ECONOMICS

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Economic Flash!
November 1, 2011 Emanuella Enenajor (416) 956-6527

Eurozone Update Faded Euphoria

Greek Referendum: The Wildcard Markets, as well as European leaders were stunned by Greek Prime Minister Papandreous decision to call a public referendum and parliamentary confidence vote in light of the recent EU deal. While the recently announced moves appear to be a political step to garner support for the ruling Pasok party, the risk of an adverse outcome should continue to keep investors on edge, and will likely hold funding costs elevated not only for Greece, but also Italy and Spain in coming months. The parliamentary confidence motion in the government of Papandreou will likely be held on Friday this week, following days of debate. Papandreou survived a similar confidence vote in June (155-143 voting split), and while the ruling Pasok party has faced recent defections, Papandreou still holds a two-seat majority in parliament, enough to conceivably squeeze through support. That outcome assumes no further defections in coming days, and no abstentions among Pasok party members. A failure of the confidence motion would trigger an election and possibly delay implementation of austerity measures. But the recent parliamentary approval of a new painful round of budget cuts (154-144 voting split with two abstentions) suggests that lawmakers are continuing to push for steps to keep Greeces public finances afloat. A firm date has not yet been set for the referendum, although it will likely occur early next year sometime after leaders finalize details of Greeces new bailout plan. Eurozone referendums on fiscal matters have been rare, but the most recent experience was the Icesave referendum in Iceland (March 2010), which was resoundingly defeatedleading to the president of Iceland refusing to sign a bill repaying loan guarantees to the UK and Netherlands. While the Icelandic constitution broadly allows referendums on bills, article 44 of the constitution of Greece specifies referendums be taken on bills passed by Parliament with the exception of the fiscal ones That has led Greek opposition parliamentarians to recently question the legality of a referendum on the EU financial deal, citing the move as an attempt by Papandreou to sidestep calls for an early election. A referendum could still be held, but the question posed may be on whether Greeks wish to remain in the euro currency region, or remain in the EU, rather than on whether Greeks support widely unpopular austerity measures. While recent polls suggest the majority of Greeks view the governments austerity plans negatively, an even stronger majority wish to remain in the eurozonelimiting the odds that the referendum will fail. Nonetheless, uncertainty in the interim will likely add to volatility of the euro, and keep funding costs of Greece and peripheral European nations elevated.

Enthusiasm over European Deal Faded Market zeal over the recent EU plan to reduce Greeces debt ratio to 120% of GDP has quickly vanished, on new fears that the Greek bailout plan is on shaky footing. A closer look at recent proposals gives further cause for caution, suggesting that the recent pull-back in the euro, and drop in peripheral sovereign debt valuations may have staying power:

A Larger Haircut to Get to the Same Place: The July 2011 Troika report assumed that Greeces debt-to-GDP would hit 127% by 2020a figure so steep that markets continued to shut Greece off from longer-term funding, requiring a second bailout. The recently proposed larger haircut is only an attempt to keep Greeces debt ratio around those levels, preventing the figure from creeping up to a whopping 150% of GDP by 2020 (Chart 1) due to more realistic assumptions about slower growth and weaker privatization receipts. So the new plan prevents Athens debt ratio from veering off-track, but does little to break new headway for debt relief for Greece. The haircut would apply to a limited selection of Greek debt: As of July 2011, the total amount of Greek debt held by the private sector subject to an adverse exchange/swap totaled 135 bn, measurably short of Athens total 350bn gross debt burden. Note that Greek debt and loans held by the ECB, EU, IMF and other public entities would not be subject the haircut, although the public sector is targeting a modest 30bn contribution (details unspecified). In the coming months, leaders will likely push for more private sector participation beyond the original 135 bn target, although that would come with additional costs to Greece in the form of credit enhancements (purchases of zero-coupon bonds by the EFSF to collateralize newly swapped debt). Preliminary statements from the ISDA suggests the haircut would not trigger a CDS credit event; however, given elevated losses to banks in the eurozone (the primary counterparties to the debt swap), contagion fears could depress valuations of Italian and Spanish debt, as is already being seen. Thus, the robustness of a capitalization plan to absorb sovereign losses is a critical prerequisite for the stability of the eurozone in the event of a direct Greek debt haircut.

Chart 1 Greek Haircut: Back to Square One

160% 140% 120% 100% 80% 60% 40% 20% 0% July 2011 Revised Assumptions: Slower Growth, Lower Asset Sale Receipts After 50% Haircut 2020F Debt-to-GDP Ratio As of October 21st EU Debt Sustainability Analysis

Source: European Commission, CIBC Chart 2 Need to Rebuild Capital Widespread Across Eurozone
35 30 25 20 15 10 5 0 Spain Germany Portugal France Greece Cyprus Other Italy 5% 0% 15% 10% , bns

Positions
25% 20%

Required Capital Buffer (L)

Share of GDP (R)

Source: EBA, IMF, CIBC

The European Banking Authority (EBA) estimates that about 106 bn in capital buffers will need to be built by mid-2012 to achieve a core tier-1 ratio of 9% across the eurozone. The largest capital buffers will have to be built in Greece, Spain and Italy, but given the size of the various eurozone national economies, the most acute capital raising will likely have to occur in Cyprus and Portugal (Chart 2)1, with the latter already struggling under austerity-related growth slowdown. As bank equity valuations remain depressed, banks will likely be pressured to shrink balance sheets to meet capital targets, exerting downward pressure on lending activity. Slower credit creation and ongoing moves towards further austerity had us downgrade our call for eurozone growth to 0.5% in 2012 from 0.8%.

Euphoria surrounding the recent EU deal has quickly fadedas significant steps are still need to clarify the details of the plan, and as Greece will still be saddled with a measurable debt burden ten years from now. Athens will likely continue to rely on funding from the EU/IMF for years to come, even beyond current timetables envisioned (mid-2014). The inability of Greece to stimulate growth has placed the burden of fiscal adjustment on higher private sector participationa step that the ECB staunchly opposes, given risks to financial stability. And while a build-up of adequate capital buffers should diminish risks of insolvency in the regions banks, restrained banking sector activity will likely hold eurozone growth at a standstill in the first two quarters of 2012.

Greek banks also have elevated capital rebuilding needs, but existing banking-sector capital backstops make up for the nations required capital buffer build-up.

Ongoing fiscal jitters and two quarter-point ECB rate cuts should weigh further on the euro in the coming year, and given ongoing risks to financial stability, investors would be wise to further underweight exposure to the region and highly exposed institutions.

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