27th October 2011

Schroders: Eurozone crisis update: Done deal

Leaders from the eurozone and the wider EU met yesterday to thrash out a solution that they hope can finally stem the contagion spreading from the European sovereign debt crisis. Late into the night, an announcement was finally made that followed the three pillars we set out in the September Economic and Strategy viewpoint.

The agreement includes:

• Private investors will be asked to voluntarily partake in the restructuring of Greek debt, which will be the equivalent of taking a 50% nominal haircut.
• The European Financial Stability Facility (EFSF) will be made more effective by 1)offering insurance on new government debt to be issued and 2) being increased in size using a Special Purpose Vehicle, which both public and private money will fund.
• European banks will be forced to meet a new higher Tier 1 capital ratio of 9% but with regulators ensuring that the deleveraging process does not involve a reduction in credit to the real economy. Banks are asked to raise capital from private investors first, and failing that, receive help from national governments. €100billion of loans will be made available from the EFSF.

In addition to the above, the changes to the EFSF's powers agreed on the 21st of July are now in force. This means that the EFSF can buy bonds in secondary markets either in conjunction with, or taking over from, the European Central Bank.

Finally, plans were announced to increase political and fiscal integration, mainly through more scrutiny of fiscal plans through the existing peer review process. We believe that these are the first steps towards a fiscal union, though we may be many years away from the model being completed.

In our view, these are very positive steps in the right direction which re-enforces our view that European politicians are willing to take unprecedented action to keep the European Monetary Union together. However, the deal is not totally finalised, and we must wait for more details on each of the three pillars of the solution.

For example, the eventual lending capacity of the EFSF has yet to be agreed. Hints of increasing its current lending capacity of between €200billion and €250billion by three or four fold has prompted headlines of €1trillion being made available. Certainly if the insurance strategy only covers the first 20-25% of losses on peripheral sovereign debt, then this would be the case.

€1trillion would be enough to support Italian and Spanish funding until around 2014. The problem with this assumption is that it relies on the market being willing to buy the bonds with the insurance - which is not guaranteed.

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