K bank fx & rates strategies an update of eurozone
1. .Mean S FX & Rates Strategies
KBank Economics /
Strategy
An update of the Eurozone debt problems
FX / Rates
23 December 2010
Eurozone’s debt problem continues to be a major concern for the
stability of the eurozone economies and a source of financial Nalin Chutchotitham
market volatility nalin.c@kasikornbank.com
EU members established three key measures to calm the
market’s concerns, as well as to deal with immediate obligations
For now, the emergency funds seemed sufficient to cover for the
combined obligations of the PIGS governments, without further
borrowing from the market
Yet, eurozone economies will continue to face liquidity concerns
in the short-run and longer-term worries on solvency
Disclaimer: This report
We think that ultimate solvency involves the eurozone’s political must be read with the
decision, something hardly predictable by economic facts Disclaimer on page 8
that forms part of it
The euro would continue to fluctuate in value against major
currencies, as it provides a mechanism for the market to cross-
check the progress made by debt-laden economies
KBank Capital Market
Research can now be
accessed on Bloomberg:
Eurozone’s debt problems and measures so far KBCM <GO>
The markets has indeed factored in a large amount of information with regards to the
extent of eurozone’s debt problems, especially for the maturing debts in the medium term
of 3-5 years’ time as well as the amount of fiscal deficit reduction. This information is
reflected through the decline in the value of eurozone’s sovereign bonds and the
fluctuating value of the euro. However, there remains a large amount of uncertainties,
namely, the ability and political will of governments to cut deficits as planned, the
coordination among member countries with regards to speedy agreements over crisis
management measures and joint commitment to the euro system.
Fig 1. EUR/USD fluctuates due to market’s sensitivity of Fig 2. EUR/CHF falls as investors shirted money into a
Eurozone’s debt problems European economy with stronger balance sheet
1.70 1.70
1.60
1.60
1.50
1.40 1.50
1.30 1.40
1.20
1.30
1.10
1.00 1.20
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
EUR/USD EUR/CHF
Source: Bloomberg, KBank Source: Bloomberg, KBank
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2. In any case, the eurozone has established three key measures to calm the market’s
concerns, as well as to deal with immediate obligations, such as repaying maturing debts
in the near-term, meeting deadlines for next fiscal year’s fiscal budget plans and so forth.
(Please see details in the table below) The establishment of the facilities was
instrumental to ameliorating market’s concerns over Greece’s debt back in May of 2010.
However, given that the eurozone does not only have a single troubled member but
several of them, the concerns could no longer be limited to country-by-country conditions
but the market has turned its attention towards risks of debt contagion and continuity of
economic recovery of the whole eurozone in the few years ahead.
Table 1. Facts about the three financial support facilities after May 2010
Description Caveats/Concerns
• Approved on May 3 with €80 billion facility from euro-area
rd
• Greece continues to face challenges in trying to achieve
members’ contributions and another € 30 billion from the IMF the targeted deficit reduction, among other conditions
that would maintain its eligibility for the future
• Funds are set up for 3-year period and conditions applied to Greece disbursement of aid funds
€110 billion package before each disbursement i.e. Greece must be making sufficient
for Greece progress towards cutting deficits down to 3% of GDP by 2014 • There remains a possibility that Greece cannot raise
funds in the market after the expiration of the aid
package. This will further increase the burden of EU
nations
• Worth 60 billion euros and administered by European Commission • The size is relatively small compared to debt problems
in the eurozone
• Backed by EU budget and viewed as good credit
European Financial
• May be against Article 122.2 of EU Treaty
Stabilsation
Mechanism (EFSM) • Issue with several guarantee (EU Budget) is that there
is no clear collateral guarantee from individual member
states
• Created by the 16 euro area member states following the decisions • Chance of EFSF’s credit rating being downgraded from
taken May 9, 2010 and jointed owned by euro-area member states AAA
• Overall rescue package worth €750 billion • Creates moral hazard for the borrowers
• Tenure of 3 years - up to June 2013, (or if loans are made, the • Due to the correlation between the Eurozone
maturity of the financing instruments) economies, the quality of the collateral are likely to be
correlated with the health of the borrowers’ economic
European Financial • Capacity to issue bonds guaranteed by EAMS for up to € 440 billion health
Stability Facility (EFSF) for on-lending to EAMS in difficulty
• Issuance of EFSF debt is only made after a loan by a
• Bonds issued by EFSF are guaranteed by member-states based on member stakeholder, a timing which is viewed
each member state’s share of ECB capital. Hence, there is negatively by the market and signals that conditions had
individual guarantee as opposes to the EFSM worsened
• Total amount of guarantee covers up to 120% of total debt issuance
Source: Professor Anne Sibert, University of London and CEPR via http://www.europarl.europa.eu/activities/committees/studies.do?language=EN and selectively summarized by KBanK
Note: There may be opinions added by the author and other facts from Bloomberg and Reuters
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3. Table 2. Contributions by each Euro Area Member State to the EFSF
Guarantee commitments
Country Share of total (%)
(EUR billions)
Germany 119.4 27.1
France 89.7 20.4
Italy 78.8 17.9
Spain 52.4 11.9
Netherlands 25.1 5.7
Belgium 15.3 3.5
Greece 12.4 2.8
Austria 12.2 2.8
Portugal 11.0 2.5
Finland 7.9 1.8
Ireland 7.0 1.6
Slovak Republic 4.4 1.0
Slovenia 2.1 0.5
Luxembourg 1.1 0.3
Cyprus 0.9 0.2
Malta 0.4 0.1
TOTAL 750 100
Source: www.efsf.europa.eu
Limitations of mechanisms
There are several limitations with the present mechanisms for solving the debt problems.
