This week’s report examines:
Looking ahead:
Monday 9 to Wednesday 11 January – Cypriot reunification negotiations
Thursday 12 January – Minutes of 9 December ECB Governing Council meeting
Thursday 12 January – Euro Working Group meets to discuss Greece
Friday 13 January 2017 – DBRS Sovereign Review of Italy, and the consequences of a downgrade for Italian banks
Week in review:
Adoption of updated Basel III standards delayed following disagreement
UK Government appoints new EU Ambassador following Rogers resignation
French Presidential Candidates begin to come under greater policy scrutiny
A. Looking Ahead
Monday 9 to Wednesday 11 January – Cypriot reunification negotiations
The major overarching political issue in Cyprus continues to be the de-facto partition of the island into the Greek speaking Republic of Cyprus and Turkish speaking Northern Cyprus. The Republic of Cyprus, more commonly referred to simply as Cyprus, enjoys international recognition from all countries except Turkey. It is a member of the European Union, and recently exited a bailout. Northern Cyprus is recognised only by Turkey. There is a significant long-term Turkish military presence in the north with an estimated 30,000 soldiers. Should negotiations succeed this week it will pave the way for simultaneous referendums in both parts of the island which, if approved, would end a 43-year standoff and bring Turkish Cypriots into the European Union.
Thursday 12 January 2017 – Minutes of 9 December ECB Governing Council meeting
The rationale behind the ECB’s decision to extend its QE programme by 9 months at a slower pace should become clearer on Thursday when the minutes of that meeting are released. Analysts will look for any divergence from the minutes of the 20 October 2016 ECB Governing Council monetary policy meeting which stated that “inflation continued to be predicated on the prevailing very favourable financing conditions, which to a large extent reflected the current accommodative monetary policy stance.”
This will be of particular interest in the context of the latest inflation numbers from Eurostat which showed headline inflation at 1.1% in December 2016, up from 0.6% in November 2016. German inflation levels also rose at their highest rate in three years, hitting 1.7% in December 2016 from 0.7% in November. Despite this, core inflation levels remain low and have not risen significantly since the ECB’s QE program was launched. Core inflation stood at 1% in March 2016 and since then has remained in the range of 0.7 – 0.9%. At the 20 October meeting both Benoit Coeuré and Peter Praet expressed concern that “underlying inflation had still not shown clear signs of an upward trend.” This remains the case despite the pickup in headline inflation and we would expect the minutes of the December meeting to once again reflect those concerns.
Thursday 12 January 2017 – Euro Working Group meets to discuss Greece
The Euro Working Group (finance ministry officials from Eurozone Member States) will meet on Thursday to take stock of negotiations between Greece and its lenders. Unsurprisingly, there has been little progress since early December given that officials on all sides enjoyed a lengthy Christmas break.
It is our understanding that all sides expect Greece’s second review to be completed in February, in time for the Eurogroup meeting on 20 February 2017. Although it would be technically possible for the review to be completed ahead of the 26 January 2017 Eurogroup, it is expected that the IMF position will be clearer in February by which point President Trump will have been inaugurated and had time to bed in.
Athens is ready to go some way to meet IMF demands by outlining the extra steps it will take should Greece fail to get to a primary surplus of 1.5% of GDP after 2018. While the IMF is insistent that Greece should legislate these measures, Athens has said that it could instead adopt a safeguard which could automatically enact additional measures post 2018. Greece’s European creditors are of the view that what has already been agreed should be enough for Athens to reach its targets but the IMF is being more stringent.
Should agreement be reached in advance of the 20 February 2017 Eurogroup, the Greek government will be hopeful that the ECB can complete its debt sustainability analysis in time to decide on the inclusion of Greek bonds in the QE programme at the 27 April 2017 Governing Council meeting.
Although we consider the above timeline to be plausible, a number of developments which suggest the government is planning a snap election should be noted. Tsipras’s pre-Christmas gift to pensioners, which caused ructions with the lenders, was clearly designed to shore up support among that key demographic. Secondly on 6 January 2017 the government announced the hiring of 1,666 people for full-time employment in public hospitals. This has been a typical pre-election tactic of several Greek governments.
