The Eurozone Sovereign Debt Crisis
Henry C.K. Liu
Part I:
A Currency Union Not Backed by Political Union
Part II: The Role of the IMF/ECB/EC Troika
The International Monetary Fund (IMF), along with European Central Bank (ECB) and the European Commission (EC), form the so-called Troika that holds the key to the resolution of the Greek sovereign debt crisis and also sovereign debt problems facing other eurozone member states.  The generation and actual release of bailout funds for European sovereign debts require an agreement among all three independent supranational entities in the Troika, each responding to markedly different mandates and incentives. The rescue funds will be channeled through the European Financial Stability Facility (EFSF), the emergency bailout fund for heavily indebted eurozone member state governments in financial distress.
German approval of expanding the EFSF is a critical hurdle. On September 29, 2011, the German Bundestag (Parliament), by a vote of 523 to 85, with three abstentions, approved the expansion of the €440 billion ($600 billion) EFSF.
The EFSF is a Special Purpose Vehicle (SPV) created by the 16 member states that use the euro as common currency on May 9, 2010 and incorporated in Luxembourg under Luxembourg’s law on June 7, 2010, with the objective of preserving financial stability of Europe’s monetary union by providing temporary financial assistance
to eurozone member states in financial difficulty. As a SPV, liabilities in EFSF assumed by the eurozone member states do not appear on the balance sheet of the treasuries or central banks of eurozone member states.
In order to reach its objective, the EFSF can, with the support and assistance of the German Debt Management Office (DMO), issue bonds or other debt instruments on the market to raise the funds needed to provide loans to countries in financial difficulties. Issues would be backed by guarantees given by eurozone member states of up to €440 billion on a pro rata basis, in accordance with their share in the paid-up capital of the European Central Bank (ECB).
Germany is the largest capital contributor by far with €119.39 billion of the €440 billion; next is France with €89.65 billion; next is Italy with €78.78 billion; next is Spain with €52.35 billion; next is the Netherlands with €25.14 billion. Greece contributes €12.39 billion, ahead of Austria with €12.24, Portugal with €11.04 billion, Finland with €7.91 billion, Slovakia with
€4.37 billion and Slovenia with €2.07 billion.
The EFSF is a very lean organization. It will have a maximum staff of about a dozen people. The lean structure is possible because the German DMO (front office) and the European Investment Bank (back office) will provide operation support to the EFSF. Additionally, the European Commission will ensure consistency between EFSF operations and other assistance to euro area Member States.
The EFSF Chief Executive Officer is Klaus Regling, a former Director General of the European Commission’s Directorate General for Economic and Financial Affairs who also worked at the International Monetary Fund (IMF) and the German Ministry of Finance and has professional experience of working in financial markets.
The board of the EFSF comprises high level representatives of the 16 euro area
Member States i.e. Deputy Ministers or Secretaries of State or director generals of national treasuries. The European Commission and the European Central Bank (ECB) each have observers on the EFSF board. The EFSF board is headed by the Chairman of the EU’s Economic and Financial Committee.
There is no specific statutory requirement for accountability to the European Parliament. However, the EFSF will have a close relationship with the relevant committees.
IMF Funding for the European Financial Stabilization Mechanism (EFSM)
The EFSF is part of a wider safety net to preserve financial stability within Europe. The full financial resource of the EFSF would be combined with loans of up to €60 billion coming from the European Financial Stabilization Mechanism (EFSM), i.e. funds raised by the European Commission and guaranteed by the EU budget, and up to €250 billion from the International Monetary Fund for a financial safety net up to €750 billion, inclusive of its own €440 billion.
The EFSF would provide loans by issuing bonds or other debt instruments guaranteed by eurozone member states. In the Greek package eurozone member states have provided bilateral loans which are pooled by the European Commission and then paid out in tranches to the Greek government. Together with financial aid from the IMF the support for Greece reached
€110 billion.
EFSF Framework Agreement
All eurozone member states have signed the EFSF Framework Agreement that makes the special purpose vehicle operational. Furthermore, the EFSF has received 13 commitment confirmations from among the 17 eurozone member states. Excluding Greece, such confirmations represent 94.9 % of the total guarantee commitments (minimum necessary 90 %). Therefore, according to the Framework Agreement, the obligation of eurozone member states to issue guarantees entered into force on August 4, 2010.
The EFSF, a Special Purpose Vehicle, is not a preferred creditor. Unlike the IMF, the EFSF will have the same pari passu standing as any other claim on the borrowing country. This is because private investors would be reluctant to provide loans to the country concerned if there were too many preferred creditors.
EFSF bonds will be eligible for ECB repo facilities. In case of issuance, EFSF bonds would be eligible as collateral to the ECB. All three major credit rating agencies (CRAs) have assigned to date the best possible credit rating – Standard & Poor’s “AAA”; Moody’s “Aaa”; Fitch Ratings “AAA” - to the EFSF. According to the CRAs, the long-term issuer rating as well as the top rating for EFSF’s possible future individual debt issues reflect the strong shareholder support and credit enhancements such as an over-guarantee of the amount borrowed by 120 % and cash buffer which will be deducted from the cash amount remitted to a borrower from each loan. The rating outlook was qualified as stable.
Any downgrade of a member state would not affect EFSF or necessarily lead to a downgrade of EFSF securities, as various credit enhancements are used under the Framework Agreement which constitutes the EFSF.
