The Credit Suisse Tome

Credit Suisse has outdone itself!  The workhorses in the European Fixed Income Research department have just released a 75 page novel entitled European Public Finances in 2012.

CS European Public Finances 2012

I highly recommend you give it a read!  I am not going to attempt to regurgitate their entire paper here, but did want to make a few cogent comments.

The CS analysts adopt a relatively optimistic view.  They base this on two factors.

•- First of all, the evidence from the first of the ECB’s three-year LTROs is that much needed liquidity is being injected into the euro area financial system, which should ease, but not alleviate many of the sovereign and banking funding pressures; and

•- Secondly, the slowdown in the euro area has, so far, been less acute than we – and other forecasters have anticipated. And the prospects for growth – driven by global developments – look, in the near term, to be slightly more promising than a few months ago.


They also believe that the ECB will massively ramp up its asset purchase program in a Fed/BoE style QE, and I will discuss this in a separate post.

With regard to their first point regarding liquidity, they argue that the first round of the LTRO added a net of 200 billion euros to the banking system.  They anticipate that the late January halving of reserve requirements will add another 100 billion.  Finally, they look for over 200 billion more in the February LTRO auction, at which time changes to collateral requirements will have taken effect.

CS goes on to point out that some of this liquidity is indeed finding its way into the sovereign debt markets, particularly in short duration instruments.  An obvious case in point is the recent Spanish auction, at which Spain was able to sell twice its target amount in three year bonds.  I will concede this point for now, although I think we need to be careful not to confuse bank funding pressures, which have been alleviated for now, with sovereign funding pressures.  It is early to conclude that the LTRO has solved the sovereign issue, and the bond subordination issue I raised in my last post must be remembered, as well as the impending recapitalization challenges banks face (see SoberLook).  The rotation into shorter term debt instruments is also a red flag.  While one could fantasize about the European situation being solved in two or three years, rollover risks are building as debt maturities shorten.  (Risks from ECB debt drip - MacroScope)

 

I won't discuss their second factor - you can read the paper if you're interested.  I will say that page 11 begins an interesting discussion of austerity measures and their fiscal multipliers.  One comment in particular strikes me as patently wrong:

"It is difficult to imagine that the deficit of a country would increase as a consequence of a tax rise and/or expenditure cuts. Such an event would be quite extreme."

 

OK, then how about Greece???

Where I would particularly like to focus is on the discussion on pages 14 and 15, titled "Policy Hurdles."  Here the team identifies three risk factors to their optimistic view.

1. PSI:  I just did a post about this topic, and won't repeat it here.
2. Firewall Construction:  Here the team discusses the EFSF, the ESM, and the IMF.  With regard to the EFSF, their view remains optimistic, but their paper was published prior to the recent S&P downgrade.  It is now quite likely that the EFSF will lose its own AAA rating, and S&P is reviewing the issue currently.  This should finally put a fork in the wacky ideas regarding leveraging this facility.  As to the ESM, the CS team would like to see its implementation moved up into mid 2012 (likely), its firepower increased above 500 bn (unlikely, given the attitude in Germany), its flexibility increased (unlikely, given Finnish and other objections to "qualified majority" decision making), and its senior creditor status abandoned (unlikely, as this superb SoberLook post argues.)  Regarding the IMF, the CS team heralds the recent 150 billion euros put into a special fund by euro area countries as a resource yet to be recognized by the markets.  This may be, but (1) it's chump change, and (2) the BRIC contribution they anticipate seems unlikely.  If it comes about, it will most certainly go to the general fund, and not into the special fund for Europe.  If the IMF General Fund contributes further to the EU crisis, IMF contributing countries will expect senior creditor status, further subordinating existing private bondholders.
3. Fiscal Compact:  Here the CS team refers to the ambitious idea for tighter fiscal rules and balanced budget amendments to EZ country constitutions.  They see implementation of this as critical to paving the way for ECB QE.  Unfortunately, but not unexpectedly, this whole fiscal compact concept is dissolving into a weakly worded mush.  (Eurozone deficit limits flexible under draft).  That, in turn, has evoked the ire of the ECB, which wrote a strongly worded letter condemning the watering down of the original compact.  (ECB raps revisions to draft fiscal pact)  Whether, in the end, this topic would really be critical to the ECB's decision regarding QE is questionable, IMO.

I would conclude that all three of their risk factors look pretty risky about now.

The rest of the paper gives a country by country briefing, focusing on overview, financing needs (net and gross), public finances outlook, risks, and ratings.  I honestly have not read every country's summary, but I certainly intend to, and recommend you do as well.