On current polling however, it would not be in the government’s interest to call a snap election. SYRIZA currently trails New Democracy by more than 5%. We think that the government moves are better understood as positioning, in case of a complete breakdown of negotiations with creditors – an eventuality that we consider to be unlikely. Nevertheless, the government needs to approach these negotiations with a sense of urgency as the window for inclusion in the QE programme will not remain open indefinitely.
Friday 13 January 2017 – DBRS Sovereign Review for Italy
We have previously commented on DBRS, the least prominent of the four ratings agencies used by the ECB, in the context of its sovereign ratings for Portugal and the consequences for QE participation. In the case of Portugal, DBRS takes a more lenient view of the country’s creditworthiness than the other three rating agencies. The apparent generosity of DBRS when rating southern European countries also extends to Italy:
Italy Credit Ratings:
Moody’s: Baa2 (Negative)
Fitch: BBB+ (Negative)
DBRS: A(low) (Negative)
S&P: BBB- (Stable)
All four ratings agencies used by the ECB maintain Italy at investment grade ratings. The forthcoming DBRS review of Italy does not therefore entail any possibility of Italy being dropped from the ECB QE programme. The risk of the DBRS review of Italy stems from the fact that DBRS is the only of the four ratings agency to have the country at an A rating.
A downgrade from the current rating of A(low), meaning that Italy would have no longer have any top tier investment grades, would increase the haircut that banks in Italy would be subject to when posting Italian government bonds as collateral with the Central Bank. Under ECB rules the haircut attached to fixed coupon government bonds issued by a sovereign with a rating of A- or greater is in the range of 0.5% – 5% dependent on the size of the residual maturity. Debt issued by a sovereign with credit quality in the range of BBB+ to BBB- is subject to a larger haircut. Depending on the residual maturity fixed coupon government bonds are subject to a haircut of 6% – 13%. It has been estimated that, should Italy be downgraded by DBRS, the average haircut on collateral posted by Italian banks would increase from 2.5% to 7.5%.
DBRS last reviewed Italy in August 2016, moving to examine the country outside of its normal calendar due to the level of uncertainty at the time. The decision taken in August was to place Italy under review, with the outlook changed to “negative”. In updates since August DBRS has noted that it will take consideration of a range of factors when making its review decision including:
the impact of the referendum result on the political situation in Italy; the prospects for an amendment of the electoral law and the continuation of structural and institutional reforms; progress nin improving the strength of the Italian banking system; and developments in the real economy and their impact on the trajectory of government debt-to-GDP
Considering the smooth political transition following Renzi’s December resignation, and the willingness of the Gentiloni government to amend the electoral law, the DBRS decision is likely to lean heavily on the state of the banking sector. This much was indicated in a statement given to the FT by Fergus McCormick, co-head of sovereign ratings at DBRS that “the key is whether MPS’s recapitalisation helps restore investor confidence and provides overall assurance to the market that enough has been done. That is very unclear”.
Should DBRS downgrade Italy, it would be a further negative development for the Italian banking sector. It is unlikely that increased collateral haircuts would push any one bank into crisis, although an increase in funding costs would weigh more heavily on smaller lenders of which there are a substantial amount in Italy. It would again highlight the need for widespread action to deal with legacy issues across the Italian banking sector as a whole, both through proactive measures to reduce NPLs and through consolidation of an overcrowded market. It would also suggest that the MPS rescue, details of which still need to be finalised, is viewed as more of a temporary sticking plaster than a solution.
B. Week in review
Adoption of updated Basel III standards delayed following disagreement
On 3 January 2017 it was announced that a planned 8 January 2017 meeting of the Group of Central Bank Governors and Heads of Supervision (GHOS), which oversees the Basel Committee, had been delayed. It had been hoped that the GHOS meeting would allow for agreement to be reached on the finalisation of the Basel III banking regulations.
European Central Banks remain concerned over proposed output floors, and on restrictions on the use of internal risk models. A tightening of both areas is being pushed by American stakeholders.
