EU's seperation of debt, PM baton to boost mkts: Experts

On this edition of Indianomics, CNBC-TV18's banking editor Latha Venkatesh discusses with Hitendra Dave of HSBC and Paul Mortimer-Lee, economist from BNP Paribas various perspectives on Europe, the global markets and the Indian econnomy.

Below is an edited transcript of the discussion on CNBC-TV18. Also watch the accompanying video. Q: Can you tell us what will be the exact impact of capitalising the banks directly and not through the sovereigns? Is it not possible that if these banks buy debt of their sovereigns, they will continue to need capital from the ESM? So are you differentiating or wrenching the banking problem from the sovereign problem? Mortimer-Lee: It is the interrelationship between the two that matters. The banks buy the debt to prop up the sovereign while the Spanish issues debt to try and prop up the banks. You have to break that interrelationship which is a vicious spiral. The EU announcement is a very good measure that the market expected. So this is a step in the right direction. Q: Will this create a problem if debt gets downgraded and increasing dollops of capital have to be given to banks? How long will you support the sovereign from the general pool, the ESM and the EFSF? Mortimer-Lee: To the extent that the banks are holding the government debt in their trading books. If they are holding it in their banking books, they don't have to mark it to market, so downgrades don't directly affect their capital.
The real damage to the capital of Spanish banks was the lending that went on during the Spanish housing boom and that is the key threat. That is why they need more capital now to provision against those losses which are not materialising at the moment.
But that is likely to be provisioned against in the next few years and this will bolster the Spanish banks. How much of Spanish debt will be allowed to be bough when the ESM is the shareholder, I don't know .
At the moment, the Spanish central bank as supervisor can strong-arm the sovereign to buy too much Spanish debt. If the ESM is the shareholder, they maybe use such strong-arm on tactics and infact they may buy less Spanish debt than they would have done otherwise.
_PAGEBREAK_ Q: So has some temporary peace and stability has returned to the European markets? Do you sense that the rally on Friday could have little more leg in the coming week or weeks? Mortimer-Lee: To be honest, the rally on Friday erred quite a lot on the fact that some while some investors were short, others were neutral. This was better news than the market had expected overall. So, that’s why there is a rally. There may be a rally in the early part of next week as investors anticipate the ECB may take more action.
But we are a very long way away from solving the fiscal problems and that’s why this summit really did nothing on the fiscal front. It asked the Rompoy Commission to come up with some proposals at the end of the year.
But this is the real difficult stuff, giving up sovereignty about your fiscal position for some people and mutualising debt for the Germans, a massively difficult problem. To be honest this summit they dealt that problem. Q: Do you think we are going to see the euro stabilise for a bit? How are you looking at the currency markets?
Dave: Most market participants viewed EU summit with very low expectations. This is the 19th summit and there have been had a lot of false starts. The market reacted by short-covering and position-building.
But the details are yet to emerge- the timeframe needed for the European central bank to establish a common supervisory framework and the conditions under which the EFSF and ESM can buy bonds directly.
Overall, the measures appears to be reasonably good. Though short covering does not explain all these details, it is clear that the measure is the first significant step towards a potential genuine fiscal compact.
So, over the next week or so will emerge statements by the ECB after its policy announcement.  For the time being I think it’s fair to say that the momentum could continue for the immediate period. Q: Will the ECB buy bonds this time around? Mortimer-Lee: No. One, the ECB is quite reluctant to buy bonds. Two, one of the agreements at the summit was that it has to be done by someone. It has been decided that the EFSF or EMF will buy bonds. The ECB clearly sees that the responsibility of supporting the bond markets belongs to the government and it does not want to monetise the debt.
The ECB does not want to have a massive fund for two reasons- one, they don't want to monetise the debt and the second reason, is that if they buy too much, the Italians and the Spanish will give up trying. So there has got to be enough money to handle the crisis, but not to make people relax.
_PAGEBREAK_ Q: With the ESM and the EFSF being able to buy bonds or could buying bonds be a positive for the markets? Do you think there are procedures or approvals required before they actually start buying? Mortimer-Lee: They could start buying, but they need governments to make an application to buy with some conditions. But the EU leaders said that the buying would have to be flexible and efficient. Q: Is the fact that the EFSF and ESM will buy bonds, be a strong positive for the markets? Dave: That goes without saying. Anything that makes a bond market stable will affect the forex, equity markets and the commodity markets. But though this summit has announced substantial measures it has not addressed core issues. Q: How long will it be before the ECB assumes some banking regulatory powers? Mortimer-Lee: No, I think that's going to be next year. Q: What would you expect from Draghi? Mortimer-Lee: Well, he's got the cut right. He had to cut rates as there was a body of opinion that already wanted to cut rates because of the weakness of the economy and to reward politicians for taking significant steps and making promises with regards to fiscal and other integration measures.
The fact that the markets have rallied mean that he doesn’t have cut rates by 50. I don't think he will buy bonds, but the key question is whether he implements any long-term repos to enable the Spanish banks to borrow to buy more Spanish debt. Q: Just one more word on the European summit, does this stem the wrought in the rupee? Dave: As RBI alluded to recently, I think the rupee's weakness in 2011 was almost significantly attributed to the global risk.
In 2012, especially after the Budget, the market realised the weakness was due to an interplay of domestic and global factors. But overall, there is a big correction in the offing on the rupee as it has become a domestic challenge.
If the international markets continue to be positive mood, it will reduce the pressure from the overseas market. So, stability in the rupee will depend if the market feels the EU summit measures to be substantive. Q: Do you think there will be some corrective measures and the worst is behind us? Dave: I think you are absolutely right. Over the last one month, there has been a surge in the levels of optimism among financial-market participants. I think there is far greater hope and vigour of a possible review of some of the fiscal policies.
The statement made by the Prime Minister on his return from the G20 meeting according top priority to fiscal and current account management will unleash a significant dose of positive sentiment in the market.