Deutsche Bank, Societe Generale, and Banco Santander are but three banks in a long list of prominent banks that are included in the soon to be reported stress tests of the European banking sector. The market is eagerly awaiting the results to be published on July 23, which will cover 91 financial institutions in total, but we have already been offered bits of information about the test settings. And from the small amount of information that has been given to us, we expect the results to provide that same optimistic view of the sector that the US stress tests showed a year ago. Even the adverse scenario is much too rosy for our liking. No major haircuts on sovereign debt, no sharp economic contraction, and renewed market turmoil is only stressed to the extent we saw in May. So why do we expect the stress tests to be a walk in the park for most banks?
For starters, the stress tests will likely only stress sovereign debt to a minor degree. That is to say that the Eurozone is conducting a range of tests that downplay exactly the scenario that has spooked the market the most in 2010. The word on the street suggests that a 17 percent haircut on Greek debt is included in the tests, but the market is already trading much lower than that. The Committee of European Banking Supervisors (CEBS), which conducts these tests, could therefore very well underestimate the impact of a sovereign default even though the Greek 10year bond is already down to 76 cents on the euro - a yield on the wrong side of 10 percent - and credit default swaps pointing to a high probability of default. And Greece is not alone. Other countries sovereign debt - including the other PIIGS countries - will most likely only be stressed in scenarios where small haircuts are taken.
All of this comes at a time where we learn that Greece is allegedly already restructuring some of its debt. The hospital system is supposedly in the process of restructuring its debt; so far with a 19 percent haircut to boot. And this is not some secret operation, but is rather explicitly stated in a joint release in June by the Greek Ministry of Health and Social Welfare and the Ministry of Finance. This is the Greek state's own calculation showing in black and white that its hospital system's old debt is not worth what was previously thought. Add to this that the 19 percent haircut would probably have been much harsher had the market had a say. Indeed, creditors are said to have not accepted the haircut yet while market participants expect the debt to trade much lower. So the stress tests will most likely downplay a scenario that is to some extent already occurring.
We are also told that the adverse scenario will be modelled as a twoyear 3 percentage point deviation from the European Commission's GDP forecast, and while that is a relatively steep drop in economic activity, we need more information about key statistics such as unemployment and prices. And let's not forget that it was only two years ago that the European Commission said the following in its Economic Forecast (Spring 2008) publication: "Overall, compared with the autumn 2007 forecast, GDP growth for the EU has been revised down by about 1/2 pp. for both this year and next, to 2.0% in 2008 and 1.8% in 2009 (1.7% and 1.5%, respectively, in the euro area)."
So two years ago we were told that growth would be 1.7 percent in 2008 and 1.5 percent in 2009. But what has happened since? GDP increased 0.45 percent in 2008 but declined 4.1 percent in 2009. That is an average deviation of 3.4 percent and while the Great Recession was no ordinary recession, it underlines the necessity of incorporating precisely such truly adverse outcomes. It is also problematic that any adversity is only expected to last for two years. If we do not rid the system of debt, a protracted period of weak growth that will last much longer than just two years is a very real possibility.
The European Commission's newest forecasts aim for 1 percent and 1.5 percent GDP growth in 2010 and 2011, respectively. So the adverse - mind you, this is not the baseline - scenario is dealing with a situation where GDP declines 2 percent in 2010 and 1.5 percent in 2011. The first quarter of 2010 saw a quarteronquarter increase of 0.8 percent annualized in GDP in the Eurozone. Of this, 4.1 percent was due to changes to inventories - and hence just a shortterm contribution - while households and governments contributed -0.4 and 0 percent, respectively.
We have an overleveraged consumer unable to spend at previous levels and governments in the process of implementing strict austerity measures which will drag down growth, and yet the adverse scenario calls for rosier growth than we have just experienced during the recent global recession and insignificant sovereign debt restructuring. When the results are published on July 23 the stress test settings better be harsh enough to convince the market of their worth otherwise sentiment could quickly sour in the Eurozone and the entire operation will look like a shell game put in place to buy some time.
Mads Koefoed
Mads is a Market Strategist and his role is to concentrate on macroeconomic topics and develop and maintain Saxo Bank's macroeconomic models based on econometrics.
