Evercore Pan Asset

We hear that the EU is working away at a solution to the Euro crisis. It comprises three main elements – more capital for banks, bigger write-offs on Greek debts, and a huge support fund to bail out any other country or bank that needs subsidy. If the package lives up to the billing it might impress the markets for a bit, and buy them some more time. It does not solve the underlying problems. There still needs to be a solution which enables the uncompetitive countries in the south to become more competitive to earn their living. If they cannot do that by the stealth of devaluation, they need to cut wages and other costs sharply, which is unpleasant and difficult to do. There has to be a way for the countries too heavily in debt to get their deficits and in due course their levels of debt down. Lending them more money puts off the adjustment, it does not make the adjustment for them.

The proposal to put more capital into the banks is not unalloyed good news. The EU governments would prefer the private sector to do this, under orders. The easiest way to get better banking ratios is for the banks to lend less. This will not help the recovery.

The German end of the argument does not like the idea of big state injections of capital. The German position has favoured private sector solutions, ranging from raising more capital on the markets through controlled administration for failing banks, with bondholders and shareholders taking the loss.

The UK has moved to this position through the FSA work on “living wills”, advanced plans to wind up a bank in an orderly way if it runs out of cash and capital. The Vickers Report endorses this approach. It now sounds as if the EU is back tracking, moving back to the old idea that in the last resort the state gives a failing bank any amount of cash and capital it needs, effectively nationalising the losses and risks. Given the weak state of most country finances, and the dislike of banks amongst electors, this is a contentious strategy. Weak countries and weak banks cannot in the end prop each other up: they pull each other down.

We are openly told the governments are working on a second Greek default proposal where lenders to the Greek state will lose more than the one fifth of their money in the old plan. It is now universally accepted that Greece “cannot” pay back its debts. If they fail to pay back half or more of what they owe, they will then be spared substantial interest and capital payments which eases the pressure on their state budget. It is a short term palliative. Once again it does not solve the underlying problem, which is the Greek propensity to live beyond her means.

A Greek default is not necessarily helpful for the other weak countries in the Euro scheme. If one country is allowed to default and does so, might another? How do the Euro authorities draw a line under a Greek default, and convince markets that other countries will be made to honour their debts? It is hardly a good advert for Euro zone management that a member state is actively encouraged to say to the countries, companies and individuals who lent to it they will not get their money back. Markets are likely to price in default danger in other Euro sovereigns, charging the weaker countries more for a loan as some protection against similar treatment.

The EU is proposing a mega fund, briefed at anything from €2trillion to €3trillion, to provide shock and awe to markets. €3trillion would probably impress the markets. It would show there was a lot of fire power, enabling Euroland authorities to help secure lending to Italy and Spain at low interest rates if the market is unwilling to do so, and enabling them to prop any bank in the system that was weak. This has to be done indirectly, as the ECB cannot lend direct to Euro sovereigns.

The issue here which the markets may test is how much political will is there to spend this money if need arises? How real is the €3trillion? Where does it come from? How does it get repaid in the end? In short, it has to be a genuinely available €3trillion that comes from a plausible source or sources. Is it any more than saying Euroland as a whole will borrow on its combined credit rating to lend to its weaker members at subsidised rates? Is Germany really up for this? Does it mean that the AAA ratings of France and Germany have to be downgraded, as they come to assume more responsibility for the debts of the weaker states?

€3trillion is a lot of money even for Euroland. It either is borrowed, or it has to be raised from taxpayers. Either route poses problems, as well as offering a temporary answer for markets. Higher taxes can have a depressing effect. There seems to be no agreement to a financial transactions tax as part of the package.

Of course, there is a third route. They could sanction the European Central Bank to go printing it. The Bank could buy up as many bonds as was needed, using electronically created money like the US and UK. That might work for a bit as well. If you do that to excess it causes too much inflation. I doubt the Germans would openly sign up for that. We need to watch the small print behind the spin.

There are also rumours of further IMF support for Euroland packages. There is a relief rally underway on the back of market perceptions that the governments of the EU might at last be putting together something big enough to do the job. We would rather play this rally through non EU assets although we accept that in the short term all types of assets may participate. We continue to recommend maintaining reduced exposures to EU investments or avoiding them altogether, as none of the actions proposed tackles the underlying deficits, the lack of competitiveness in the southern countries, and the likely slow growth as the banks are put under further regulatory pressure.