From sovereign debt woes to political brinkmanship and the swathe of new regulations hitting banks, the events of 2011 have reverberated across markets and around the world. There have been a few bright spots, not least the growing confidence of local currency debt markets, but overall it has been a gloomy year. Most believe the fate of 2012 lies in the hands of European policy-makers.

On January 1, 2011, Estonia became the first ex-Soviet country to join the eurozone and the 17th country to join the EU's currency bloc. Even given the growing problems surrounding peripheral countries' sovereign debt in 2010, the policy-makers from this small Baltic nation of 1.3 million people could not have envisaged the maelstrom that they were jumping into. 

Within three months of Estonia's entry, Portugal admitted it could no longer deal with its finances alone and sought help from the EU; within four months, eurozone finance ministers had been forced to adopt regulation that will establish a permanent bailout fund. The situation has continued to deteriorate. Two democratic governments have now been replaced with European technocrats in the hope that they will be able to push through the fiscal consolidation that eurozone leaders and markets are demanding.

Euro woe

The eurozone crisis encapsulates the three key themes – political wrangling, sovereign debt woes and tough new financial regulation – that have dominated 2011. Between them, they have driven market sentiment and corporate outlook and are reshaping the global banking industry. 

The direct impact of all three is felt most keenly in Europe and the US – with spreads in eastern Europe pummelled so heavily that Hungary has said it will seek further help from the International Monetary Fund – but the effects have rippled out across the world. On November 16, the yield on Mexican 10-year bonds had widened by 30 basis points (bps) in five days, while the difference in yields on Brazilian bonds maturing in January 2013 and January 2017 had risen by 20 bps in two weeks.

A statement from the India-China Financial Dialogue held in New Delhi in November said the global economy was in a critical phase and told Europe to get its financial house in order. While growth was “relatively stronger” in emerging markets, the statement said: “There are clear signs of a slowing as developments in advanced economies begin to weigh on these countries.” 

Market impact

Few areas of economic or financial activity have escaped the impact. Equity markets have been volatile and increasingly bound to news flow coming out of Europe. Asian stock markets fell in November, with many exporters being sold down because of concerns over faltering growth prospects. 

In a recent note, Sam Peters, portfolio manager of US mutual fund house Legg Mason, wrote that with markets worrying about the disintegration of the eurozone, equities have become an “undifferentiated lump of risk assets”, to be bought during 'risk-on' periods and sold or shorted during 'risk-off' episodes.

The malign connection between political squabbling, poor growth and sovereign debt fears proved disastrous in the third quarter, says Nick Williams, head of Europe, the Middle East and Africa (EMEA) equity markets at Credit Suisse. “In the third quarter, disappointing economic data in the US, the shock of the US downgrade and brinkmanship around the US debt ceiling combined with intensifying problems in Europe. This switched market sentiment from glass-half-full to glass-half-empty, and the markets fell out of bed,” he says.

Bad stock

For stock pickers, it has been a horrible year, with the correlation between a diverse universe of corporates resolutely climbing. By November, the average level of the Chicago Board Options Exchange's Implied Correlation Index for the S&P 500, which tracks how much stocks move in tandem, was a record high of 82. Many argue that until a eurozone solution is in sight, markets will remain indiscriminate.

Corporates have absorbed the negative sentiment pervading the global economy. While many have healthy-looking balance sheets and are looking for opportunities to invest or acquire, Giuseppe Monarchi, head of mergers and acquisitions (M&A) for EMEA at Credit Suisse, says M&A is unlikely because the biggest driver of corporate activity is CEO confidence and that has evaporated. Volume in the third quarter was down by 19% compared with the same period a year before. 

“[M&A] is a lot about psychology,” says Mr Monarchi. “There is just too much uncertainty over what's happening in the eurozone and how that is spilling over into other economies. Because of the uncertainty, valuations are down and it is increasingly difficult to reconcile the valuation gap between buyers and sellers. Corporates are asking themselves if it is better to preserve cash than use it for acquisitions. For those looking to the debt markets, where they can still access them, funding is at a minimum more expensive. All of this is holding back activity. The situation is unlikely to improve until markets believe that a resolution plan is in place and working.” 

2011 timeline Jan-May

Sovereign bank loop

Nowhere has the eurozone crisis had greater impact than on the region's banking sector. In an article for the Financial Times, Sony Kapoor, managing director of economic think tank Re-Define and visiting fellow at the London School of Economics, describes the relationship between Europe's governments and the continent's banks as “a dance of death”, with the deterioration in one creating greater uncertainty about the soundness of the other.

Many believe that what the eurozone's policy-makers have come up with is too little too late, and bemoan the fact that even the plans that have been mooted have yet to be implemented. In mid-November, Mario Draghi, the newly appointed head of the European Central Bank, highlighted the failure of governments to make operational the EU’s bail-out fund, the European Financial Stability Facility, which was launched 18 months ago.

