A Quick Summary of The New EU Program
On the Thursday Euro area summit, European leaders have come up with a set of proposals that is designed to solve peripheral countries’ sovereign debt crisis and that demonstrate their strong desire to keep the Euro together. The official statements came after the European trading session.
I. Global Market Reactions
Ø In general we saw a risk relief.
Ø Equities: Stoxx600 and S&P 500 added +1.03% and +1.35% last night. Both index went up +3.3% and +3.7% from their Monday's lows.
Ø Credit: Main, Crossover, Fin Sen and Fin Sub have tightened around 16bp, 60bp, 34bp and 57bp respectively since Monday's wides while SovX has seen the most notable spread tightening (67bp tighter).
Ø Precious Metal: Gold touched softer at $1589/oz but down from a recent record of $1610/oz earlier this week.
II. Highlights of EU Proposals
1. The Greece new program
Ø The EU has agreed to provide an estimated EUR109bn financing for the sovereign together with IMF and the voluntary contribution of the private sector.
Ø The original bilateral program, which has disbursed EUR 65bn, is now closed and the new program will be funded by the EFSF.
Ø The new program will feature extended maturities and lower interest rates.
n The total amount of the official loans to Greece in the period 2010-2014 will be EUR174bn.
n The new EFSF loans will have a coupon of around 3.5%, a grace period of 10 years, and a maturity of between 15 and 30 years,from the current 7.5 years.
n Existing Greek loan maturities will also be extended substantially, but the borrowing cost will not be reduced.
Ø The EFSF lending rates and maturities agreed upon for Greece will also be applied to Portugal and Ireland.
2. Private Sector Involvement (PSI)
Ø In terms of PSI, EU has decided against the Bank Levy option.
Ø Instead, the financial sector is prepared to participate in a voluntary program of debt exchange and a buyback plan developed by the Greek government.
Ø The program basically involves an exchange of existing Greek securities into a combination of four instruments together with a Greek Debt Buyback Facility.
Ø The four instruments are
1) A par bond exchange into a 30 year instrument
2) A par bond offer involving rolling-over Greek government bonds into 30-year instruments
3) A discount bond exchange into a 30-year instrument
4) A discount bond exchange into a 15 year instrument.
u The principal amount of the first 3 options is fully collateralized by 30-year zero coupon AAA bonds
u The fourth option will see the principal partially collateralized through funds held in escrow.
u All instruments will be priced to produce a 21% NPV loss based on an assumed discount rate of 9%.
Ø The program seeks to extend the average maturity of Greece's debt from 6 to 11 years.
Ø The size of the buyback facility is still unknown but is expected to be large enough to see a meaningful reduction in Greece's debt/GDP ratio.
Ø The list of financial institutions in support is disclosed and for the period 2011-2019 the total net contribution of the PSI is estimated at EUR106bn.
3. Preventing Contagion Risks
Ø EU has agreed to allow the EFSF to fund the recapitalization of financial institutions via loans to government, including non-program countries, and to intervene in the secondary Government bond markets.
Ø The latter will be determined by ECB analysis recognizing the existence of exceptional financial market circumstances and risks to financial stability, and also on the basis of a decision by mutual agreement of the EFSF/ESM Member states.
Ø The necessary procedures needed for implementing this will be initiated as soon as possible.
Ø EU also agreed to reduce the reliance on external credit ratings in the EU regulatory framework.
III. Outlook for the new program
In the near-term, the new program is a bigger package than most were expecting. It at least seems to have brought some unity back between Euro Governments and ECB.
However, in the medium-term, I think whether such proposals could ultimately succeed largely depends upon
Ø Whether the peripheral countries can use the time it allows them to make large internal adjustments
Ø Whether the European economy manages to squeeze out enough growth for them grow out of their problems
Ø Looking forward, if growth falters and if indeed European economies have a recession (or hint of it) over the next 1-2 year, such package is highly unlikely to be able to prevent the crisis spreading.
IV. Latest Euro-area Economies Updates
As mentioned in the Point III, the hope of success for this new program relies on the growth prospect of the local economies. Thus the latest weakness in European data is worth noting:
Ø The July flash composite PMI for Eurozone dropped to 50.8 in July and was well below expectations of 52.6 vs. a 53.3 print in June. This brings the index to levels last seen in June 2009 a time where Europe was barely exiting from recession.
Ø The market cannot just blame the peripherals for this month's weakness as the German manufacturing PMI was also WTE (52.1 vs. 54.1).
Ø Balancing growth during periods of austerity remains a challenge and the bond market will continue to monitor this carefully.
Ø In fact, one of the reasons for the recent weakness in the Italian bond market was the sub-50 print in Italy's June PMI manufacturing.
