EU summit leaves important questions unanswered

For the most part, analysts are happy that the summit produced several important new commitments. TD Economics notes that the substantive new plan to address the fiscal crisis “was absolutely critical”, adding, “Had they been unable to reach an agreement, a deeper financial crisis would likely be unfolding.”

However, analysts are also generally worried about the plan’s lack of details, and the implementation risks. Indeed, TD says that investors should ignore the rally in equities and focus on the sovereign bond market reaction. “Italian, Spanish, and Irish yields have been trading only a few basis points below the levels observed yesterday,” it points out.

TD cautions that, even in the very short term, Thursday’s announcements leave some important logistical questions unanswered. “What will happen if come December, Greece misses a few of its original program targets – which in turn would compromise its debt sustainability analysis – and the private sector involvement is not finalized yet? We will be having exactly the same discussion we have been having over the last three months and Greece will once again be facing the risk of a technical default.”

“Our assumptions about how the plan might be implemented raise the possibility that the new proposals may not be adequate to fully address the fiscal and financial challenges facing Europe,” TD says, although it does see it as a step in the right direction.

BMO Capital Markets notes the main steps agreed by European leaders “will take weeks, if not months, to finalize.” Moreover, it says that the plan falls short in a number of areas. “That leaves the region at risk of another flare up perhaps as early as next year, if something unexpected happens (e.g. larger-than-expected fiscal deficits),” it says.

HSBC Bank plc says that it is particularly concerned about the lack of detail on plans to bolster the European bailout fund. It also notes there is uncertainty about the role for the European Central Bank; the effectiveness of the bailout fund bond guarantee scheme and possible unintended consequences in terms of sovereign market liquidity; the potential for rapid commercial bank deleveraging; the conditionality of the plans; and, the ongoing lack of collective fiscal responsibility.

Fitch Ratings stresses that the political and technical complexity of the issues inevitably meant that “a detailed set of proposals was unlikely to emerge”. However, it believes the main elements of the announced policies appropriately target the key causes of the recent intensification of the crisis, and the it views the broad agreement as a positive outcome of the summit.

It says that bolstering the bailout fund’s lending capacity to €1 trillion is a critical first step to enhancing market confidence, but more detail is needed to assess the viability of the two options being considered, particularly their structure, financing sources and implementation.

“Given this level of uncertainty and until the viability of these options can be assessed, Fitch views as critical the role of the ECB in continuing to intervene in the secondary market for euro area sovereign bonds, and ultimately to be ready to act as a lender of last resort to solvent but illiquid sovereigns issuers,” it says.

Fitch also says that Greece will continue to face significant challenges following the proposed debt exchange, amid anemic growth, austerity fatigue, and continuing high debt levels.

“Parallels with the Euro Area summit of 21 July, when a warm afterglow of confidence quickly dissipated, underline the importance of rapid and full implementation of the policy commitments,” Fitch stresses, noting that summit also included commitments to enhance the region’s bailout fund, a new plan for Greece including a debt restructuring agreement, commitments to fiscal discipline and structural reforms, and a strengthening of euro area surveillance and governance.

“Moreover, until there is a broad-based economic recovery across the euro area, progress on reducing government budget deficits and stabilising and then reducing government debt ratios, and structural reforms to enhance competitiveness and long-term potential growth within the euro area, further bouts of financial market volatility appear likely and downward pressure on sovereign ratings will persist,” Fitch concludes.

BMO also stresses that Greece, Ireland, Portugal, Spain and Italy all have to follow through with budget cuts, asset sales, and economic reforms “or recent efforts will have been for nought.” And, France could be included in that list as well, it says, with its AAA credit rating at risk.

“This package should at best mark the beginning of the end of the crisis. At worst it will buy Europe more time to implement economic reforms and strengthen the monetary union before another inevitable crisis flares up,” BMO concludes. “Considering that we remain concerned about Greece, bank recapitalisation appears lacking in size, and the EFSF is not of sufficient size to bail out Italy and/or Spain, the debt troubles will likely linger well into 2012 and perhaps beyond, even if the acute phase of the crisis has passed.”