The US DOC overnight announced anti-dumping duties of
31.14~31.22% on Chinese cells. This is in addition to the 2.9~4.7%
anti-subsidy duties announced earlier in March. We view the ruling
as materially negative for China Solar cell manufacturers, with the
duties coming in higher than market expectations. However, most
China-based module manufacturers can skirt the ruling by using
imported cells from Taiwan and thus are relatively less impacted.

While positive for Taiwan manufacturers, pricing remains a
concern. We note that this is the preliminary determination of
duties, with the final ruling likely only in November 2012. China is
also expected to announce anti-dumping tariffs on US polysilicon.
While the stocks reacted sharply last night, we remain conservative
given worsening macroeconomic concerns.

US DOC sets 31% anti-dumping duty on cells made in China
Overnight, the US DOC (US Department of Commerce) announced its
preliminary anti-dumping duties on PV Cells. It has levied a duty of: 1)
31.14% on Trina; 2) 31.22% on Suntech; 3) 31.18% on other Chinese
manufacturers; and 4) 249.96% for China-wide imports from companies
that did not participate in the case. We understand that these duties are
for all PV cells imported from China irrespective of whether a part of a
module or stand-alone. This is in addition to the 2.9~4.7% anti-subsidy
duties announced earlier in March.

The duties are retroactive 90 days (17 February 2012) from the date of
the ruling. Backed by this ruling, overnight stocks saw strong reactions:
JA Solar: -15.3%; Yingli: -13.0%; Trina: -7.9%; Canadian Solar: -6.7%;
Suntech: -5.8%; and LDK: -5.8%.

As we had mentioned in our 5 December 2011 note, ITC approves injury
determination, we believe there is an economic case in favor of keeping
solar imports to the US devoid of duties, as cheaper solar cell/modules
enable solar to become a realistic alternative energy source. This in turn
has the potential to drive faster job growth and cheaper access to
electricity and potentially reduce US reliance on other energy imports.

China solar cell manufacturers most affected
We view the ruling as materially negative for China Solar cell
manufacturers. In this regard, we believe the JA Solar 1Q12 earnings
call will be revealing. After the low countervailing duties announced in
March, the market was expecting token anti-dumping duties, but the
imposition of over 31% is meaningfully high. Moreover, we understand
that US Senators are calling for Chinese solar modules to be excluded
from investment tax credits to PV projects.

We see module manufacturers being less impacted as they can skirt the
ruling by:
 Using imported cells from Taiwan – We expect utilizations for
Taiwan cell makers to remain strong as outsourcing from China
increases.

 Setting up manufacturing plants outside China – We expect
companies to look at setting up new plants in low-cost locations. Case
in point – Trina, which is looking to set up a manufacturing plant in
Malaysia.

Limited pricing impact for Taiwan cell makers
We view the ruling as marginally positive for the Taiwan solar cell
makers. We expect utilizations for Taiwan cell makers to remain strong
as outsourcing from China increases. While Taiwan cell makers in theory
should benefit on pricing, we see two concerns:

 We understand that Chinese companies have been increasingly
outsourcing cells to Taiwan since January given the 90-day retroactive
imposition of duties. Nevertheless, we have not seen any pricing
stability in Taiwan. Note: Cell ASPs have declined 10.5% since
February 2012. Given the continued oversupply across the value
chain, we expect pricing to remain under pressure.

 We estimate the US market to be 16% of global demand in 2012F. We
do not believe pricing power has meaningfully shifted towards the
Taiwan cell makers. Note: Assuming China is not able to support
demand into US, we believe that there is ample supply from Taiwan,
US and Europe which could keep pricing in the US in line with the
global markets.

Investigation remains long drawn
We note that this is a preliminary determination of duties and is a part of
what remains a long-drawn process. The DOC has said that it will make
its final ruling only in early October 2012. This will be followed by a final
ruling by the US ITC (International Trade Commission) on or before 19
November 2012. Only when both bodies agree to impose duties will the
DOC issue its anti-dumping order.

We note that in November 2011, China had initiated an investigation into
dumping of US polysilicon in retaliation for the US investigation. With the
DOC applying preliminary tariffs, an announcement on tariffs on US
polysilicon is being expected by the market. While we believe this would
be positive for domestic polysilicon demand, we see pricing pressure
remaining as oversupply continues.

