After the recent extreme volatility, the markets face two key immediate events this week:. ...
Adam Cordery
Head of European and UK Credit Strategies
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• The votes in three of the four key northern European countries (Germany, Austria and Finland) to ratify the upgrades to the European Financial Stability Facility (EFSF) agreed by EU members on 21st July (the fourth key country – the Netherlands – will vote sometime in October).
• The return of the IMF/EU teams to Greece to decide whether or not to disburse the next loan.
My expectation is that the three key countries will probably vote to ratify the EFSF upgrade and that the EU and IMF will probably agree to make the next loan.
These developments would both be positive for now, but they won’t mark the end of the crisis or the volatility. There are still question marks over whether the Dutch parliament will ratify the EFSF changes at the first attempt in October, and it is also doubtful whether the IMF/EU will agree to another loan disbursement to Greece after this one.
It has been our view for a while now that any eurozone sovereign default – whether in Greece or elsewhere – would be “managed” so as to ensure it does not bring about the demise of the major Western European banks and a depression.
Following the statements made during the weekend and in previous days, this appears to me to be the plan now being put together by the world’s politicians:
a “controlled” or “contained” default plan.
Greece’s efforts at fiscal reform are now looking increasingly futile. Greece has been trying to improve its public finances but has not moved fast enough in relation to how quickly its GDP has been shrinking, so the key debt-to-GDP ratio is not improving. As a result, we think it seems quite plausible that the authorities’ contained default plan could be put to the test in the next few months.
The components of the plan could well consist of new initiatives and ideas, or any that are currently in the pipeline or being mentioned such as:
• The EFSF’s activities and resources to be expanded as per the 21 July upgrade agreement.
• Swap lines with the Federal Reserve to source US dollar funding for Europe’s banks.
• The EFSF to use leverage to increase its resources.
• The early launch of the European Stability Mechanism (ESM) in mid 2012 to run alongside the EFSF.
• ECB launch of unlimited 12 month loans to banks.
• ECB to expand sovereign debt purchases.
• The IMF to get involved or expand its resources.
If the plan is one that will succeed, there will still be volatility and lots of scary news headlines, but ultimately the markets will eventually come to believe in it:
European assets will attract buyers, corporate bonds and bank debt will rally, gilts and bunds will sell off.
If the plan is not one that can succeed, the markets’ doubts will grow: the flight from European assets will continue, corporate bonds and bank debt spreads will continue to widen, and gilts and bunds will rally to even lower risk-free rates.
I believe that the authorities’ plan is more likely than not to be made to work and that the authorities will probably be able to break the contagion cycle at some point. I also believe they can contain runs on major banks and prevent widespread defaults among sovereigns and banks.
Disclaimer:
The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
For professional investors and advisers only.This document is not suitable for retail clients.
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Source: BONDWorld – Schroders
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