Eurozone Debt Resolution

In an effort to defend the European economy, banks have agreed to accept haircuts of 50% on Greek debt. EU leaders also agreed to expand the firepower of the European Financial Stability Facility, to around EUR 1 trillion. With the plans broadly in line with expectations, market participants attributed Thursday's sharp rally to relief that an agreement had finally been reached, as there had been fears discussions could remain ongoing.

Gains were across the board, but the banking sector, which has been hit hard recently due to its exposure to peripheral European debt, was the standout performer. Under the new measures announced, banks will be made to raise their core tier one capital ratio to 9%, leading to around EUR100 billion in additional capital for about 70 banks.

This deal will reduce Greece’s debt to GDP ratio from 180% to 120%; however the economy has already contracted by about 10% in the past 2 years and will come under further pressure given the austerity cuts being implemented and the country’s inability to compete in terms of its exports with its European neighbours. For the Greeks to get on a more sustainable footing, bondholders will eventually be forced to accept haircuts of at least 60% to 70% in order to reduce its debt to GDP ratio to a level that will be sustainable.

Markets have accepted the recent move positively, however most analysts expect to see more detail on the Eurozone proposals. This will be presented in the G20 meeting in November which will be hosted by Sarkozy. Bearing in mind what he will deliver will bolster chances of him being reelected in the 2012 presidential election, we believe he is more than determined to deliver a sustainable and comprehensive response in order to recapitalize European banks and present a plan to accelerate economic growth in the Eurozone.

On October 17, Moody’s reported that France’s AAA credit rating is under pressure. which was then followed by a report four days later by Standard & Poor’s mentioning France was among the euro-region that might be downgraded in a stressed cased economic scenario.

Expecting growth to contract to about 1% next year and to protect France’s AAA rating, Sarkozy plans to have up to EUR 8 billion in additional budget cuts. In a recent interview, Sarkozy said the French economy will expand less than the 1.75% his government forecast in August. To compensate for less tax revenue, he is expected to announce budget cuts of between EUR 6 billion and EUR 8 billion and is also considering some tax increases.

In the short term, haircuts, budget cuts and tax increases may seem improper, however going forward, we believe with the determination currently presented by the leaders, problems that may have seemed unsolvable are looking less gloomy. As mentioned in our previous outlook, we are now beginning to see the turmoil abating. We look forward to a more detailed plan in the G20 summit, which will then further enhance global market performance.