Worse, some believe that the rescue plans attack the problem from the wrong angle. “No matter how much bank capital you raise it won't save European banks if the markets continue to worry about the solvency of Italy, Spain and others,” says one banker.

In his Financial Times article, Mr Kapoor argues that EU policy-makers have let Greece's unique fiscal problems wrongly dictate their prescriptions for other countries, and this could have disastrous consequences for the banking system.

“Greece was insolvent, but was handled as though it had liquidity problems. Spain and Italy, which are solvent but illiquid, are being allowed to drift down towards bankruptcy through an insufficient provision of liquidity support. At this rate, they will take the EU banking system down with them,” writes Mr Kapoor.

Spain and Italy, which are solvent but illiquid, are being allowed to drift down towards bankruptcy through an insufficient provision of liquidity support. At this rate, they will take the EU banking system down with them

Sony Kapoor

Bank funding

A November research note from Barclays Capital suggested that continuing brinkmanship among policy-makers in Europe risks further tightening of financial conditions for European banks, which are already under strain.

Some already have virtually no access to the dollar market. Money market funds, for example, are increasingly avoiding European bank assets as the crisis deepens. In September alone, they reduced exposure to eurozone debt – much of which was bank debt – by $54bn.

"Bank funding is severely curtailed and the senior funding market has dried up. Only the best can access the markets," says Carl Bauer, co-head of the financial institutions group at Credit Suisse. "In addition, investors do not have a clear understanding of what balance sheet write-offs are going to look like if the worst happens, and therefore what the impact will be on capital."

With $700bn of European bank debt scheduled to mature over the next nine months, the interbank funding market is beginning to echo 2008, when interbank lending all but ceased as trust between banks disappeared. Recently, stronger banks across Europe and the world have been depositing excess funds with central banks and cutting interbank lending as they seek to reduce risk. The UK's four biggest banks, for example, cut their interbank lending more than 24% in the three months to the end of September.

The ramifications of this pull-back are already being felt in eastern Europe. Moody’s recently cut the outlook for the Polish banking industry on grounds of problems with its western European lenders. While Polish banking sector profitability is robust, Western parent groups have put on sale the largest number of banking assets in the country in an effort to raise capital.

The effect of tightening bank credit conditions will stretch far beyond Europe's borders. In early November, HSBC chief executive Stuart Gulliver warned about the possibility that European banks could retrench from Asia, where bank credit has played an important role in growth. The effect would be significant. According to the Bank for International Settlements, continental European banks were responsible for 21% of the $2500bn in loans outstanding in Asia, excluding Japan.

2011 timeline July to November

Regulatory push

The impact of deteriorating sovereign debt on bank capital levels is being compounded by the regulatory push that is well under way. From the new requirements of Basel III at a global level, the EU's Capital Requirement Directive, and additional national recommendations such as those from the UK's Independent Commission on Banking and the so-called Swiss finish for Switzerland's banks, banks are under huge pressure to increase capital.

Raising additional capital at a time when their shares are trading at a fraction of their book value is an unpalatable option for those that can avoid it. As a result, bank capital raising volume for the first nine months of the year was 22% down on the same period in 2010, and in the third quarter fell by 53% compared with the same quarter the year before.

Instead, banks have a powerful incentive to shrink their balance sheets. Bank of America-Merrill Lynch (BAML) may have virtually doubled its core Tier 1 capital ratio since 2009, but much of that has been achieved by belt tightening. In the third quarter alone it reduced its balance sheet by $42bn and its risk-weighted assets by $33bn. Christian Meissner, co-global head of corporate and investment banking at BAML, says that Basel III compliance is fundamentally driving what business banks do (see Agenda, p30).

It does not take long for the effect of such changes to be felt elsewhere. Limited access to dollar financing has been compounded by a tougher regulatory approach to riskier business such as commodities financing. In the third quarter of 2010, $56.8bn was raised in trade finance. This year, that figure had plummeted by nearly 30% to $40.4bn (see Commodities report).

Uncertain rules

Moreover, there is still a lot of uncertainty about what the finished rules will look like. A working document released by the EU's Polish presidency published in November, for example, reveals that some European member states want the freedom to use their own judgement to decide what variables to consider when calculating a buffer guide – the basis for determining whether a counter-cyclical buffer should be applied to local banks.

Demetrio Salorio, global head of debt capital markets at Société Générale Corporate & Investment Bank (SG CIB), says that more certainty is needed. “Banks have so far adapted well to the new environment. The only thing [they] need now is a consistent set of rules,” he says.

