October 31, 2011 GE N.

130

Global Economy N.130

Agreement on rescuing the euro zone Risks of financial contagion Briefs Deciphering

AGREEMENT ON RESCUING THE EURO ZONE

Will it be enough to overcome the sovereign debt crisis? The world awaited anxiously the result of the Euro Summit. Stock prices rose and fell with hopes or despairof reaching a successful agreement. As Angela Merkel told the German Parliament: The world looks to Germany and Europe to see if we are ready and capable of assuming our responsibility in the worst crisis since World War.II. If the euro fails, Europe will fail.! In the end, European leaders were able to agree on a plan to rescue the euro zone, and financial markets reacted with euphoria. Among the main elements of the agreement: The European rescue fund will be increased to $1.4 trillion dollars, more than double the present amount, thus enabling it to address risks arising from debt in Italy and Spain. Banks will be compelled to raise $147 billion dollars of additional capital before the end of next June, so that their safe assets will equal 9% of total capital. They will thus be better prepared to withstand shocks from debt defaults. Banks will have to accept a 50% loss on the value of their holdings of Greek debt, which may now be brought down to more manageable levels. (Last June, it had been agreed that losses would only reach 21% of value.)

Will this be enough to put an end to the crisis? Probably not. Unresolved aspects of the agreement It was difficult to overcome disagreement among the main European actors in the crisis. The plan that was agreed upon gives the impression that negotiations were successful, so markets were relieved; but many of the thorny issues have not been resolved. Discord has not been thoroughly addressed, and many of the risks in the crisis are still there. An example is the agreement to increase the rescue fund. An impressive $1.4 trillion dollar figure was set, but who

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gives how much has yet to be determined. The Euro Summit communiqu provides no details on how this issue will be resolved. It will continue to be a sticky point. Countries in the euro zone have very high public debts as a proportion of GDP and reduced financing possibilities; and, especially in the Northern countries, taxpayers are strongly against continuing to pay for bail-outs. Besides, some of the smaller countries hold that, even though they did not contribute to create the crisis, they are carrying an unduly large burden in financing bail-outs. In this state of affairs, many are looking to China and the International Monetary Fund as possible contributors to the rescue fund. Banks resisted to the last having to raise more capital in a few months. In the Basel III accord, this was to be done over several years. Now, by December 25 they will have to submit to national authorities their strategies for recapitalization before July. But the higher their exposure to risky debt, the less they are able to raise new capital. So the Euro Summit agreement asks for smaller end-of-the-year bonuses. The most touchy issue is the 50% haircut (or loss) banks will have to take on their holdings of Greek debt. Last July, they had already agreed to a 21% haircut, but Germany insisted that private investors take a larger responsibility. The idea is to reduce Greek debt from around 160% of GDP, to 120%; still a very high figure, but one that has a better chance of being sustainable without a default. In any case, it would seem that a 50% haircut on value, although voluntary, is a de facto default, even though it does not bear that name. Losses will put at risk precisely those banks that are most exposed to Greek debt, starting with Greek banks. Those banks will have to be rescued or nationalized, as has already been done with the French-Belgian bank Dexia. Several of the large French banks are in a similar position. This time, where will bail-outs come from? The mechanism was laid out in the procedures for recapitalizing banks. The Euro Summit agreement states that, to increase their capital, banks must turn first to private sources of capital. If necessary, governments could provide support. Only when neither is possible may banks ask for a loan from the European bail-out fund (European Financial Stability Fund, or EFSF). A better governance for the euro zone Paradoxically, in spite of all the disagreements, governance in the euro zone will be strengthened. The Euro Summit determined that there will be new summits at least twice a year. A more integrated euro zone, capable of designing strategies for overcoming shocks, is undoubtedly needed to face the debt crisis.

RISKS OF FINANCIAL CONTAGION

Haircuts on Greek debt raise problems for banking and for credit default swaps A report by the International Monetary Fund1 found, last July, that financial contagion arising from euro zone
1

IMF, Consolidated Spillover Report, July 11, 2011.

tensions is manageable; but if uncertainty should arise over the soundness of banks in the euro zones core countries, contagion to the rest of the world will be significant. It could be similar to the postLehman Brothers contagion, and this

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time around there is less room for economic policy. Does a 50% haircut on Greek debt now raise doubts over the soundness of banks in large economies such as France and Germany? By itself, perhaps it doesnt, except in a few exceptional cases. But trust has not been regained in Italy and Spain. After the Euro Summit, the cost of debt financing has soared for these countries. In Italy, for instance, the reform plans presented by Silvio Berlusconi are considered inadequate and difficult to implement. Futhermore, Italys debt is 1.9 trillion euros, of which 300 billion must be rolled over next year. Now, the exposure of European banks to other European countries debt is huge (see the Deciphering section). If the risk of default grows in countries such as Italy and Spain, European banking will be in deep trouble. How far will banks be able to count on bail-outs from governments and the European bail-out fund?

