measures announced via the EU Summit, it is unlikely these measures (which may deliver long term benefit) can solve the near term problem of high bond yields stemming from the lack of confidence in Europe. The “avalanche” of refinancing needs in the next two months likely indicates that the crisis could worsen (before it ameliorates) and the ECB would then finally be compelled to enact further measures such as hiking its bond purchases. Furthermore, given the spotty track record of the Europeans, it is unlikely that the measures outlined by the EU Summit can be carried out seamlessly which would exacerbate the lack of confidence in Europe.

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