We remain cautious on the industry
We reiterate our cautious stance on the global solar industry given the
continued pricing pressure and macroeconomic concerns. While the
ruling appears positive for Taiwan solar names, we continue to remain
negative on Motech, as we see higher-priced wafer purchases from
domestic peers continuing to keep profitability constrained. We are also
negative on Suntech, Yingli and LDK given their stretched balance
sheets. We maintain our Neutral recommendations on Trina, GCL, JA
Solar and Canadian Solar. Of all midstream players (i.e. cell and
module) we see Canadian Solar as best positioned, albeit we remain
Neutral on industry dynamics.

Peer valuation comparison

The risk of a Greek euro exit is rising
The recent political paralysis has now brought Greece to what could prove to be
the worst stage of its crisis. Following the failure of the elections of May 6, another
election has now been called for June 17. The latest polls suggest the risks of a
coalition government against the austerity programme, or no agreement on a
government at all – are increasing. Although polls in Greece show very strong
support for the euro, we believe that the current situation could trigger a chain of
events that could lead Greece to exit on its own.

But so too are the incentives to keep Greece in
If Greece were to exit, the implications would be profound both for Greece and the
euro zone economy. This suggests euro zone policy makers would go a long way
to keep Greece in the euro. According to IMF figures, in the event of an exit,
Greek GDP could contract by as much as 10% in year one. For the euro zone, we
assume that a forceful set of policy measures would be implemented but they
would nevertheless result in elevated costs. Greek assets of ca. €450bn could
also be at risk of significant losses in the immediate aftermath of a euro exit. In
addition, a Greek exit could spill over to other countries resulting in deposit flights
threatening the stability of banking sectors and destabilising sovereign bond
markets. As policymakers assess the effect of Greece leaving the euro, the high
costs and risk of contagion will, in our view, raise the impetus to keep Greece in.

In the event of an exit, the policy response is critical
In our view, the situation in Greece is distinct from elsewhere in the periphery. So
while expectations of spillovers may be understandable, they might not be rational.
The euro governments may look to use pan euro deposit guarantees and capital
injections to contain the potential contagion through the banking sector. The ECB
may commit to provide liquidity to banks and act as a backstop on the sovereign
bond markets, provided the Bank was backed by the 16 euro governments.

Immediate reaction likely risk-off, but squeezes are then possible
Initial market response to a Greek exit is likely to be risk-off. EU banks could test
Nov-11 lows and EURUSD could dip to 1.20 even though positioning in both is
underweight. Despite rising concerns in Europe, investors are also underweight
Bunds and, in our view, 10y Bund yields could dip to 1% in the aftermath of a Greek
exit. Investors remain overweight EU cyclicals and EM indices as a wider global
recovery play, potentially leaving these assets vulnerable if EU issues lead to cuts in
global growth forecasts. However, in the short run if the ECB responds decisively
we believe risky assets, especially bank stocks and periphery bonds, may be prone
to a short squeeze. While in the longer run, as the EU stabilises, exporters would
h ave scope to outperform domestically geared stocks for a lengthy period.

What is the risk of a Greek euro exit and how could it work
in practice?
The new adjustment programme in Greece went on hold before it even started.
Following a first programme approved by the IMF board in May 2010, the
recession proved to be much deeper than initially projected (Chart 1) and there
were continued delays in reform implementation. As a result, a new programme
was approved in March 2012, including more funds, a substantial debt haircut,
and a renewed focus on reforms. However, by the time this programme was put
together, the country’s debt dynamics looked unsustainable again (Chart 2).
Growth well below projections, no progress in privatisation, and high bank
recapitalisation needs kept the level of government debt high, while the ambitious
reform agenda failed to persuade markets that the new programme could
succeed.

The recent political paralysis has now brought Greece to what could prove to be
the worst stage of its crisis (Greece – it ain’t over yet and Greece: Now what?).
Following the elections on May 6, the Greek political parties failed to agree on a
coalition government. Moreover, the parties that supported the programme did
poorly. Another election has now been called for June 17. The latest polls
suggest that Syriza, a leftist party strongly against the programme, could win. We
think there is a high risk of a coalition government being formed that opposes the
programme, or of there being no agreement on forming a government at all –
which would require yet another election a month later.

