Goldman On The Just Commenced Europarliament Summit: "Decision Time"

by Tyler Durden

For what it's worth, and probably not much, here is Goldman's Francisco Garzarelli on why it is "Decision Time or bust" for Europe. With the just commenced summit, the market has very high expectations of a favorable outcome. Should the proposed resolution end up being disappointing, and it likely will upon a close read between the lines as it can not possibly be anything more than merely another can kicking exercise, look for the EUR to tumble after this final relief rally.

From Goldman Sachs

News that Germany and France have reached an entente on how to provide further help to Greece has buoyed Euro-zone government bond markets. One of the benchmarks on which investors will judge today’s announcements from the European Council will be the losses inflicted on private holders of Greek debt. Crucially, however, the market reaction will depend on the extent to which the Euro area members are willing to share in each other’s sovereign credit risk without strict conditionality.

Final discussions are underway in Brussels on a second multi-annual financial support package for Greece, and “measures to improve the Euro area’s systemic capacity to resist contagion risk” (Eurogroup statement, 11 July).

Last night, Germany and France, the major holders of Greek debt, reportedly reached a common position that will be presented to the European Council for broader discussion. A press conference will be held at the end of a working session starting 3pm Brussels time.

We laid out our thoughts on the main issues facing markets in a note published at the start of the week. Here we summarize what we expect to come out of the meeting, and how markets could react.

• An increase in the EUR110bn package for Greece has been agreed. The baseline assumption is that it will be in the region of EUR100bn-EUR115bn, covering financing needs through mid-2014 (and allowing a buffer in the event of slippages). We expect funds (EUR20-30bn) to be earmarked to prop up the Greek banks, after third-party diagnostics of their balance sheets have been carried out (as in Ireland). The Euro-zone portion of the second package (assumed to be in the region of EUR70bn, net of EUR15bn-worth of privatization receipts and EUR30bn from PSI – see below) will likely be funded by the EFSF, rather than bilateral loans. Margins will likely be reduced from the 200-300bp over 3-mth Euribor today. The same terms would be extended to Ireland and Portugal. It is unclear if the IMF will contribute to this second package. For reference, the Fund’s current exposure is EUR30bn on SBA terms, of which EUR18bn have been disbursed. On the central assumption, the Euro-zone will have committed EUR150bn to Greece, of which EUR47bn have already been disbursed. Assuming the remainder of Greek bilateral loans are rolled into the EFSF, the latter would have committed up to EUR146bn to the three program countries out of a lending capacity of EUR440bn. The portion of this total amount backed by AAA countries still available (originally EUR255bn) would then be EUR109bn.
• Greece would still have a high debt burden, but liabilities would be more affordable and spread over a longer time horizon. The country’s new creditors would continue to have a large influence on the government’s cash flows, and this may increase the chances of front-loaded structural reforms being carried out (see the IMF’s 4th Review for details). The market float of Greek bonds (ex-bills) would also continue to decline, and by end-2013 it should have fallen to around 35% (net of ECB holdings). Similarly, the share of Greek bank funding via the ECB would increase to 30% of total liabilities, before declining as the banks' aggregate balance sheet shrinks. We have dubbed these dynamics ‘managed deleveraging’. If these magnitudes are confirmed, European policymakers will have made a clear choice – this time around, capital debt restructurings would be heavily piloted by the official sector. From 2013, sovereign debt instruments carrying Collective Action Clauses and homogeneous legal support should make crisis management more efficient.
• To provide political support for this process, private-sector involvement (PSI) remains a possibility, as a Franco-German ‘common position’ would also suggest. As we have written before, we do not expect this to change materially the debt dynamics (which will be primarily influenced by growth prospects). However, alongside privatization proceeds, PSI would reduce the bill for tax-payers by an estimated EUR30bn. We have long favoured purchases of Greek bonds by the EFSF, as such purchases could put a floor under recovery values, allowing investors to exit positions, and achieve a mild form of ‘bail-in’. Purchases could be carried out once or staggered over time. Voluntary maturity extensions, our central expectation for several months, could also be on the menu. PSI is likely to trigger ‘selective default’, at least temporarily, but the ECB could compromise on its collateral policy.

Secondary market purchases by the EFSF of Greek bonds would be an effective way to achieve PSI, in our view, but they ultimately still represent a form of liability management within a framework of conditionality on the country’s cash flows. Given the extension of sovereign tensions to larger high-rated sovereigns, namely Italy and Spain, the most crucial parts of today’s announcements will involve mechanisms to address systemic risk. These would need to be unconditional, ex ante risk-sharing solutions available to all EMU countries. The ‘wish list’ includes the introduction of ‘flexible credit lines’, such as those the IMF made available to Poland in 2009. Or, more ambitiously, secondary market purchases of government bonds outside program countries by a joint Debt Management entity (initially the EFSF). Eurozone-wide schemes to provide funding guarantees to banks (against a fee) that have passed stress tests would go a long way towards separating sovereign and financial risk. We expect steps in this broad direction to be taken and this will be the main benchmark against which to judge the outcome of today’s summit. Even if details are not completely fleshed out (there will be much discussion on the size of the facilities, accountability, etc.), any hint at such initiatives would be an important breakthrough. Any institution delivering unconditional risk-sharing would need deeper Euro-zone fiscal governance as a counterpart (the Pact for the Euro represents a step in this direction).

We said at the start of the week that Euro-zone bond markets would be volatile, caught between attractive valuations and expectations of a deal, and the uncertainties surrounding PSI. On light flows, some of the sell-off has reversed over the past 48 hours. If our baseline case above plays out, we would expect more upside and almost all of the widening in intra-EMU spreads seen since Moody’s downgrade of Portugal could be corrected.

We doubt we will see more upside than that, at least for a while. It will take some time for the new policies to be articulated and implemented, and all decisions taken today will need to be put before national Parliaments, probably at the start of September. Moreover, concerns over the pace of global growth remain in the background weighing on weaker borrowers. Last but not least, investors have been heavily affected by recent events and thus may want to reduce risk in a recovering market.

A more sustained tightening of spreads awaits fresh inflows into the Euro-zone fixed income markets from investors outside the single currency area, primarily in Asia. This requires greater clarity on the Euro-zone’s evolving fiscal governance.

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