Evercore Pan Asset

It’s time again for the political leaders to prepare themselves to save the financial world. The press and financial markets are busily working up a head of comment, demanding action to sort out the banking crisis, the sovereign debt crisis, and the rolling Euro crisis. They would quite like an answer to the currency and trade war issues between the USA and China, sensible stimulatory measures on both sides of the Atlantic, and the sudden advent of low inflationary growth everywhere for good measure. Why not?

There are limits to what these political leaders can do. They are hedged in by their own political ambitions and electoral cycles, by public opinion back home, by the intractable nature of the problems, and by the conventional thinking that stalks banking parlours and treasuries. In the USA the President is worried about the lack of jobs in the slow recovery so far. He would like to tip more stimulus at it, as he wants to be re-elected next year. His Republican opponents have power to stop him and do not think more state borrowing is the answer. In France the President faces an election in May 2012. He wants to get there with no downgrade of France’s credit rating, no French banking crisis, and with better prospects for the Euro. He got through the Dexia crisis by requiring Belgium to take the biggest part of the hit. The German leader wants to see the Euro through its twin banking and sovereign debt crises, but knows there are limits to how much German money she can throw at the problem given German public opinion and the attitude of the Bundesbank. The Chinese leadership would like inflation to subside rapidly so they can reflate a bit prior to the change of leadership next year. The UK Coalition government sticks to the rhetoric of deficit reduction, but is having difficulty delivering the figures of its five year plan.

So what do the advisers and officials put on the agenda for them? In Euroland, the epicentre of the wider crisis, they plan bank recapitalisation. We learn that they want all EU banks to hit 9% Tier One capital ratios, with a tougher definition of the ratio than Basel II without going the whole way to Basel III. Analysts have put the requirement at €200 billion to meet this. Banks are saying they might get to the new ratio by cutting lending and selling assets rather than by raising new share money. The plans will overhang bank share markets, and will confirm the European slowdown as banks decline to lend as much as is needed. There is talk of the banks having to mark their holdings of sovereign bonds to market, recording heavy losses on the weaker sovereigns. The European Central Bank, the proud owner of large amounts of sovereign debt, is not happy about this proposal. It does not like the implied threat that some Euro area sovereigns will fail to repay the money in full.

The advisers are finding a resolution of the sovereign debt problems altogether less easy. Some think that Greece has proven the impossibility of achieving the deficit reduction necessary by spending cuts. Increasing tax revenues and selling assets hasn’t gone well either. That leaves the option of sending Greece more money by way of grants or heavily subsidised loans. The Euro area is in the business of finally agreeing a €440 billion intervention fund to lend to troubled sovereigns and banks, first agreed in July. At the same time they are trying to find a way of beefing this up to €2-3 trillion. With that sort of money they hope to face down the markets and inspire confidence again in Italian debt and Spanish economic policy. This money would come by Euroland borrowing money on its common credit to lend on to the weaker members. They could also consider printing some more Euros, though Germany is likely to be worried about any such move.

We watch the Italian ten year bond yield closely. In July this briefly went above 6%, causing worry. The ECB started a programme of buying Italian and Spanish bonds in the secondary market. They seemed to want to get Italian 10 year yields down to around 5%, a level they thought the Italian state could afford as it rolled over its borrowings. The yield is currently back up at 5.8%. Each state auction of new debt to replace maturing borrowing or to pay for current excess spending is a trial for the authorities. They appear to have lost the battle for Greece, and are probably now in discussions about the size of the Greek debt write off. They need to win the battle for Italy, given the size of the Italian debt, and the knock on effects to European banks of losses on this paper.

Markets may rally if the Europeans do stump up a large amount of cash to shore up their currency. The US economy may make a bit more progress in the fourth quarter. The Chinese authorities are nearer to shifting towards a more expansionary policy, so all is not lost. However, the agenda of more prudent banks and continuing sovereign debt losses in Euroland is not good news for Euroland assets in the longer term. There is still no solution to the underlying problems of the single currency and the overspending governments in sight.