Evercore Pan Asset

Last week-end the Finance Ministers of the EU had to meet again to deal with the problems in Ireland. They concluded that a “loan to Ireland is warranted to safeguard financial stability in the Euro area and in the EU as a whole”.

Things should not have worked out like that. Clause 126 of the Treaty of European Union instructs Member States to avoid excessive deficits. The Treaty included a range of procedures from surveillance, reporting, requesting changes of policy through to special deposits and fines to keep member states budgets in good shape. The European Central Bank was put at the head of the system of Euro area banks with duties to keep the banks in good order and to keep the markets functioning well.

Article 125 of the Treaty is a no bail out clause, saying “The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities…”So what went wrong?

The Irish troubles are first and foremost a failure of EU and Irish banking regulation.  Banks were allowed to increase their balance sheets beyond prudent levels, and beyond a size which the Irish state could guarantee on its own.  The €85 billion package includes €10 billion for immediate recapitalisation of the weak banks, and €25 billion in contingency money should more need arise.

The second problem was ineffective policing of member states budgets. All too many EU countries allowed their annual budget deficits to soar well above the 3% of National Income limit. The EU obtained information and urged better behaviour, but did not press its case hard enough or seek to enforce its will. As a result many countries were borrowing in their common currency well beyond the levels recommended by the founders of the Euro. It was only a matter of time before markets expressed their disapproval and action had to be taken.

The EU hopes that last week-end will draw a line under the rolling Euro debt crisis. Ministers changed the terms of the Greek package as well as negotiating more of the details of the Irish one. They have sent a strong message to other countries rumoured to be in difficulties that they need to solve their own problems by cutting spending, raising revenue and recapitalising any bank at risk. By charging Ireland and Greece 5.8% to borrow they have imposed a rate more than double the German 10 year borrowing rate for shorter term money.

Will this mark the end to the troubles? I fear not. Market lending rates to Ireland, Greece, Portugal and Spain remain much higher than core Euroland rates, and have risen a little even after the announcement of the package. The markets will want more proof that each country with overextended banks has a proper plan in place to deal with it. Markets were not entirely convinced by EU stress tests which were not thought to be stressful enough.

Markets also want more understanding of the likely future policy of the European Central Bank. Is it really going to reduce its support to European banks at this sensitive time? If as the authorities say all the main EU banks are solvent, why doesn’t the ECB provide as much liquidity as they need? Is there a guiding central hand ensuring that all the main banks are following wise policies to keep them out of trouble?

None of this is good news for investors. If the EU pursues deep spending cuts and large tax rises to tackle the deficits they could end up in a worse mess if economies like Greece fail to grow. If the ECB removes its support too quickly from a fragile banking system some banks could be left short of liquidity and in need of special measures like the Irish ones. Meanwhile German public opinion is not happy at the thought of having to assist with bail outs. Ireland may change its government as a result of the crisis. Will any new government just accept the terms of the deal?

We continue to recommend that investors avoid European equity investments.

As published in Investment Week