Saturday, March 26, 2011

Euro Slumps Following EUnited Statemmit Conclusion and Amidst Portugal Worries

*EU Summit shows divisions…*

The EU Summit has came and went, and all the hoopla about a
comprehensive solution to the sovereign debt crisis may have been
misguided. We continue on a similar path of status quo.

What was accomplished was to finalize the details of how the European
Stability Mechanism would be funded after Germany opened up a rift by
claiming the accord agreed upon by finance ministers to start the week
was not acceptable as it caused too much payments up front by Germany.

The ESM, which will take effect in 2013 – after the current European
Financial Stability Facility or EFSF runs its course – will have a
total capital base of 700 billion euros, which will allow it to have a
lending capacity of 500 billion euros and an AAA rating. Of that
total, cash contributions or guarantees will total 80 billion euros,
while the rest of the 620 billion euros will be callable capital.

The funds paid-in capital as of 2013 was cut to 16 billion euros from
the finance ministers originally stated 40 billion euros, on
Germany's insistence and that made up the bulk of the debate during
the EU Summit. After the initial 16 billion euros, countries will make
further 16 billion payments per year over five years. Under the terms
of the ESM deal, eurozone countries agreed that they would speed up
their financial backing of the fund if a large country needed a
bail-out and there was not enough cash in the fund to cover the size
of the rescue.

The sudden change by Germany angered other EU members, but since they
are footing the larger part of the bill for the bail out fund Germany
has the most leverage in having its conditions met.

With tensions high, it undercut the perception that EU leaders were
unified in their stance on tackling the sovereign debt situation.

Also, details on increasing the lending capability of the EFSF was
delayed till June, as there continues to be uncertainty about how to
best go about it. While the fund has enough to cover a potential
Portugal bailout, the news could still upset markets that EU leaders
could not come together to tie up the loose ends needed to put the
sovereign debt crisis to rest.

*…while Portugal's fiscal situation deteriorates.*

Standard & Poor's downgraded Portugal's long-term credit rating by
two notches, from A- to BBB, bringing the country's credit standing
closer to junk status.

The political uncertainty in the country after the failed austerity
vote and resignation of the Prime Minister can damage market
confidence, pushing up financing costs and increasing the likelihood
that Portugal would need a bailout. The interest rate that Portugal
needs to pay to sell bonds shot up across the board, and these yields
were already at levels that the government considers unsustainable.

Portugal has a total of 9.5 billion coming due in April and June, and
while it may meet the redemption on the April debt, its unlikely that
it can do so for the June batch. A bailout – that looks more and
more inevitable – may wait till June though as the country needs to
first figure out its political situation.

Here is a look at redemptions coming due for Portugal in the coming

From Financial Times: " Ms Zhang said that despite the rejection of
European Commission-backed austerity measures by Portugal's
opposition parties, reduced investor appetite for Portuguese debt
meant the next government would have no alternative but to adopt
similar reforms.

European Union leaders meeting in Brussels on Thursday urged
Portugal's political parties to adopt new austerity measures and
economic reforms as proof of their commitment to fiscal

In a blow to market confidence, a major European clearinghouse said
Portuguese government bonds will no longer be eligible as collateral
in certain transactions, which weighed on the EUR.

From MarketWatch: "Clearing house LCH.Clearnet on Friday said
Portuguese government bonds will no longer be eligible for delivery in
any of its RepoClear baskets effective Monday. The move follows
ratings agency Standard & Poor's decision to downgrade Portugal's
credit rating to BBB. Until the downgrade, Portuguese bonds had been
eligible for inclusion in the firm's single-A basket, LCH.Clearnet
said in a notice on its website."

The Euro which had managed to shrug off most of the negative news
finally succumbed to selling pressure around the mid-point of the NY
session. The EUR/USD fell below 1.40, retesting its lows from
yesterday's session.

The lack of unity at the EU summit amidst the very real problems of
Portugal show us that the sovereign debt situation will continue to
act as a downward force on the Euro even as interest rate expectations
favor it.

The market's focus will now turn to Spain, which is undergoing a
restructuring of its banking sector. If Spain's banks shows weakness
and are unable to re-capitalize it can have damaging effects on the


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