Smoke and Mirrors Thicken in Euro-land

01/31/2012 3:06 pm EST


Jim Jubak

Founder and Editor,

Leaders are producing less impressive news on the debt crisis with each summit, but strangely, the markets don’t seem to care right now, writes MoneyShow’s Jim Jubak, who also writes for Jubak’s Picks.

Even if you’ve come to expect empty promises dressed up as major progress from summits of European leaders, yesterday’s announcement of a breakthrough deal might have left you marveling at the audacity of Merkel, Sarkozy, Draghi, and company.

Not only did the announced progress—an agreement to back a treaty that would enforce fiscal discipline and to accelerate the setup of the permanent €500 billion rescue fund—have even less content than usual, but it also opened up new problems for countries such as Ireland.

And, of course, nothing in that progress, scheduled to take effect in June or later, does anything to address the looming March deadline for a potential Greek default.

But then why should Eurozone leaders blaze a new path and actually propose measures to end the crisis, when the tried and true talk and switch continues to work? Yields on Italy’s ten-year government bonds fell 0.12 percentage points to 5.97% today. The yields on Spanish ten-year bonds dropped 0.06 percentage points, to 4.98%. Even Portugal’s ten-year bonds climbed, dropping the yield 1.17 percentage points to 16.23%.

Let’s start with the bigger announcement: the agreement by 25 out of 27 countries in the European Union to a new treaty that would enforce budgetary discipline. This “agreement” doesn’t really advance things much from the December agreement to put together a new treaty.

The treaty doesn’t go into effect immediately—a formal vote is scheduled for the end of March, and will go into effect when 12 countries sign on. Even then, it’s not clear what any country signing the treaty has signed up for.

In December, German Chancellor Angela Merkel talked about countries adopting a constitutional amendment to guarantee that they didn’t violate the rules for budget deficits. Now the draft says that the guarantee should be “preferably constitutional,” but budget discipline could be “otherwise guaranteed to be respected through the national budgetary processes.” Whatever that means.

Treaty signatories would be able to take other signatories to the European Court of Justice if they didn’t follow the treaty’s budget rules. The court could then impose a financial penalty of up to 0.1% of the guilty country’s GDP. (To give you an idea of what kind of sums we’re talking about, that would amount to a fine of up to $2.15 billion if France violated the treaty’s deficit limits.)

But the real sting in the treaty comes in two other relatively minor clauses.

First, no country that doesn’t ratify the treaty would be eligible for aid from the permanent €500 billion bailout fund, the European Stability Mechanism, set to go into operation on July 1. Take that Greece, Portugal, and Ireland—all those countries will need help from somewhere to refinance debt in 2013 and beyond. Some—Ireland—have voted down Eurozone treaties in the past.

(Fortunately, Ireland may have already found on out. Yesterday, Ireland switched about 30% of its debt coming due in 2014 into bonds due in 2015. Ireland’s €67.5 billion bailout left the country funded through 2013, but Ireland faces a big debt lump in 2014. Yesterday’s switch gives the country more room to maneuver. So why did Ireland’s creditors agree? Remember that Ireland’s financial mess is a result of the country’s bailout of its biggest banks. The government now essentially owns five of the country’s six biggest banks. All the evidence is that it was those banks that agreed to the debt switch.)

Second, the treaty would require governments to put collective-action clauses into new bond issues by January 2013. That would allow a debt restructuring to go ahead by a vote of a supermajority of bondholders. Solitary investors would not be able to veto a restructuring.

Such clauses are common in the United States and the United Kingdom, but much less so in the Eurozone. (Logic would suggest that lenders would then require a higher yield from countries with collective action clauses since they face a higher risk of restructuring. Yet another unintended consequence?)

The news conference announcing this agreement was barely over before—as has been so frequent through this crisis—a major player said that the agreement wasn’t quite as firm as it seemed. French President Nicolas Sarkozy, Chancellor Merkel’s key partner in this crisis, said that he would not ask the French assembly to approve the treaty before April’s presidential election.

Sarkozy’s major rival in that election, Francois Hollande, has said he would renegotiate the treaty. Currently, Sarkozy trails Hollande in the polls.

How about announcement No. 2—the accelerated startup of the permanent European Stability Mechanism? If you think you’ve heard this before, it’s because you have. European leaders agreed to move up the beginning of the fund’s operation when they met last December.

The big open issue then was whether Eurozone countries would contribute more to the €500 billion fund in order to make it a more credible firebreak against the crisis spreading to Italy and Spain. That’s still an open issue.

Germany continues to oppose adding to the fund, although the country has agreed to let the old European Financial Stability Facility operate in tandem with the new European Stability Mechanism. That would add the facility’s remaining €250 billion in guarantees to the new €500 billion in the mechanism.

But what about Greece?

Germany’s Merkel continues to oppose adding another euro to the €130 billion in the still-unimplemented October rescue package—even though the International Monetary Fund now estimates that the continued Greek recession has turned October’s €130 billion gap into a €145 billion gap.

Merkel says that she wants private creditors to pick up the slack. Which would require yet another renegotiation of the Greek debt-swap deal now on the verge of completion. Creditors would have to “voluntarily” submit to something beyond the 69% haircut now on the table.

I don’t think that’s likely—especially not by the February 13 deadline set by Greek Finance Minister Evangelos Venizelos today. (Deadlines in the Greek crisis are, of course, a very slippery concept.)

Merkel has basically refused to talk about the hole in the Greek rescue package, saying that she is waiting for a report from the inspectors from the International Monetary Fund, the European Central Bank, and the European Union who are now in Athens.

Maybe she’s hoping that they will conclude that the Greek government is incapable of meeting its promises of budget cuts and tax increases, saving her and the other leaders of the Eurozone from having to sort out their own disagreements about how much “supervision” the Greek government would have to submit to in exchange for the cash.

Germany has proposed that a European commissioner take charge of the Greek budget. Many members of the Eurozone find that an appalling attack on national sovereignty.

(Personally, I like the suggestion made by James Mackintosh in today’s Financial Times for a deal that would trade a European budget commission in Athens to impose austerity in exchange for a Greek commissioner in Berlin who would make sure that German consumers upped their spending.)

Maybe none of this actually matters today as far as the financial markets are concerned, though, despite the way that the news of this “progress” has dominated the day’s headlines.

Maybe the crucial explanation for why European stock markets up today, and Italian, Spanish, and Portuguese bond yields are down, is speculation on the size of the next offer of three-year loans by the European Central Bank on February 29.

Remember that back in December, European banks surprised the markets by gobbling up €489 billion of three-year loans in the central bank’s first offer of three-year money. Speculation now is that banks could take down even more money this time. Goldman Sachs is estimating something like €1 trillion flowing to European banks.

That wouldn’t solve the Greek debt crisis, but it sure would make sure that Europe’s banks are solvent and have met all their financing needs well into 2013.

Sounds like “progress” to me.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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