The EFSF will not default if one of its member states defaults, because the credit enhancement mechanisms under the Framework Agreement are designed to avoid such an eventuality. Should a member state defaults on its payments, guarantees would be called in from the guarantors, and payments could be made from the cash buffer. If a guarantor did not live up to its obligations, guarantees from others could be called in to cover the shortfall.
If several countries ask for assistance simultaneously, the volume of the EFSF, together with the European Financial Stabilisation Mechanism (EFSM) and the IMF, is large enough to provide temporary liquidity assistance to several member states of the euro area simultaneously.

The EFSM is an emergency funding program reliant upon funds raised on the financial markets and guaranteed by the European Commission using the budget of the European Union as collateral. It runs under the supervision of the Commission and aims at preserving financial stability in Europe by providing financial assistance to member states of the European Union in financial difficulty.

The Commission fund, backed by all 27 European Union member states, has the authority to raise up to €60 billion. A separate entity, the EFSF is authorized to borrow up to €440 billion.
The EFSM is rated AAA by Fitch, Moody’s, and Stadard & Poor’s.
The EFSF provides loans to member states in financial difficulties. But it could be agreed with a member state that receives funds to use them partially for financial support to banks in accordance with the agreed country program.
If there is no financial operation by the EFSF, it would close down after three years, on June 30, 2013. If there is a financial operation then, the EFSF would exist until its last obligation has been fully repaid.
EFSF Funding
EFSF funding will be done by the German DMO (Bundesrepublik Deutschland – Finanzagentur GmbH), Europe’s benchmark issuer with a funding volume of € 275 billion in 2011. The German Finance Agency is a service provider for and controlled by the German Federal Ministry of Finance, managing the German Federal Government’s issuance activities, debt and liquidity, but with the EFSF,  the Special Purpose Vehicle of the  as the issuer.
The funding strategy is still under discussion and will be decided soon. Funding instruments shall however have in general the same profile as the related loans to the country in difficulty.
The funding strategy will be closely coordinated between EFSF and EFSM under each country program which will be agreed upfront by finance ministers. While it is accepted that the EFSM will be in the market first, both mechanisms could raise money at the same time
Unlike the EFSM which only issues debt in euro, the EFSF does not have any currency limitation for its funding activities. However, it is expected that the majority of funds would be raised in euro.
There has been a clear political decision by finance ministers not to access financial markets until a euro member has submitted a request for support. There will be no pre-funding by the EFSF.
The EFSF is not expected to reduce liquidity for other borrowers in the market by driving up net funding demand in the eurozone. If the EFSF borrows, the country that receives the funds will borrow less, thus leaving no impact on aggregate liquidity, provided an efficient market continues to operate, which is a big provision. Recent experience has shown that sudden market volatility exacerbates market disequilibrium and reduces market efficiency.
Funds raised by the EFSF will be released as loans to qualified eurozone member states that requested financial support. However the cash buffer, which is retained by the EFSF, will be invested in top rated liquid assets. Some asset-liability management will therefore be necessary and will be conducted by the German Debt Management Office.
EFSF Lending Conditions
EFSF can only lend after a support request is made by a eurozone member state that has negotiated a country program with the European Commission and the IMF and after such a program has been accepted by the eurozone finance ministers and a Memorandum of Understanding (MoU) has been signed. EFSF loans would only be granted when the borrowing country is unable to borrow on markets at acceptable rates.
It will take three to four weeks to draw up a support program including sending experts from the Commission, the IMF and the ECB to the applying country. After eurozone finance ministers have approved the country program, the EFSF would need several business working days to raise the necessary funds and disburse the loan. The process may hamper emergence needs in avoiding a sovereign default.
Any financial assistance to a country in financial need would be linked to very strict policy conditions which would be set out in a Memorandum of Understanding (MoU) between the country in need and the European Commission. Decisions about the maximum amount of a loan, its price and duration, and the number of installments to be disbursed would have to be taken by the finance ministers of the 16 eurozone member states unanimously.
The loan disbursements and the country program could be interrupted until the review of the country program and the MoU is renegotiated. In such cases the conditionality still exists.
Competition Among Eurozone Member States for EFSF Rescue Funds
Competition from eurozone member states with sovereign debt difficulties are beginning to surface. The first shot was fired by Ireland on October 5, when press reports headlined a statement by Irish Deputy Prime Minister Eamon Gilmore saying that Ireland will capitalize on any moves by euro-zone governments to use the EFSF to shore up their banks. “We just want to make sure that if any additional measures develop to deal with the crisis that they work to Ireland’s benefit,” Mr. Gilmore reportedly said.
The possibility of widespread recapitalization of euro-zone banks was pulled into focus as fears of a default by Greece intensified in October. In France, Autorite Des Marches Financiers (AMF), the market regulator, released a statement on October 5 that 15 to 20 banks in Europe needed additional capital, although no French ones was in that group “at this stage”. It was reported the same day that BNP Paribas was attempting to raise capital funds in Qatar.
France’s banks are heavily exposed to Greek government debt and would have to write off substantial losses in the event of a sovereign default. Shares in BNP, Société Générale and Crédit Agricole, have fallen by more than 5% over the past three months as Europe’s sovereign debt crisis intensified. Their shares rallied yesterday on speculation that the French government will take steps to bolster their capital and might seek to raise funds from the EFSF.
