From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Komal S. Sri-Kumar, Chief Global Strategist TCW, explains why investors shouldn’t get too excited about supposed developments in dealing with eurozone banks.
After Italy’s victory over Germany on the football field on Thursday, Prime Minister Mario Monti also won for Italy at the negotiating table the following day. At an emergency summit meeting held in Brussels, Mr. Monti forced German Chancellor Angela Merkel to make the significant concession that a newly created European bailout fund could recapitalise troubled Eurozone banks directly rather than through the respective countries’ public sector entities.
Thereby, leaders of France, Italy and Spain – proponents of the shift – hope bailouts would be made available without the intrusive oversight by the European Union, the European Central Bank or the International Monetary Fund (the “troika”). The first potential beneficiary of the change in policy would be Spain where a previously announced EUR 100 billion aid package to the banking system had been structured to flow through the Spanish government, boosting the country’s public debt and the public debt-GDP ratio. The sum will now be infused directly into the Spanish banking system. And should Italian banks be unable to access public markets, they too could eventually tap the official emergency rescue sources more easily.
Global markets rallied on Friday, and Italian and Spanish bond yields fell. Was the just concluded crisis meeting – which was the 19th or 20th in sequence depending on who was keeping count – the charm?
Reality Will Soon Replace Market Euphoria
While Chancellor Merkel’s concessions did come as a major surprise and could bring some relief to Spanish and Italian banks, the euphoria is likely to be short-lived. The infusion of capital into the Spanish banking system will not occur until a Europe-wide banking supervisory organisation is set up, probably as part of the ECB. This could take until at least the end of the year, and European negotiators hope that the announcement itself would suffice to provide relief to the regional banks until then.
Second, while European leaders agreed that private sector funds flowing into the Spanish banks’ capital structure would not be subordinated to the official flows, investors will have to be convinced that this would, in fact, be the case. For example, in the case of the Greek bailout, the ECB’s participation was introduced on a more senior basis despite the lack of a legal provision to do so. And if private investors are not convinced by the officials’ promises, they may take advantage of the new official relief programmes to exit at better prices, rather than add to their investments. This is a significant risk – that the new programmes pile on more Spanish and Italian debt owed to other European official entities because they attract few new private sector investors.
Third, and most important, the shift from the Spanish public sector to the banks of the EUR 100 billion bailout will transfer the obligation from the books of the public sector to those of the banks. However, the new loan would still increase the country’s total debt by EUR 100 billion! If the Spanish banks are eventually unable to service their obligations, does anyone doubt that the debt will become the responsibility of the Spanish government? If banks default on their debt, they may have to be nationalised, with the Spanish government left to repay the debt. Simply put, housing the debt with the banks rather than the government worsens the country’s debt ratios just the same.
Concessions will Raise German Country Risk
While the results of the meeting in Brussels have elements of “kicking the can further down the road,” that is not the principal criticism of decisions the European leaders made last week. Should the measures start to get implemented as announced, they would contribute to raising German country risk by increasing the German taxpayers’ obligation to support other European countries. This is because the proposed bailout fund, the European Stability Mechanism, would provide debt financing to Spanish banks which, in turn, would buy Spanish sovereign paper. And the German government will be the principal financier of the ESM. This explains why the German 10-year debt yield rose on Friday even as yields fell for Italian and Spanish paper, and the yield on French 10-year debt remained roughly unchanged.
Chancellor Merkel defended her concessions in a speech to the Bundestag, the lower House of German parliament, by pointing out that backing for Spanish or Italian banks would be contingent on the two governments agreeing to supervision by an entity within the ECB. This should not satisfy global bond investors. Until recently, bank stress tests assumed that lending to European sovereigns was risk-free because defaults by European governments were “impossible.”
It is unlikely that an ECB-based bank examiner would be allowed to conclude, for example, that the Italian banking system’s risk had increased because of growing holdings of Italian government paper. And since Mr. Monti anticipates that conditions accompanying future loans would be less stringent than those included in the Greek, Irish and Portuguese bailouts, the ESM may end up basing its lending decisions on increasingly questionable assumptions.
An increase in German country risk would raise the European crisis to a new level. It goes to show that you cannot resolve a problem of excessive debt by further increasing debt levels.
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