The Basel Committee has insisted that it does not want to significantly increase overall capital requirements through the introduction of an output floor. European banks maintain that even if the proposals aim to avoid significant capital increases from a global perspective, and with an output floor calibrated at 60%, that it will require substantial capital increases in Europe and particularly in the Nordic countries and the Netherlands. European Banks are particularly exposed vis a vis American banks due to the significant amount of mortgages on their balance sheets.
European stakeholders have consistently stated that they will not be forced into endorsing the proposed new standards. In November 2016 Bundesbank executive board member Andreas Dombret said that “the Bundesbank is not prepared to reach agreement at any price” echoing a September 2016 warning from Valdis Dombrovskis, European Commissioner for Financial Stability, that he would not sign off on any deal that would require significant capital increases for European Banks.
Finalisation is now being targeted for March. This is the second delay to the finalisation process, following an indecisive meeting in Santiago in November 2016. For a solution to be found by then, GHOS may take on more direct involvement in the process of negotiation.
UK Government appoints new EU Ambassador following Rogers resignation
In our report of 4 January 2017 we noted that although the resignation of Ivan Rogers as the British Ambassador to the EU had exposed tensions within the UK establishment, we did not think that the resignation would in itself delay the process of Brexit.
The British Government moved quickly to replace Rogers and on 4 January 2017 appointed Tim Barrow as his replacement. Like Rogers, Barrow is a career civil servant. His appointment will provide continuity, rather than the disruption that could have ensued if an avowed Brexiteer was parachuted into the position.
The appointment of Barrow is an indication that Theresa May wants to maintain as broad a possible pool of expertise and contacts as the UK heads toward Article 50 notification and subsequent Brexit negotiations. The risk is that too many cooks could spoil the broth. We have highlighted how Rogers’ apparent difficulties in presenting his conclusions to Eurosceptics mirrored the absence – to date – of clear political agreement on what Brexit should entail.
Barrow could well encounter the same frustrations as Rogers did in dealing with Eurosceptics. Indeed, although Barrow’s appointment was welcomed by a number of Eurosceptic politicians, it has been reported that civil servants in the Department for Exiting the EU were keen to use Rogers resignation to take greater control of diplomatic interaction with Brussels. The potential for disagreement between UK participants in negotiations could easily be matched by disagreement on the European side, as various stakeholders wrestle for influence. This would serve to further complicate what is already set to be a difficult process.
In an 8 January 2017 television interview Theresa May defended her government against charges of muddled thinking over Brexit. She said that more detail on her government’s strategy will be revealed later in January. May’s statement that Britain would not be able to keep bits of the European Union has been interpreted by commentators and investors as a signal that a hard-Brexit, with full withdrawal from the single market, is more likely. This led to declines in the value of sterling on 9 January.
French Presidential Candidates begin to come under greater policy scrutiny
As the French Presidential Election gradually comes into sight, increasing attention is being paid to the policy proposals of candidates and particularly the front runners Marine Le Pen (Front National) and Francois Fillon (Les Republicains).
In our risk report for 2017 we noted that some of the more extreme policy proposals advanced by the two candidates could alienate voters. In the past week Le Pen has attempted to water down her policy on French Euro Membership. Le Pen has now said that France should leave the single currency, but that a replacement currency could remain tied to a common European Currency Unit (ECU) as had been the case before the Euro was created. One problem with this proposal is that the old ECU no longer exists, having become the Euro. Le Pen’s proposal, such as it is, appears to be a non-starter. As has happened in previous votes where questions of currency have arisen, such as the 2014 Scottish Independence Referendum, voters may be put off by a lack of clarity on what is actually being proposed regarding their cash.
Fillon, meanwhile, has attempted to moderate some of his more radical proposals for privatisation of health care. The effect of this apparent flip-flopping has been a decline for the Republicain candidate in the polls, although in favour of Emmanuel Macron rather than Le Pen.
As set out in our risk report, it is our expectation that Le Pen and Fillon will contest the second round of the Presidential Election, and that Fillon is the strong favourite to prevail overall. As the campaign gets underway, however, candidates will be more closely scrutinised on policy. The effect that this can have, particularly as radical proposals are brought into the open, means that no investors should consider the election result – or even the identity of the final two candidates – to be a fait accompli.