Portugal, Italy and Spain can also be expected to make similar demands on the EFSF in a wave of political contagion. A Greek sovereign default is now considered increasingly likely. Citibank warned on the same day as the Irish statement that “we now expect a substantial and probably coercive debt restructuring of the Greek sovereign by the end of 2012 at the latest and likely much sooner.” Citibank’s European economics team warned the same day that lower global growth and Greece’s inability to comply with the terms of its bailout, combined with increasing opposition in key countries such as Germany to further bailouts, made a default likely by the spring of 2012 or even December this year. “In order to reduce the debt-to-GDP levels from 80% to 60% by 2012, it would require debt haircuts (ex-IMF) of 67 %, (54%) in Greece, 53% in Portugal and 34% in Ireland,” the Citibank team added.
Irish Minister for Finance Michael Noonan offered a more positive view of Ireland’s prospects at the World Bank/IMF annual meetings in Washington on September 23-25, telling IMF officials and international bankers that Ireland “has a plan, is on target, and is actually surpassing some goals.” Mr Noonan pointed out that Bank of Ireland raised €1.7 billion in risk equity in the summer, and that Irish banks broke their reliance on the Central Bank by raising €4.5 billion in term financing on the markets, using residential mortgage-backed securities as collateral. He also highlighted statistics released on September 15 showing that Irish GDP grew 1.6% in the second quarter of 2011. The funds raised by Bank of Ireland are particularly significant, Mr. Noonan reportedly said. “It’s really positive that the € 1.7 billion came from private sector investment, because people took out their own cash and invested it. We want to get that across, as well as the fact that our banks are actually accessing money markets.” Bank of Ireland shareholders invested €600 million, and five large North American investment funds invested €1.123 million in risk equity, without State guarantees.
EFSF Credit Rating
The EFSF has received the best possible credit rating off all major rating agencies (Standard & Poor’s “AAA”; Moody’s “Aaa”; Fitch Ratings “AAA”). This was achieved through credit enhancements foreseen in the agreement between the participants (framework agreement): an over-guarantee of 120 per cent on each bond, an up-front cash reserve which equals the net present value of the margin of the EFSF loan, a loan specific cash buffer.
Together these credit enhancements ensure that all loans provided by the EFSF are backed by guarantees of the highest quality and sufficient liquid resource buffers. The available liquidity will be invested in securities of the best quality.
The extent to which such credit enhancements affect the maximum lending capacity depends on a number of variables, and cannot be exactly calculated up front. The structure of guarantors, interest rates, maturities and other loan conditions will determine the lending capacity. Further options of credit enhancement, which could expand the margin of available lending, are currently discussed and could be specified for individual loans. Calculations of lending capacity and specific credit enhancements will be fully transparent to investors and markets once a country program is concluded and loan terms and conditions for each country will be defined.
Eurozone member states will provide guarantees for EFSF issuances up to a total of
€ 440 billion allocated pro rata according to their participation in the capital of the ECB. The available amounts under the EFSF will be complemented by those of the European Financial Stability Mechanism (€ 60 billion) and of the IMF. They are sufficient to deal with possible needs.
The Framework Agreement does not contain any maturity limitations for the loans nor for the funding instruments. However, in line with the experience under the Greek program, loans and bonds are envisaged to have an average maturity of three to five years.
The blueprint for EFSF support - although not binding - is the financial aid package to
Greece where, for variable-rate loans, the basis is three-month Euribor, while fixed rate loans are based upon the rates corresponding to swap rates for the relevant maturities. In addition there is a charge of 300 basis points for maturities up to three years and an extra 100 basis points per year for loans longer than three years. A one time service fee of 50 basis points is charged to cover operational costs.
There is no binding agreement with member states outside the eurozone. However two non-eurozone member states, Poland and Sweden, have indicated that they are prepared to consider contributing additional financial resources on a voluntary basis, in parallel to the EFSF.
For member states outside the eurozone, other European Union support mechanisms exist. For member states that are not members of the eurozone, there is the Balance of Payments facility. For countries outside the EU, there is the Macro-Financial Assistance program. Furthermore, the EFSM could support all European Union member states.
The concept of precautionary credit lines does not fit with the approach of the EFSF. Eurozone finance ministers decided that the EFSF will only provide financial support if a eurozone member is unable to access markets.
Greece has its own rescue package. Therefore it is not envisaged that Greece could expect support by the EFSF.
Leveraging Up EFSF to Help Eurozone Deleverage
European officials are reportedly working on a scheme to build a Special Purpose Vehicle that would lever up existing EFSF funds 8 to 1 to buy up European sovereign debt and then use the sovereign debt as collateral to issue bonds.
The scheme relies on the private sector to lend to the EFSF in times when the private sector is least likely to be lending and banks are in distress. Private sector loan will require higher yield that ECB financing, or EFSF’s own triple-A bond market funding, to push up funding costs for the leveraged EFSF, which will be passed on to countries being rescued. The EFSF is an off-balance-sheet Special Purpose Vehicle, with no recourse beyond the guarantees that the euro-zone countries pledge to it. When the size of the EFSF’s bond and loan portfolios exceeds those guarantees, creditor exposure will jump exponentially. The ECB, as the parent of the SPV, would have the same problem, too, if it financed a leveraged EFSF. But losses on the ECB’s own balance sheet are ultimately the responsibility of the euro-zone nations. The size of a privately leveraged EFSF will be smaller than an ECB-leveraged EFSF, the feasibility for which is remote at best.
The German Bundestag enabling vote in September 15 also agreed to grant the EFSF new powers, including the authority to issue liquidity loans to eurozone member states in sovereign debt difficulties. This was considered by eurozone government officials as the most important step in a tortuous process that has unsettled financial markets and raised doubts about the ability of eurozone governments to resolve the expanding sovereign debt crisis and curb its contagion.