Mads Koefoed has been part of the Strategy team since May 2009. Mads publishes comments and analysis on macroeconomic topics and is responsible for the Bank's macroeconomic models. Mads has a master's degree in economics (cand.polit.) from The University of Copenhagen, where his primary focus was finance and econometrics. Prior to joining Saxo Bank Mads worked for Danske Capital for two years.
For starters, the stress tests will likely only stress sovereign debt to a minor degree. That is to say that the Eurozone is conducting a range of tests that downplay exactly the scenario that has spooked the market the most in 2010. The word on the street suggests that a 17 percent haircut on Greek debt is included in the tests, but the market is already trading much lower than that. The Committee of European Banking Supervisors (CEBS), which conducts these tests, could therefore very well underestimate the impact of a sovereign default even though the Greek 10year bond is already down to 76 cents on the euro - a yield on the wrong side of 10 percent - and credit default swaps pointing to a high probability of default. And Greece is not alone. Other countries sovereign debt - including the other PIIGS countries - will most likely only be stressed in scenarios where small haircuts are taken.
All of this comes at a time where we learn that Greece is allegedly already restructuring some of its debt. The hospital system is supposedly in the process of restructuring its debt; so far with a 19 percent haircut to boot. And this is not some secret operation, but is rather explicitly stated in a joint release in June by the Greek Ministry of Health and Social Welfare and the Ministry of Finance. This is the Greek state's own calculation showing in black and white that its hospital system's old debt is not worth what was previously thought. Add to this that the 19 percent haircut would probably have been much harsher had the market had a say. Indeed, creditors are said to have not accepted the haircut yet while market participants expect the debt to trade much lower. So the stress tests will most likely downplay a scenario that is to some extent already occurring.
We are also told that the adverse scenario will be modelled as a twoyear 3 percentage point deviation from the European Commission's GDP forecast, and while that is a relatively steep drop in economic activity, we need more information about key statistics such as unemployment and prices. And let's not forget that it was only two years ago that the European Commission said the following in its Economic Forecast (Spring 2008) publication: "Overall, compared with the autumn 2007 forecast, GDP growth for the EU has been revised down by about 1/2 pp. for both this year and next, to 2.0% in 2008 and 1.8% in 2009 (1.7% and 1.5%, respectively, in the euro area)."
So two years ago we were told that growth would be 1.7 percent in 2008 and 1.5 percent in 2009. But what has happened since? GDP increased 0.45 percent in 2008 but declined 4.1 percent in 2009. That is an average deviation of 3.4 percent and while the Great Recession was no ordinary recession, it underlines the necessity of incorporating precisely such truly adverse outcomes. It is also problematic that any adversity is only expected to last for two years. If we do not rid the system of debt, a protracted period of weak growth that will last much longer than just two years is a very real possibility.
The European Commission's newest forecasts aim for 1 percent and 1.5 percent GDP growth in 2010 and 2011, respectively. So the adverse - mind you, this is not the baseline - scenario is dealing with a situation where GDP declines 2 percent in 2010 and 1.5 percent in 2011. The first quarter of 2010 saw a quarteronquarter increase of 0.8 percent annualized in GDP in the Eurozone. Of this, 4.1 percent was due to changes to inventories - and hence just a shortterm contribution - while households and governments contributed -0.4 and 0 percent, respectively.
We have an overleveraged consumer unable to spend at previous levels and governments in the process of implementing strict austerity measures which will drag down growth, and yet the adverse scenario calls for rosier growth than we have just experienced during the recent global recession and insignificant sovereign debt restructuring. When the results are published on July 23 the stress test settings better be harsh enough to convince the market of their worth otherwise sentiment could quickly sour in the Eurozone and the entire operation will look like a shell game put in place to buy some time.
Mads Koefoed
Mads is a Market Strategist and his role is to concentrate on macroeconomic topics and develop and maintain Saxo Bank's macroeconomic models based on econometrics.
Mads Koefoed has been part of the Strategy team since May 2009. Mads publishes comments and analysis on macroeconomic topics and is responsible for the Bank's macroeconomic models. Mads has a master's degree in economics (cand.polit.) from The University of Copenhagen, where his primary focus was finance and econometrics. Prior to joining Saxo Bank Mads worked for Danske Capital for two years.
