LONDON (Reuters) - The long and winding process of reforming the European Union takes another step on Monday when the region’s leaders gather for their first 2012 summit with investors desperate for a show of unity on tackling the region’s debt crisis.
Agreement is crucial for European debt markets, which are slugging their way through a heavy first quarter of refinancing. Despite the increased liquidity in financial markets, fears remain that the strong start in global asset markets could be put at risk.
Hope is nonetheless rising that EU leaders are moving towards agreement on the key issues of how much money to put into the bailout funds for debt-ridden countries and the shape and enforcement of budgetary reforms, known as the fiscal compact.
“It seems as though a consensus is building,” said Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management.
Though Poole has no illusion this is going to be agreed at the upcoming leaders meeting, he is hopeful a package of measures could be ready by the next summit in March.
“The fiscal compact, if it’s agreed and if it’s got teeth, should start to give investors a feeling that, if we can get over the current problems, then in the future there’s a mechanism to get over these problems again,” he said.
In the short term the key risks surround Greece and the progress it makes in meeting the conditions required to trigger bailout funds from the EU and International Monetary Fund needed to cover bond redemptions due in March and avoid a messy default.
“For me that aid package is what controls systemic risk,” Mohit Kumar, head of Europe & UK rates strategy at Deutsche Bank said.
“What happens in Greece is important for Greek bondholders but what is more important as far as the rest of Europe is concerned is whether there is a systemic risk of contagion or not,” he said.
Otherwise the huge liquidity injection by the European Central Bank at the end of 2011, the prospect of another big round at the end of February, plus the outlook for a long period of low interest rates and some improving economic data have encouraged optimism among investors.
“The reality is there’s plenty of cash in the system. It’s just not going in the right place,” said Poole.
The MSCI ACWI Index .MIWD00000PUS that is designed to measure the equity market performance of developed and emerging markets is on track to rise by 6 percent in January while 10-year Italian bond yields, an informal bellwether of euro zone risks, were at 5.85 percent on Friday, well below the 7 percent level seen as unsustainable.
One issue that has emerged to threaten the fragile state of investor confidence is Portugal, where the recent downgrade to junk status by Standard and Poor’s saw it drop out of key investor indexes, triggering debt sales and rising yields.
Portugal’s fortunes are fast on the decline, with a Reuters poll of 50 economists finding there is a 70 percent chance that it will require a second EU/IMF bailout at some point.
Portugal has already borrowed 78 billion euros ($102.6 billion) in an EU/IMF deal and began receiving the funds in May but has struggled to meet the terms set out as part of the loan.
It said it only met the first budget gap goal under the pact, of 5.9 percent of GDP in 2011, using a one-off transfer of banks’ pension funds to state coffers.
“The EU/IMF will probably have to agree another aid package in 2013 of about $50 billion,” Deutsche Bank’s Kumar said.
Still, Portugal, which has around $157.4 billion in outstanding debt, does not face a big redemptions crunch this year.
In June it has a little more than $13 billion in debt coming due, but this is expected to be met by the existing aid package.
Investor sentiment maybe tested next week when Portugal auctions around 1 billion euros of three month Treasury bills although these are expected to be taken up by domestic banks.
Portuguese 10-year government bond yields, which have failed to recede to anywhere near manageable levels since the bailout funds arrived, are currently around 15 percent while its five-year bonds are yielding over 20 percent.
Portugal, Ireland, Italy government bond spread
Portugal overview: link.reuters.com/nyj94s
But the market’s perception of Portuguese debt is currently very different to Greece.
The current average market value of a portfolio of Portugal’s bonds, weighted for the different amounts it has issued, is about 63 percent of face value, and an event which triggered a payout on credit default swaps would cost the sellers of protection about 1.4 billion euros.
On a similar basis the market value of Greek debt at the moment is about 28 percent of face value and if a CDS payout were triggered it would cost sellers about 1.7 billion euros.
Elsewhere on the sovereign debt market next week, Italy will auction debt up to 8 billion euros of new 10 year bonds at a time when its yields have been falling back to around 5.9 percent and the auction is expected to go well.
($1 = 0.7601 euros)
Written by Richard Hubbard. Editing by Jeremy Gaunt.