The palliative effectiveness of this key event in German domestic politics on the market will be tested in a matter of weeks, if not months, should a Greek sovereign debt default become the unhappy outcome as anticipated by many market participants.
IMF/ECB/US Troika Reopened Talks with Greece
Officials of the Troika of IMF, ECB and UC reopened stalled talks in Athens immediately after news of the German Bundestag September 15 enabling vote. The talks centered on the progress of the government of Greece in pushing through an austere fiscal budget target that would be required before EFSF could release the next €8 billion tranche as part of the €110 billion on-going recuse program.
If an agreement is not reached by the Troika in these talks, the needed €8 billion payment will be delayed, leaving the Greek government with no cash in October to meet its obligations on pension, civil servant salaries, and interest payments. Further, it may cause a renegotiation on the second €109 billion rescue package already committed by the EFSF in July, 2011.
German legislators have made clear that should there be an unexpected wider financing gap in Greek sovereign debt payments, it cannot be filled with more public money, especially from German taxpayers. Private creditors would have to take a bigger writedown (known in workout circles as a haircut) in the value of distressed Greek sovereign debts they hold, and suffer bigger financial loss at the time when European banks are not in good financial shape.
In Greece, where social instability has been turning violent in recent months over proposed government austerity measures, a new government proposal in September to cut an additional 30,000 public sector jobs within two months to help reduce the mounting fiscal deficit was met with fierce opposition in an emergency cabinet meeting.         
The German Bundestag enabling vote on expanding the EFSF also represented a narrow but significant political victory for Chancellor Angela Merkel, as fewer lawmakers (15) than expected from her own coalition broke away to join the opposition vote. The majority included votes from both major opposition parties: the Social Democrats and members of the Green Party.
Several eurozone member state governments are quietly calling for a review of the harsh terms of the July 21 package with international banks on rollover and buyback of Greek sovereign debt. Greece received a three-year, €110 billion rescue in 2010 from the European Union and International Monetary Fund that anticipated the country returning to financial markets in 2011. With its 10-year bond yielding about 18%, financing in the markets proved unrealistic and the EU was forced to draw up a second rescue package to fully fund Greece for three years
There is also the question of whether an expanded EFSF with new bond issuing powers can be fully operational by October, in time to deal with a possible Greek sovereign default or even debt rescheduling.  Also, some analysts are questioning even with the expanded EFSF borrowing capacity of €440 billion, it would not be large enough or felxible enough to counter a new wave of contagion and speculative attacks in financial markets.
German Domestic Politics turning towards Economic Nationalism
Germany has the largest national economy in the eurozone and is the only eurozone member state with the financial resources and fiscal space to pull fellow eurozone member states out of pending sovereign default. The German government of Chancellor Merkel is doing its best to move the unpopular rescue plan for Greece through the convoluted German political process, but many analysts are of the opinion that Germany, given the limits of its domestic political dynamics, could offer only temporary relief rather than anything approaching a permanent structural solution.
Chancellor Merkel’s September 15 Pyrrhic victory in the Bundestag on the Greek rescue plan merely provided breathing room for the crisis. Yet it came only after a politically costly divisive debate within Merkel’s own parliamentary bloc. The contentious vote has weakened her political leadership at a critical moment. Opposition politicians, citing the vocal opposition within her own political ranks, suggested that Chancellor Merkel had lost full control of her fragile political coalition and needed to dissolve the government for a new election.
But in the end, the measure passed without needing opposition support, giving her the needed “chancellor’s majority”, which had been uncertain in recent weeks up to the final moment of the vote. As it turned out, Chancellor Merkel received 315 votes within her coalition, four more than needed for the chancellor’s majority. The vote allowed Germany to agree to an increase in its share of the EFSF guarantees to 211 billion ($285 billion), from 123 billion.
Finland Demands Collateral for Loans to Greece
Even with German Bundestag approval, another 6 of the 17 eurozone legislatures still need to ratify the agreement reached in the July 21 package. A significant hurdle was overcome when Finland on Wednesday, September 28, voted for the expanded EFSF bailout fund despite strong domestic political objections and an unresolved dispute over Finland’s demand for collateral from Greece for additional loans.
Finland’s demand for collateral on new Greek loans left European leaders with a Hobson’s choice: accept AAA rated Finland’s terms and risk jeopardizing the rescue plan, or reject its demand for collateral to risk the collapse of the pro-euro Finnish government to be replaced  by Finnish euro-skeptics.
Luxembourg Prime Minister Jean-Claude Juncker, who also chairs eurozone finance meetings, reportedly said on August 29 he was “confident” an agreement could be reached by mid-September, while criticizing the Finnish demand for collateral. “I don’t like this mechanism and I don’t like the bilateral arrangements,” he told the European Parliament’s economic committee in Brussels.
Collateral accords would be “fatal” for further bailout aid, said Michael Meister, the senior finance and economy spokesman for German Chancellor Angela Merkel’s Christian Democrats, said in Berlin on August 30. Eurozone governments “must talk to Finland” about its demand for collateral, Meister added.
The collateral flap reflected the bailout fatigue that had been spreading in the more fiscally prudent countries of northern Europe, fueling popular support for political parties opposed to aid to the eurozone’s more profligate member states. National politics has been increasingly at odds with efforts to forge European unity, complicating a comprehensive response to the sovereign debt crisis that now also threatens Portugal, Ireland, Spain, Italy and even France.
