Stock Markets Put Faith in Policymakers’ Resolve

European stocks and the euro continued their bullish run, as the Euro Stoxx 50 benchmark equity index rallied 3.8 percent without any major interruptions to close at 2,355 for the week. 

The euro gained 3.41 percent to close at $1.38, a gain even more impressive as usually currencies do not move as much as equities.

Bank Recapitalization Plan Boost Markets

The week started off with comments from German Chancellor Angela Merkel and French President Nicolas Sarkozy, as both leaders reaffirmed their commitment to stabilize the eurozone and solve the underlying economic problems. "We are very conscious that France and Germany have a particular responsibility for stabilizing the euro," said Sarkozy. Merkel reaffirmed by adding that a bank recapitalization plan would help stabilize the current situation: "We are determined to do the necessary to secure the recapitalization of our banks." 

They did not, however, cite any details but pledged to release a detailed and comprehensive solution by the end of the G-20 summit in Cannes, which starts on the Oct. 23. High leverage and the low equity capital structure of the European banking system are widely perceived to be blocking elements to a lasting solution of the sovereign crisis. These comments by Merkel and Sarkozy did reassure the markets, which continued on their positive stride.

Cautious market commentators pointed out that the amount of money needed to recapitalize the European banking sector might be very large and it is as of yet unclear where the money will come from. Analysts from Credit Suisse estimate the total amount needed under a new stress test scenario might be up to 400 billion euros (US$553 billion), which is slightly less than the U.S. TARP program, but represents roughly 75 percent of the total market capitalization of the European banking sector. 

Capital raisings at depressed share prices are problematic, as an increased number of shares need to be sold to meet the required amount in euros. As more shares are sold, the earnings for each share become less, a process known as dilution. If the earnings per share become less for existing shareholders, the current market price will have to decrease further in order to match the existing valuation. This might be the reason why the Financial Times cited bank insiders saying that they would rather liquidate assets to improve capital ratios.

More Banks Nationalized as ECB Torpedoes Dexia Bailout

That there is a need for a pan European solution for bank capital shortfalls was made clear after the announcement that Danish Max Bank and Greek Proton Bank were handed over to their respective regulators. In addition, the previously announced details of the joint takeover of Dexia by the French and Belgian government got a hit by the European Central Bank (ECB), which suggested that the current format was against the euro charter. 

Belgium would buy the Belgian consumer bank for 4 billion euros (US$5.5 billion) and the French and Belgian governments would extend guarantees for 120 billion euros (US$166 billion) for the bonds of the holding company that remains outstanding. The ECB however, issued a statement on Oct. 13 in which it directly advised Belgium not to extend guarantees for too long a timeframe. Those support measures could disrupt the current monetary policy stance of the central bank. 

In addition, because the Dexia guarantees will last 20 years in some cases, they might be against EU guidelines for support, which is supposed to be temporary in nature. There have been no new developments since this statement, but the ECB can only give advice and has no authority to stop the current bailout plan.

EFSF Complete as Slovaks Approve but Spain Gets Downgraded

Another positive for the market was the final completion of the European Financial and Stability Facility (EFSF), which is now formally ratified after the Slovak Parliament gave its consent on Oct. 13 as the last country to approve this facility. 

This process, however, illustrates the sometimes-difficult approval process in the EU. The EFSF was decided on July 21 by the finance ministers of the eurozone, the 17 countries which have the euro as their common currency. The Slovak government fell over this issue on Oct. 11 and only a repeat vote could guarantee success. Slovakia is the smallest member of the eurozone and has the smallest contribution to the EFSF. Nonetheless, its vote was crucial, as the so-called bailout fund would have no legitimacy if it is not ratified by all 17 members.

The EFSF now has the capacity to issue 440 billion euros (US$609 billion) in bonds and use those funds for troubled countries or alternatively to inject capital into ailing banks directly. The bonds the EFSF issues are over guaranteed by the 17 members of the eurozone, which gives the facility a AAA rating. 

As a country that long since lost its AAA rating, Spain got downgraded to AA- from AA by Standard & Poor’s (S&P) which cited, “Spain’s uncertain growth prospects in light of the private sector’s need to access fresh external financing to roll over high levels of external debt amid rising funding costs and a challenging external environment.”