Moreover, there are grounds to activate credit derivative swaps, if haircuts on Greek debt are considered to be a default. Financial institutions that have to make good on such derivatives, meant to protect against losses, will have a hard time. We still have fresh in our memory how in the United States, a few days alter the Lehman Brothers bankruptcy, credit derivatives led AIG to the brink of bankruptcy, and then to a $182 billion dollar bail-out from the US government. What is the amount of over-the-counter credit derivatives outstanding? According to the Bank for International Settlements,2 , at the end of 2010 the notional amount of OTC derivatives contracts in the world was $601 trillion dollars, about 42 times the US GDP. Of these, $29.9 trillion are credit derivatives. Risks are very high, but they are well known to European leaders. Thus their decision to achieve better cooperation and governance in overcoming the sovereign debt crisis.

BRIEFS
After 5 years, the US Congress finally approved free trade agreements with the Republic of Korea, Colombia, and Panama. Approval by the Korean Parliament is still uncertain. By means of the sovereign wealth fund China Investment Corporation, the Chinese government had to intervene buying shares of the 4 largest banks, which control 2/3 of the banking market. This measure is considered to be a bank bail-out. The French-Belgian bank Dexia had to be split up and bailed out because of its exposure to Greek sovereign debt. Dexia will receive 121 billion euros in state guarantees, and the Belgian unit will be nationalized, The Mexican firm America Movil, leading provider in Latin America of mobile2 phone services, launched a bid to acquire the 40% of shares it does not already control in the fixed-line telephone firm, Telmex. It also agreed to acquire from Claxson Interactive Group, 100% of shares in DLA, leading Latin American firm in entertainment solutions for digital distribution. There was surprise and rejection in Wall Street over the plan to implement the Volcker Rule. The proposal would
2

Bank for International Settlements, BIS Quarterly Review, June, 2011, p. A131.

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compel banks to generate income mainly through commissions, and not by changes in the value of the assets they control. The rule would also apply to foreign banks operating in the US. The merger between Deutsche Borse and NYSE Euronext, valued at $9 billion dollars, was questioned by the European Commission, because it may create a monopoly in the control of derivatives contracts cleared through European exchanges. November 8 has been set as the date by which the exchanges must submit their reply. In Mexico, the Comision Federal de Competencia advised Televisa that its purchase of 50% of Iusacell has not been approved, so that the deal may not be closed. The decision is expected in December. In order to improve its production of natural gas, Kinder Morgan is acquiring El Paso Corporation in a deal worth an estimated $21.1 billion dollars. There is a rumor that the financial weakness of American Airlines (a unit of AMR Corp) could result in the airlines bankruptcy or a merger with US Airways.

DECIPHERING:
Total exposure of European banks to public and prvate debt in other European countries (not including exposure to domestic national debt) is nearly $11 trillion dollars. If Spain should default, banks in the United Kingdom would be the most affected. Their banking exposure to Spain is more than 1/5 of their total exposure.. Since the United Kingdom is one of the worlds main financial hubs, it has the largest banking exposure to other countries debt. If Italy should default, German banks would have serious problems. Their exposure to Italian debt is 1/5 of their total exposure. If Germany and the United Kingdom should have to bail out their banks, their public debt would soar, and this would have a negative impact on banking risks in several of the major European countries. This explains the keen interest in strengthening the European bail-out fund and in compelling banks to recapitalize.

Solana Consultores www.solanaconsultores.com Paseo de la Reforma 2608-1706; Mxico, D.F. 11950 Tel (52-55) 52-58-95-31 al 34 central@solanaconsultores.com

October 31, 2011 GE N.130

EXPOSURE OF BANKS IN SOME EUROPEAN COUNTRIES TO PUBLIC AND PRIVATE DEBT IN OTHER EUROPEAN COUNTRIES Second quarter of 2011 Billions of dollars COUNTRY United Kingdom TOTAL EXPOSURE $2000.0 MAIN EXPOSURE, TO DEBT OF: Germany $511.2 Spain 430.2 France 293.6 Switzerland 226.4 Ireland 161.2 Netherlands 160.4 Italy 267.5 France 262.9 Netherlands 198.9 United Kingdom 183.8 United Kingdom 291.6 Germany 223.3 Netherlands 110.4 France 412.9 Germany 161.8 Germany 170.3 France 137.5 United Kingdom 131.9 Germany 177.5 France 152.2 United Kingdom 105.7

Germany

1,300.0

France

901.5

Italy Netherlands

832.2 620.8

Spain

651.7

TOTAL EXPOSURE OF EUROPEAN BANKS TO THE PUBLIC AND PRIVATE DEBT OF OTHER EUROPEAN COUNTRIES

$10.953.8

Source: Financial Times and Solana Consultores, with data reported by the Bank for International Settlements

Solana Consultores www.solanaconsultores.com Paseo de la Reforma 2608-1706; Mxico, D.F. 11950 Tel (52-55) 52-58-95-31 al 34 central@solanaconsultores.com