Political concensus among the eurozone member states is needed to resolve the issue, Austria’s Finance Minister Maria Fekter said in Vienna on August 30, adding: “It is emerging that the civil servants alone aren’t coming up with a solution.”
EU leaders initially agreed to the demand for collateral protection by Finnish Prime Minister Jyrki Tapani Katainen, who was chosen on July 22, to head a new Finnish government coalition of 6 of the 8 political parties, two months after his party, the National Coalition Party won parliamentary elections, and only one day after the July 21 European summit in Brussels that hashed out the 159 billion-euro ($231 billion) rescue for Greece.  The Finnish National Coalition Party is center-right, strongly pro-European and is a member of the center-right European People’s Party (EPP), the largest party represented in each of the institutions of the European Union (EU), and also the largest in the Council of Europe. 
Spanish and Italian bond yields surged on July18, 2011, putting market pressure on European officials to address the sovereign debt crisis quickly. Spain and Greece sold €6.08 billion ($8.6 billion) of bills on July 19. The Treasury in Madrid said it sold €3.79 billion of 12-month bills at an average yield of 3.702%, compared with 2.695% the last time the securities were sold on June 14. The yield on 10-year German government bonds, the region’s benchmark, increased six basis points to 2.71%.
EU Summit Statement
The July 21 EU summit in Brussels issued a statement of obligatory rhetoric reaffirming the leaders’ commitment to the euro and “to do whatever is needed to ensure the financial stability of the euro area as a whole and its member states,” admitting that the the initial bailout to Greece, with its high interest rates and short payment period, was impossible for Greece to cover. The statement then called for lengthening the maturity of future EFSF loans to Greece to the maximum extent possible from the current 7.5 years to a minimum of 15 years and up to 30 years with a grace period of 10 years. “We will provide EFSF loans at lending rates equivalent to those of the Balance of Payments facility (currently approx. 3.5%), close to, without going below the EFSF funding cost,” the statement added.
Political leaders at the EU summit acknowledged that Greece’s is “an exceptional and unique solution”. Between the lines is a message that the second bailout of Greece is in fact designed to reduce the cost of saving Italy and Spain, admitting that decisions taken at the just-ended EU summit were not part of a well-worked, long-term, system-wide strategy, but constituted yet another ad hoc measure, just like all the previous measures that have proven to be failures. The press was calling the approach “kicking the can down the road” without knowing where it should end up.
Then upsetting news of the details of a collateral deal Finland negotiated with Greece emerged in August, triggering a backlash and demands for similar treatment from other eurozone creditor nations, including Austria and the Netherlands, threatening to delay or torpedo the Greek recuse plan.
Far from resolving the debt crisis, contagion continued after the July 21 EU summit . The ECB began buying Spanish and Italian bonds to help bring down yields that reached euro-era records. Divisions over the collateral matter contributed to a further market slump for Greek bonds with the yield on the country’s two-year notes topping 45% in August.
Understandably, leading politicians in Slovakia were highly critical of the terms of the rescue agreement for Greece, with a division in the governing coalition in the Slovak capital of Bratislava over whether to help Greece, with a 2010 nominal per capita GDP of €20,400, which is much richer than Slovakia, with only €12,100. Why should a poor country spend its tax money to help a rich country with no fiscal discipline?
S&P Downgrade of Italy Sovereign Debt
As a sign of the seriousness of the sovereign debt problem, Italy, with the third-largest economy in the eurozone after those of Germany and France, had to pay a sharply higher rates when she went to the credit market on Thursday, September 29, for its first sovereign debt auction of 7.9 billion since the September 19 Standard & Poor’s downgrade of its unsolicited long- and short-term sovereign credit ratings from A+ to A, with an outlook negative.
S&P in a statement said the downgrade “reflects its view of Italy’s weakening economic growth prospects and its view that Italy’s fragile governing coalition and policy differences within parliament will likely continue to limit the government's ability to respond decisively to the challenging domestic and external macroeconomic environment.”
The S&P statement went on:
Under our recently updated sovereign ratings criteria, the "political" and "debt" scores were the primary contributors to the downgrade. The scores relating to the other elements of our methodology--economic structure, external, and monetary--did not contribute to the downgrade.
More subdued external demand, government austerity measures, and upward pressure on funding costs in both the public and private sectors will, in our opinion, likely result in weaker growth for the Italian economy compared with our May 2011 base-case expectations, when we revised the outlook to negative.
We believe the reduced pace of Italy's economic activity to date will make the government’s revised fiscal targets difficult to achieve. Furthermore, what we view as the Italian government’s tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy’s economic challenges. (Emphasis by S&P)
The political uncertainty concern identified by S&P applies to all eurozone member state governments.
EFSF Expansion Falls Short of Escalating Needs
Under the anxious watch of nervous investors, the torturously meandering approval process for sovereign debt rescue has revealed even more political fissures, decision-making layers and complex geopolitical dynamics in Europe that adds up to a worrisome inability or weak political will to react quickly and decisively to fast-moving financial market volatility. Analysts are already reportedly suggesting that the expanded EFSF, even if it receives final political approval in time, will in all likelihood be too small to defend against speculative attacks on deeply indebted eurozone sovereign governments, particularly as the political delays have been enlarging the size of the needed rescue by the week. What was adequate in July is no long sufficient for September as the financial crisis spins rapidly further out of control.
