The party’s over as Europe gets serious (sort of)

Last week, the leaders of the Euro zone economies announced a package of measures designed to restructure Greece’s public debt, and recapitalise Europe’s banks that are set to take a “voluntary” haircut on their holdings of Greek debt.

The announcement has three broad components. First, negotiations with private sector lenders have resulted in those lenders agreeing to a voluntary 50 per cent haircut on their Greek debt holdings, a move which is expected to reduce Greece’s public debt to GDP ratio from 160 per cent of GDP to 120 per cent.

Second, Europe’s banks are required to achieve a level of tier 1 capital equivalent to 9 per cent of risk-weighted assets by June 2012 which, according to estimates released by the European Banking Authority, requires major banks in 13 countries to raise EUR106.4bn of additional capital, including EUR30bn in Greece, EUR26bn in Spain, EUR14.7bn in Italy and EUR8.8bn in France. That capital is to be obtained from the private sector wherever possible – where that is not possible, national governments are meant to cough up, and where that is not possible, either, the European Financial Stability Facility (EFSF) can be utilised.

Finally, the remaining funds in the EFSF (after providing a second aid package to Greece of about EUR100bn) will be leveraged by four to five times so that its total firepower will be EUR1 trillion. The details of how this will be done (for example, via first-loss guarantees on new debt, a Special Purpose Vehicle or some combination of the two) are to be determined by the end of November.

Markets initially responded to the package extremely positively. Share prices soared in the 24 hours or so following the announcement. I hate to sound like a party pooper, but…

A 50 per cent haircut that takes Greece’s debt to GDP ratio back to 120 per cent is not enough. The austerity that is still required by the Greeks is just not achievable. Even with a primary budget balance or small surplus (that is, the Greek Government raises enough tax revenue to fund its day to day operations – quite novel really) which would still require a significant degree of austerity, the debt interest alone would still leave an overall budget deficit of around 8 per cent of GDP.

The lack of detail around the leveraging of the EFSF is puzzling given how long they have had to think about this, and suggests that there are real tensions about how to achieve this and who is going to fund it, not to mention the problem of financially stretched Governments stretching themselves even further, to bail out players that are even more stretched.

Recapitalising Europe’s banks is essential, but EUR106 billion simply is not enough if you assume that this problem is about much more than Greece. A haircut for Greek bondholders is a start, but what about Ireland and Portugal – not to mention Spain and Italy? Depending on the assumptions you make about likely Portuguese and Irish haircuts, coming up with a figure of EUR300 to 400 billion is pretty easy, but getting that kind of money from private investors at this point is a tall order to say the least.

Look, what they’ve announced is a marked improvement on what they’ve dished up to date, but as EU Commission President Jose Manuel Barroso indicated yesterday, this is a marathon, not a sprint. For the time being, financial markets seem willing to again give Europe the benefit of the doubt.

But for how long?

Brian Parker is an investment strategist with MLC.