Re-shaping businesses and putting the right processes in place is a challenging task when there are so many moving parts. For example, the details of the Volcker Rule, which bans proprietary trading (and which its advocate, Paul Volcker, has admitted are much more complicated than he intended) are nowhere near settled.

“Banks have got to grips conceptually with what [the Volcker rule] entails, but the implementation is a different matter. If we buy a security from a customer and it happens to go up in value, is that a prop gain or is that customer facilitation? We're still not sure how that should be accounted for, and building systems to measure and accommodate that is complicated. That's a big task that is still ahead,” says one banker.

Not all doom and gloom

While it has been a challenging year by any measure, there have been bright spots. Like other financial markets, debt capital markets (DCM) experienced a difficult third quarter, with issuance in September falling to similar levels as 2008, but volume in the first nine months is down just 4% on last year. In Europe, issuance stood at $1850bn, just above the level recorded in the first nine months of 2010.

Investment grade corporate issuance was up by 9% on the first nine months of 2010, despite a 17% drop in the third quarter. SG CIB's Mr Salorio says that corporate paper has become a safe-haven as sovereign debt has become more risky. “There is too little issuance to satisfy demand,” he says.

Similarly, global high-yield bond volume reached a record $261.9bn in the first nine months of 2011, despite third-quarter volume dropping to just over a quarter of that in the first two quarters. Again, notwithstanding a third-quarter drop, nine-month European issuance also reached record levels, at almost $59.9bn via 108 deals, surpassing the previous record of $44.5bn in 2010.

Corporations that are concerned about losing support from lenders are keen to issue bonds and [are] more open to paying higher coupons to secure long-term financing. We will see volumes growing consistently

Demetrio Salorio

Mr Salorio says the European high-yield market has matured this year. “It's not just a story of strong volumes, it is about the quality of the market; we see an increasing number of participants in terms of issuers and investors. Corporations that are concerned about losing support from lenders are keen to issue bonds and [are] more open to paying higher coupons to secure long-term financing. We will see volumes growing consistently,” he says.

Rise of the dim sum

Local currency debt issuance was another positive business area. International emerging market debt denominated in local currency reached $30bn in the first nine months of the year, the highest volume on record and double the $15.1bn issued in the same period last year, according to information provider Dealogic.

For many, the story of the year is the rise of the offshore renminbi bond market (called CNH by traders). So-called dim sum issuance has rocketed in just a couple of years. In 2009, the market consisted of eight issues totalling Rmb16bn ($2.5bn). Year-to-date in 2011 there have been 250 issues valued at Rmb140bn (including the first ever Basel III-compliant deal in Asia – a 10-year non-core 5 at 6% from ICBC Asia), according to HSBC, which so far this year has worked on 69 issues.

The market took off in July 2010 when Beijing liberalised trade settlement – giving renminbi-hungry investors the opportunity to participate in China's currency appreciation. James Fielder, head of local currency syndicate in Asia at HSBC, says there are clear signs the asset class is developing.

“Buyers were originally happy with low yields in the anticipation that there would be an appreciation in the currency, making the total yield comparable with other investments,” says Mr Fielder. “After the sell-off in the global markets in the third quarter, the offshore renminbi market shut down for a few weeks and the offshore spot rate started to trade above the onshore fixing; this undermined that investment rationale. Since then, investors are requiring higher yields but also look in greater detail at individual credits with relative value playing a greater role. This is a positive sign that the market has become more like other credit markets.”

The total in outstanding bonds in Hong Kong was Rmb210bn in October compared with deposits of Rmb622bn, so demand should still be strong. Mr Fielder says there are many trends that point to further growth. “There are an increasing number of funds participating in this market, as well as a growing number of corporates looking to issue, so the diversity of the market is improving.”

Waiting for the uptick

Many argue that it would not take much to create the right environment for a pick-up in activity in other areas. Credit Suisse's Mr Monarchi says his outlook is prudent. “In Europe, there's no doubt that the sovereign debt crises and growth problems will not be solved overnight, but there is the potential to instil greater stability, and that will help capital markets, which will help valuations, and that will create a positive effect on corporate activity in M&A.”

Many are playing a waiting game, keeping businesses ready to execute when the opportunity arises. In equity capital markets, Mr Williams says that those transactions that were lined up to be done in the third or fourth quarter are still in the pipeline and waiting for the right market. “Ironically, it feels like the macro picture globally, excluding-Europe, is relatively more constructive in terms of lead indicators, data coming out of the US, China and elsewhere, such that the global outlook is arguably more benign than when markets went into freefall in August and September," he says.

"Now it’s a question of if and when politicians in Europe are able to deliver a decisive resolution for the eurozone; logically they should, because the downside risk is too great. If they do and risk appetite returns, investors will be massively underweight riskier assets and will need to re-weight. Equities will be cheap under that scenario and there will be a lot of activity.”

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