No Long-term Solution
Further, long-term structural solutions are nowhere insight, as European politicians, including German Chancellor Merkel, have been forced by domestic politics to resist calls for converging fiscal union for eurozone member states, or the issuance of common sovereign debt referred to as euro bonds, backed by the full faith and credit of the eurozone as a fiscal union. Many eurozone governments simply cannot politically survive years of open-ended fiscal austerity in a recession that could run a whole decade. Without a fiscal union, the sovereign debt crisis of the eurozone cannot be solved fundamentally.
German Resistance
German protesters are labeling the EFSF derisively as “Europe Finance Suicide Fund”, because of public concern on limitless exposure Germany faces in covering Greece’s mounting distressed sovereign debt and later other eurozone member states with bigger sovereign debt problems. There is widespread worry among German taxpayers that Germany is being asked to throw good money after bad, and that Greece cannot be saved in its current fiscal shape and trying to save it will only drag Germany down into a bottomless financial abyss.
German Finance Minister Wolfgang Schäuble tried to assure concerned Bundestag members as well as the anxious public during a debate that a positive vote on expanding EFSF did not represent a blank check, and that any additional funds would still have to be approved by the Bundestag and that oversight monitoring will be required and not up for debate. While such categorical assurance helped secure the Bundestag vote, it did not sit well for financial markets as investors know the sum approved so far will not be enough by a long shot to bail Greece out of its sovereign debt hole, let alone the other sovereign debtor states in the eurozone.
Klaus-Peter Willsch, a member of Chancellor Merkel’s Christian Democrats who in the end voted with the Chancellor, nevertheless complained: “We have to borrow the money from our children and grandchildren — as we don’t have it.”
German Leadership Wavering
While the vote finally passed in the Bundestag, Merkel’s government has been politically weakened by it. Without a reliable majority to push though unpopular legislation going forward, the chancellor could be reduced to a toothless and ineffective figurehead. Unlike in the US, where a similar legislative victory would be hailed as a bipartisan success story, in the German parliamentary system, power rests on the Chancellor’s ability to hold together the members of the coalition that make up the majority. Political parties in Germany have much more control over their members. Candidates are nominated by the party rather than competing in primary elections. Without strong and decisive political leadership from Germany, the European sovereign debt crisis will quickly turn into a chaotic quagmire in the market that will lead to a global financial disaster in short order.
Democracy against Global Market Capitalism
The irony is that the democratic form of government in Europe is serving as the grave digger of global market capitalism, the ideological claim of the symbiotic link between political democracy and market capitalism notwithstanding. The same scene had been played by the liberal democratic/capitalistic market economy Weimar Republic in 1933, a fact that few Germans will ever forget.
New IMF Leader Tackles Old Problem
Two weeks earlier, the annual meeting of the International Monetary Fund and World Bank in Washington on September 17-18 featured a new IMF head in the person of highly respected Christine Lagarde of France, and a year-old challenge of how to stem a sovereign debt crisis that threatens to spread through Europe and beyond in the event of a intergovernmental political impasse.
Christine Lagarde, a former Minister of Finance for France and a former director of the IMF, where her leadership position of the IMF is not quite three months-old, and she is already facing a boisterous debate over whether the IMF can stage-manage a seemingly inevitable Greek sovereign debt default to prevent it from turning into an eurozone-wide and global financial crisis that will put the last nail in the coffin for any hope of a quick recovery for the global economy.
At a news conference on Thursday, September 15, IMF head Largarde skirted any specifics but complained that the financial markets, which had been falling, were ignoring “bold” efforts by EMU members to deal with the Greek sovereign debt crisis, adding that the multi-government process needed “collective momentum”.
Still, a growing number of market analysts are expressing doubt on whether Greece will ever be able to pay back all its huge sovereign debt. Even if the fundamentals of the Greek sovereign debt situation provide for an arguable scenario that the Greek economy can ultimately repay its sovereign debt, the market has passed the stage of concern for fundamentals to the stage of exposure hydraulics in which each creditor sees each exit by another creditor as an increase in the remaining credit exposure and potential loss for those creditors still holding Greek sovereign debt. Creditor exposure hydraulics will generate a negative “collective momentum” for mass exit to cause a global credit market failure.
World Stock Markets in Bear Market Mode
Bloomberg reported that global stocks officially entered secular bear market territory the week ending September 16, as the benchmark MSCI All-Country World Index of 45 nations fell more than 20% since July 22 into bear market mode for the first time in more than two years, after the worsening European sovereign debt crisis and heightened threat of a US double-dip recession erased more than $10 trillion from market value of equities since May, 2011. The index tumbled 4.5% to a 13-month low of 277.38.
The MSCI World Index of shares in developed nations led the fall into bear market mode, plunging 4.2%. The index fell after Standard & Poor’s cut the US sovereign credit rating following a Congressional standoff over raising the nation’s legal borrowing limit, as speculation that Greece will default intensified, and troublesome news of Chinese inflation accelerating to a three-year high. The slump pushed the price-earnings ratio for the index down to 11.4, the lowest since March 2009 and 46% less than the 16-year average.
The Standard & Poor’s 500 Index extended its drop since its peak on April 29 to 17%. As one of the most commonly followed equity indices, it is considered a bellwether for the American economy, and is included in the Index of Leading Indicators. Many mutual funds, exchange-traded funds (ETF), and other funds such as pension funds, are designed to track the performance of the S&P 500 index The gauge has retreated even as analysts raise projections for 2011 corporate profit to a record $99.34 a share this year from $98.73 on April 29. The market seems to know that corporate profits are from Fed quantitative easing money, not from economic vitality.
