Markets to remain defensive, says DBS

As conditions in Europe seem likely to get worse before they get better, any increase in short-to-intermediate maturity swap rates in Asia in our view still represents an opportunity to establish tactical receiving positions. The crisis in Europe is no longer just about Greece and conditions in the EMU’s sovereign debt markets but about the European financial system as a whole. Markets don’t believe that the banking system is capitalized well enough to deal with potentially highly disruptive events, like a Greek default, should it come to that in the coming months. That this is the case despite the fact that the ECB is providing unlimited liquidity against eligible collateral through its liquidity-providing operation shows how serious the situation is.

As market concerns center on bank capital levels, a certain degree of capital infusion - even in the core banking system - will probably now be necessary to restore market confidence. This will likely involve the European Financial Stability Facility (EFSF), after euro-area leaders agreed on July 21 to let the EFSF help finance the recapitalization of financial institutions and intervene in the secondary markets. This still needs ratification, but essentially it means that the risk-taking capabilities of the EFSF have been expanded considerably, making it more powerful to fight the crisis by providing risk capital as the fiscal agent of the euro-area governments. The market now needs to know that - and how - the new powers will be put to use. A new credible restructuring solution for Greece within the constraints of the evolving institutional framework needs to be announced and troubled assets on bank balance sheets dealt with soon.

At this point, it is clear that strategies to buy time will no longer work. The political and institutional issues at the heart of this crisis have been revealed and will now have to be addressed. The uncertainties, and hence the real problems, don’t lie with Greece’s budget deficit and unsustainable debt, but with the lack of a clear strategy from the euro-area governments to deal with it. From the market’s point of view, Greece will cease to be a problem, once there is a credible approach to restructure its debt in a meaningful way. The problem is that this restructuring, in one way or the other, has to be paid for by the euro-area governments with money from European tax payers. This creates a fairly hard constraint on how much money politicians, especially in Germany, are willing to commit – essentially no more than the EUR440bn that have already been allocated to the EFSF for all emergency loans. Depending on how the money is used (together with funds from the IMF and ECB), it might actually be enough, but the politicians have to tell us now what exactly the crisis-fighting strategy is.

Where does this leave us? The restructuring of Greek debt, the stabilization of government bond markets and the recapitalization of financial institutions now all look inevitable to many in the market to put an end to the current crisis. Therefore, until we see measures from politicians that credibly address all three issues, we should expect markets to remain defensive. This is especially so, as the size of the EFSF remains limited and the new powers don’t make it an effective crisis response mechanism. The authority to deploy EFSF funds remains with the governments of the member countries and that will make it slow and very unpredictable.