The most obvious one is being the mismatch between the projected time needed to solve
the problems and the expiration of the mechanisms put in place. For example, the largest
pool of funds, the EFSF, is due to expire in June 2011. However, there are many more
problems than just the expiry date of the fund. Below, we quote Professor Anne Sibert
from the University of London and Centre for Economic Policy Research (CEPR), who
was requested by the European Parliament’s Committee to analyse the consequences of
the EFSM and EFSF below in a study paper dated Sep 2010. In any case, the gist of her
statement is that the establishment of emergency funds would result in moral hazard
problems and indicate a transfer of wealth from the funds provider to the funds user. At
the same time, the dealings of such bail-out measures may also run against the
fundamental laws that helped to form the European Union itself.
The new facilities were created by European Union policy makers to lower the borrowing
costs of financially troubled countries. The idea is that if the euro area borrows as a whole,
it can get better rates than a troubled country can and it can pass on these rates to this
country. Unfortunately, the lower borrowing costs come with a political problem. If some
euro area countries must make good on the euro area’s guarantee as a whole in the case
of one or more other euro area countries defaulting, then this is a transfer of wealth from
these countries to one or more others. It may be seen as a violation of the so-called “no
bailout clause”, Article 125.1 of the Treaty (consolidated version) which says:
“The Union shall not be liable for or assume the commitments of central governments,
regional, local or other public authorities, other bodies governed by public law, or public
undertakings of any Member State, without prejudice to mutual financial guarantees for the
joint execution of a specific project. A Member State shall not be liable for or assume the
commitments of central governments, regional, local or other public authorities, other
bodies governed by public law, or public undertakings of another Member State, without
prejudice to mutual financial guarantees for the joint execution of a specific project.”
Indeed, the fiscal austerity measures either announced or adopted by the eurozone
governments have created dissatisfaction among their people, both in the fund-providing
nations and the fund-receiving nations. Hence, the financial and political risks involved in
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4. future measures are likely to be much greater, should the existing ones be insufficient. At
the same time, the euro-area government continues to run the risk of making insufficient
efforts in the eyes of investors and other market players. This problem had been one of
the key sources of volatility in the financial market in the year 2010 and could potentially
reduce the effectiveness of the measures taken.
Are the emergency funds sufficient?
Next, we will consider the impact of debt repayment of Ireland, Spain, and Portugal on
the emergency facilities, excluding the Greece’s debt burden. The government of Greece
had been granted a separate aid package worth €110bn, subject to a set of criteria for
reduction of debt levels into the future. This amount should be sufficient to cover for
Greece’s repayment obligations over two years. The amount of treasury bills maturing in
the year 2011 is €8.8bn and €9.2bn if all of the bills maturing in 2010 are refinanced. As
for maturing bonds and interest payments for the years 2011 and 2012, they are
separated into €40.5bn and €41.6bn, respectively. The budget deficit plan passed by the
Greek parliament on December 23rd is €17bn for the year 2011 (about 7.4% of GDP). In
total, this amounts to €108.3bn of financing need for the next two years, excluding the
budget deficit of the year 2012. There is some risks to the funds allocation for Greece
should government spending gets out of hand. However, given that political pressure
from Greece’s neighbors would be substantial, the funds allocated should be sufficient for
the next two years.
Let’s now take a look at the other three troubled economies – Ireland, Spain, and
Portugal. Below is the amount of debt repayment burden plus financing needs from
Treasury bill rollovers and budget deficit borrowing. The total sum of financing
requirement for the three governments comes up to about €313.0bn in the year 2011 and
€155.1bn in the year 2012. Assuming that the three governments do not borrow from the
market in the next two years, the EFSF should, by itself, be able to cover for all the
required funds. However, the numbers here are based on many assumptions, including
the halving of budget deficits in the year 2012 from 2011 and that the troubled
governments remain within the PIGS group. In any case, the overall burden of the
governments is immense, as indicated by the financing needs measured against annual
nominal GDP.