The 15 national stock gauges with the biggest losses since the MSCI All-Country World peaked on May 2 are for European countries. Greece’s ASE Index has lost 42%, Italy’s FTSE MIB Index has plunged 40% and Hungary’s Budapest Stock Exchange Index has retreated 38%. The Euro Stoxx 50 Index has tumbled 28% since July 22 as Greece edged closer to defaulting on its sovereign debt and the cost of insuring western European countries’ loans rose to new record levels.
The MSCI Emerging Markets Index has also retreated 27% since its 2011 high on May 2. The MSCI Asia Pacific Index has fallen 19.7% since its 2011 high on the same date. China’s Shanghai Composite Index has tumbled 23% since its peak in November, and Japan’s Topix has slumped 25% since April 2010.
The 20% decline in global equities in 2011 ended the bull market driven by government quantitative easing money that began in March 2009. The MSCI All-Country World Index climbed as much as 107% during the liquidity rally. The measure avoided a bear market in 2010, when it fell 16% between April 15 and July 5.
A bear market is a prolonged period of falling prices. A bear market in stocks is usually brought on by the anticipated of declining economic activity and a bear market in bonds is caused by rising interest rates. Technically, a bear market is defined by traders as a 20% or greater decline in value for a major stock market index from its last high. A secular bear market is a decline in the major stock averages of at least 40% - and considerably more in secondary stocks - where the decline lasts at least three to five years during which each rebound fails to reach the previous high. The fall is then followed by a long hangover that drags on for a number of years as the excesses are purged.
A “bear” is a trader who believes the trend of stock prices is down and trades with that trend by selling his stocks to buy back later at a lower price or by selling short. A “bear spread” is a strategy in the options market designed to take advantage of a fall in the price of a security or commodity. This is done by buying a put of short maturity and a put of long maturity in order to profit from the difference between the two puts as prices fell. A bear trap is a situation that confronts short sellers when a bear market reverses itself into a bull market. Anticipating further declines, the bearish trader continues to sell, and then is forced to buy at higher prices to cover.
The MSCI All-Country World Index rebounded after Federal Reserve Chairman Ben S. Bernanke hinted, at the Fed’s annual meeting on August 27, 2010, in Jackson Hole, Wyoming, a $600 billion quantitative easing in bond purchases meant to prevent deflation and stimulate growth.
In the previous bear market, the Dow Jones Industrial Average dropped 38% from January 14, 2000 (11,723) to October 9, 2002 (7286.27). The NASDAQ dropped even further, falling 78% from March 10, 2000 (5048.62) to October 9 2002 (1114.11). Financial stocks posted the biggest losses in that bear market. Financial stocks are leading declines again in late summer and early fall of 2011 amid growing concern that European banks will have to write down their holdings of government debt. At this writing (early october), banks, brokerages and insurers in the MSCI All-Country World Index have collectively lost 31% since May 2.
By early October, Société Générale SA of Paris has retreated 66% since May 2, the second-biggest loss among financial stocks in the MSCI All-Country Index, behind Athens-based EFG Eurobank Ergasias, the shares of which fell from 52 week high at €5.26 to 52 week low at €0.88 in 2011. EFG Eurobank Ergasias is third largest bank in Greece, with more than 300 branches throughout the country.
EFG Eurobank Ergasias
EFG Eurobank Ergasias, a European banking group headquartered in Athens that operates in 10 countries mostly in eastern Europe, with total assets of €81.9 billion, employing more than 20,000 people and offers its products and services through its network of 1,600 branches, business centers and points of sale, as well as through alternative distribution channels. In 2006,  EFG Eurobank Ergasias acquired 100% of Nacionalna štedionica – banka in Serbia, 70% of Tekfenbank in Turkey, 99.3% of Universal Bank in Ukraine, 74.3% of DZI Bank in Bulgaria. In 2008, with gross revenue of €3.277 billion ($4.456 billion), it could not pay one single cent of dividend. It is forcasted to have gross revenue of €2.567 billion in 2012, yet with a projected loss of 1.74 cents euro per share. Most of the loss was from debt writedowns.
Pursuant to Laws 3723/2008, 3756/2009 and 3844/2010, banks participating in the Greek Economy Liquidity Support Program were prohibited by the Greek Government from declaring a cash dividend to the ordinary shareholders for the years 2008 and 2009. In view of this and in the context of current economic conditions, the Directors do not consider that the distribution of a dividend for 2010 would be appropriate. In June 2010, and following the Annual General Meeting’s approval, the 10% preference dividend for 2009, amounting to €59 million, was paid to the Hellenic Republic
At year-end 2010, EFG Group, through merger and acquisition, had total consolidated shareholders’ equity of €6.7 billion, total assets of €104 billion and over 25,000 employees in more than 40 countries worldwide. Listed on the Athens Exchange, Eurobank EFG has a diverse shareholder base, including over 210,000 private and institutional investors.
Eurozone Banks Hit by Market Restreat
UniCredit SpA, based in Milan, has retreated 62%. Banks in Europe hold 98.2 billion ($132 billion) of Greek sovereign debt, 317 billion euros of Italian sovereign debt and about 280 billion euros of Spanish sovereign debt.
Financial companies whose shares are in the MSCI All-Country World Index sank 77% during the bear market in 2008 as government bailouts rescued the biggest U.S. banks from collapse after Lehman Brothers Holdings Inc., once the nation’s fourth-biggest securities firm, was forced to file the nation’s largest bankruptcy in September 2008 when an arranged takeover by Brtish bank Barclays failed to receive regulatory approval from London.
