On Oct 9, Ch. Merkel and M. Sarkozy announced that they “will reach an agreement regarding the recapitalization of Europe’s banks”. Since then news reports have indicated that the European Central Bank is considering a requirement that European banks increase Tier I common equity capital from a minimum of 7% to 9% within 9 months. If they cannot raise private capital, they will be required to accept some form of government aid. In the meantime, the “troika” of international auditors are supposed to approve Greece’s next distribution of funds from the EU. There is great risk in both of these steps which are fundamental to solving the European fiscal crisis.
The Merkel-Sarkozy agreement is only a statement of principle and not in any sense a real agreement. It fudges the main issue dividing the two countries. There are two schools of thought. The Germans want to see recapitalizations handled on a country-by-country basis. Lets call this the “Irish Solution”. The French want to handle it on a consolidated European-wide basis. Lets call this the “French Solution”.
The issue with the Irish Solution is that the sovereign debt of the home countries would escalate dramatically, which (1) could lead to a down grade by the rating agencies and certainly would lead to an increase in spreads in the financial markets; and (2) it would highlight the political fallout of a bailout for ‘bankers'. The French solution would involve the use of the European Stability Fund but augmented in some way. The French feel that they have already contributed to this fund by their guaranty of payment and it should be used first.
The plan is supposed to be announced no later than early November at a meeting of the G-20 but the October 23 meeting of EU leaders will be an early test of the resolution.
In the meantime, Greece has announced a new round of budget austerity measures designed to both cut expenses and raise revenues. Again, there are many unanswered questions and the plan looks fudged. The plan relies on property tax since Greeks are notorious cheaters on income tax. But property tax is also problematic since there is no systematic record of property ownership in Greece. Moreover, what is reported is often based on unrealistically low appraisals relating back many years. So tax collection has an element of “volunteerism” that is likely to be ignored by many Greeks. There is also a plan to reduce government employment and a further reduction in government salaries (40% in total reductions). The latter are good ideas in a country in which civil servants obtain salaries that are said to be 2-3x of the private sector with generous pensions and yet corruption is still rampant. The only problem is that the real reductions in employment are still to come. The Greek “austerity” plan is really a dramatic cultural change with a smaller and more efficient civil service that will be paid closer to levels of the private market. This seems ambitious for a plan that is to be implemented in just 2-3 years. There is plenty of room for disappointment—meaning default. Assigning compliance to the “troika” seems to set the stage for a default at some point; if not in November, then early in 2012.
The history of this saga has been filled with half-measures that are taken only when the EU has been forced to act by external factors. The world’s equity markets seem now to believe that this cat is going to change its stripes and now act decisively and definitively. There is plenty of room for disappointment.
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