Table 3. Government debt repayment burden in 2011 unit: billion of euros
Bond Interest
Deficit Treasury bills Total Grand total
principal payment
Spain 92.7 45.1 18.7 76.9 233.4
Ireland 19.3 4.5 4.2 6.0 34.0 313.0
Portugal 13.3 9.5 4.7 18.1 45.6
% of nominal GDP
Spain 8.8 4.3 1.8 7.3 22.2
Average
Ireland 12.1 2.8 2.6 3.8 21.3
23.5%
Portugal 7.9 5.7 2.8 10.8 27.1
Government debt repayment burden in 2012 unit: billion of euros
Deficit
Bond Interest
(assuming ½ Treasury bills Total Grand total
principal payment
of 2011)
Spain 46.4 46.4 16.6 6.9 116.3
Ireland 9.7 5.6 4.0 0 19.3 155.1
Portugal 6.7 8.5 4.3 0 19.5
% of nominal GDP
Spain 4.4 4.40 1.58 0.65 11.03
Average
Ireland 6.1 3.51 2.51 - 12.11
11.6%
Portugal 3.9 5.06 2.56 - 11.52
Source: European Commission ( May forecasts), Bloomberg, nominal deficits are approximated using nominal GDP in 2009
Estimations exclude Ireland’s injection of capital into its banking sector
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5. Fig 3. Financing needs in 2011 - 2012
billion euros
350
300
250
200
150
100
50
0
2011 2012
Spain Ireland Portugal
Source: European Commission, Bloomberg, KBank
Liquidity vs. solvency problems
The eurozone debt problem would take many years to solve and its impacts on global
financial market would have to be separated into issues of liquidity concerns or solvency
concerns. Liquidity concerns involve the ability of the government to make timely
payments of their immediate obligations, including maturing bonds and due interest
payments. Liquidity concerns could be potentially lessened with the help from the EU
emergency aid packages as well as the governments’ demonstration of a believable
economic recovery and growth going forward. As for the longer-term solvency concerns,
further analysis is needed to determine the ability of the government to repay its debts
after the aid packages expire. These include concerns for possibility of eventual default
risks and member country’s exit from the euro zone and currency devaluation.
Table 4. Impacts to the euro-area due to liquidity and solvency conditions of eurozone governments
Issues Impacts
- Euro currency will weaken and governments have to tap into the
Financing of maturing debts in the funding of emergency packages
near-term
- Raises the problem of moral hazard and leads investors to
demand more details of other potential troubled governments
- Governments are forced to borrow at higher costs, exacerbating
Liquidity
their debt problems
Refinancing is costly as markets - ECB would come under pressure as the purchaser of eurozone’s
drive sovereign bond yields higher sovereign bonds who tries to keep bond yields low
- Private sector will have to bare higher costs of borrowing as well
as the reference
- one announcement of default by a member of the eurozone can
send a ripple-effect across the region that could lead to investors’
panic
Ability of government to generate
sufficient tax revenues to pay for
Solvency long-term obligations and - questions are likely to emerge with regards to the effectiveness
eventually bring down debt-to- of cooperation among eurozone (and also EU) members in
GDP ratio emergency situations
- the stability of the euro system and the credibility of the ECB
would be at risk as well
Source: KBank
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6. For both of the concerns, there is a need for governments to ensure trustworthy efforts in
debt and deficits reduction going forward. Once again, we iterate that this sticking to
plans would be difficult across Europe, given the weak economies, higher borrowing
costs, “piggy-backing” of some economies by the others, and limited adjustments in the
value of the euro. The most obvious evidence of why the market continues to have
mistrusts in the governments came from historical experience. From past perspective,
countries with more severe debt problem were seemingly less discipline in term of
keeping budget deficit under 3% of nominal GDP. Hence, it is logical for investors to
doubt the success of the austerity plans of these economies as well as the government’s
commitment to keep to their promises. Hence, we expect that the euro would continue to
fluctuate in value against other major currencies, as it provides a mechanism for the
market to cross-check the progress made by debt-laden economies.
Fig 4. Historical budget deficit/GDP ratios Fig 5. Historical budget deficit/GDP ratios
% of GDP % of GDP
4 6
2 4
2
0 0
-2 -2
-4
-4
-6
-6 -8
-8 Euro area (16) European Union (27) -10
Germany France -12 Euro area (16) Italy Portugal
-10 -14
United Kingdom Ireland Greece Spain
-12 -16
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Eurostat, KBank Source: Eurostat, KBank
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8. Disclaimer
For private circulation only. The foregoing is for informational purposes only and not to be considered as an offer to buy or
sell, or a solicitation of an offer to buy or sell any security. Although the information herein was obtained from sources we
believe to be reliable, we do not guarantee its accuracy nor do we assume responsibility for any error or mistake contained
herein. Further information on the securities referred to herein may be obtained upon request.
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