More than $37 trillion was erased from global equity values in the bear market that lasted for 16 months after the MSCI All-Country World Index peaked on Oct. 31, 2007. The index fell as much as 60% amid the first global recession since World War II and more than $2 trillion in losses and writedowns at financial companies worldwide after housing prices collapsed.
The current sell off—which pushed markets from China to Ireland to Italy into bear territory—came as fears of a Greek default escalated and economic data around the globe hinted at the likelihood of a worldwide double-dip recession.
The Dow Jones Industrial Average will be affected by 10% to markets in other developed nations. Sixteen of the Dow 30 industrial companies all receive more than 25% of their revenues from Europe. The crisis of 2008 showed that developed economies do not de-couple from each other, not even from emerging economies.
The Dow hit its post-crisis bull market high on April 29, closing at 12,810.54. The benchmark on Friday, September 23, was about 17% off from that high after its worst week in almost two years.
The MSCI World Index encompasses the equity performance of 24 developed markets. Following eight 20% pullbacks for the index since 1987, the measure, on average, goes on to fall another 9%. Technical analysis shows that about 80 more days of weakness are ahead with a bottom at the start of December 2011. Nineteen of 29 major world markets—both developed and emergingare now in bear markets. China and Portugal stock benchmarks ended the week of September 23 down about 23% for the week. India, Australia, Japan and Taiwan also breached the 20% mark as well. France and Germany were already well into bear market territory entering the last week of July and down more than 30% by September.
While global contagion from the euro sovereign debt crisis has began, European policymakers are working to project an image of quickening their preparations to cope with an escalation of the eurozone sovereign debt crisis as talk of a possible Greek default gained momentum on Friday, September 23. Finance ministers from around the world have turned up the heat on their eurozone colleagues to do more to prevent Greece’s sovereign debt difficulties from infecting other eurozone governments and the world economy via contagion.
Following US example, official strategy of eurozone member states in Europe now appears to be turning towards safeguarding the European banking system more than rescuing the greatly impaired economy of Greece, as international lenders increasingly lose patience with Athens consistently missing fiscal and financial reform targets due to domestic political and social unrest.
British Finance Minister George Osborne reportedly said on the sidelines of semiannual policy discussions in Washington that the eurozone needed to gain control of the sovereign debt crisis by the time leaders of the Group of 20 economies meet in Cannes, France on November 3 and 4, as France assumes the rotation presidency of G20. That gave the Greek rescue problem six weeks from mid September to cut through the complex network of hurdles.
World stock markets, which had plunged to a 14-month low on fears about the expanding scale of the eurozone sovereign debt crisis, steadied after European Central Bank officials said they would use more firepower to help the European banking system withstand financial strains.
Pressure is growing on European governments for a recapitalization of the region’s banks to strengthen them in the event of a Greek default. At the same time, European policy-makers seemed to be warming to the idea of giving more resources to EFSF, the SPV bailout fund, which would be severely tested if Greece defaulted.
Greek Finance Minister Evangelos Venizelos was quoted by two newspapers as saying an orderly default with a 50% haircut for bondholders was one way to ease his government’s cash crunch. Greece’s negotiation position appears to be that if the Troika pushes Greece into a corner, it may leave Greece with no option except to default, in which case Greece would not be worse off than an austere Troika workout, but the eruozone will face massive damage, more than what it would cost to bailout Greece on reasonable terms. 
Greece is reportedly in tense talks with the International Monetary Fund/ECB/EC Troika to secure an urgently needed next 8 billion installment of its rescue package to avoid bankruptcy in mid-October.
Greece had originally expected a review by the country’s debt inspectors from the Troika of IMF/ECB/EC, to be completed in September and approve the sixth installment of €8 billion of the €110 billion ($149 billion) loan commitment from EFSF, the SPV bailout fund.
But inspectors from the Troika suspended their review in August amid talk of missed targets and budget shortfalls by Greece. Venizelos said the Troika would return to Athens in the last week of September, and that the disbursment of the next bailout tranche of €8 billion would be approved in time as there were several eurogroup meetings in early October during which the other eurozone countries could approve the payment.
In return for emergency aid, Greek officials pledged more austerity measures, but Troika negotiators have expressed frustration at what they say is Greece’s slow reform pace. Reports said Venizelos met new IMF head Largarde on Sunday, September 25, to what one official characterized as “going over again measures they had agreed to months before … with a sense of deja vu.”
While the October payment from EFSF is still widely expected to be made to Greece, the next installment due in December is much less certain. ECB President Jean-Claude Trichet reportedly urged authorities to take decisive action, saying risks to the financial system had “increased considerably.” Three officials of the ECB reportedly suggested the ECB could revive its one-year liquidity lines to shore up European banks.
The IMF, which has been pressing aggressively for an immediate recapitalization of Europe’s banks, estimates the debt crisis has increased the banks’ risk exposure by 300 billion. In a sign Europe was coming to terms with the idea of a bank recapitalization, The Autorité des marchés financiers (AMF), France’s financial market regulator, announced that 15 to 20 banks needed extra capital.
The growing talk of a Greek default met with stiff opposition from German Chancellor Angela Merkel. She told a meeting of her political party members that default was not an option because it might trigger a domino effect with other struggling eurozone economies. “The damage would be impossible to predict,” Merkel warned. She meant damage to the euro as a currency, the eurozone economies and specifically Germany.
“It's not a question of [financial] ability for the eurozone,” Bank of Canada Governor Mark Carney pointed out the obvious. “It is a question of political will,” he added.
October 7, 2011
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