Although other members cannot force a country out of the euro zone and the
polls in Greece continue to show a very strong support for the euro, we believe
that the current situation could trigger a chain of events that could lead Greece to
exit on its own. As Greece has no market access, official funding seems to us the
only alternative to printing a new currency:

* Despite implementing certain adjustments during the programme, Greece
still has large funding needs. The government’s primary budget deficit was
2½% of GDP in 2011 and the programme target is 1% of GDP in 2012.
Greece’s current account deficit remains large – it was 9.8% of GDP in 2011.
* Greek banks are also heavily dependant on external funding. They need the
euro system for their liquidity and rely on EFSF loans for recapitalisation,
particularly following heavy losses from the private sector debt exchange
programme (PSI). The continued losses of bank deposits is of concern, as
both President Papoulias and Prime Minister Papademos have recently
warned (Chart 3).

* If the next election fails to lead to a government committed to the overall
programme targets, we believe that the IMF-ECB-EU troika will stop funding
Greece. Without deep and broad economic reforms, Greek government debt
dynamics would remain unsustainable in our view, requiring increased
funding. This funding would be impossible to satisfy using official sources.
The current IMF programme mandates debt sustainability and the yet-to-be
approved ESM has similar requirements. And politically, it would be
untenable for the rest of the euro zone to maintain an open-ended funding
commitment to Greece, in our view.

Consequently, we think the only alternatives to official financing are an even
sharper adjustment, or printing a new currency. Failing to adjust gradually under
what is currently a fully funded programme, we do not expect Greece to adjust
much faster and without any financing outside a programme. Introducing a new
currency could be the only available option to address what could be severe
macroeconomic instability, a collapsing financial sector, and potentially severe
social unrest.

When might Greece run out of money?
Table 1 presents a simple cash-flow analysis of the Greek financial dynamics
over the next three months. Data on cash available currently in public coffers are
very difficult to come by so we rely on a statement made by a senior government
official on the online newspaper imerisia.gr on May 7. According to this source,
Greece has currently roughly €2.5bn as available cash at its disposal.

Additionally, the EFSF decided yesterday to disburse the tranche that was agreed
upon in March; however, there was considerable debate among the European
country members given the worrying developments post the elections. As a
result, it was decided that €4.2bn will be disbursed this week and the remaining
€1bn in June. It is unclear if this will be dependent on the election outcome next
month. At the same time, Greece has to pay a €3.3bn maturing bond held by the
ECB and a €0.4bn maturing old international Greek bond that was not exchanged
by its holders during the PSI process (although it remains to be decided if and
how much of that redemption Greece will actually honour).

On the monthly revenue/expense side, data is not readily available so we had to
back them out from last year’s budget execution bulletin and adjust for the
amount of interest payments that are left for the remainder of the year (down 53%
from the same period in 2011). Excluding interest payments, the period Jan-Mar
2012 showed little variation compared to the same period in 2011, so we
assumed that the numbers for our baseline scenario for the May-July 2012 period
should reflect those during the same period of last year.

Scenario 1 – all revenues and expenditures as expected
In Table 1, we assume that the government collects all expected revenues and
pays all anticipated interest and non-interest expenses; in this case – and taking
as given that the €1.0bn EFSF payment will be disbursed on time – we estimate
Greece would run out of money sometime at the beginning of July, absent any
additional EU/IMF disbursement. This highlights the extreme urgency for the
Greek political system to resolve the governance issues as soon as possible.

Scenario 2 – crisis intensifying
In case of the crisis intensifying without political leaders managing to come up
with a viable solution, it is unlikely that the revenues, especially in June and July
would be collected as planned. Without a formal government and uncertainty
culminating, domestic demand would collapse making collection of indirect taxes
almost impossible. Moreover, households may chose to withhold payment of their
tax obligations and firms are likely to halt VAT payments to the state. We assume
now, that ordinary revenues in June and July will be halved, probably an
optimistic scenario. In this case, we find that Greece would run out of money
sometime in June, a much worse outcome than before but one which we believe
is not unrealistic should things take a turn for the worse.

Scenario 3 – revenue collection deteriorates
In case revenue collection deteriorates, Greek authorities may decide to meet
payments only for salaries, pensions and debt servicing. Salaries and pensions
are pretty stable throughout the year ranging from €1.8bn to €2.0bn a month. In
this case, Greece might be able to buy some more time (a couple of months) at
least in principle. However, the severity of the event would dampen tax collection
even further while the probability of social upheaval increases further.

Without the next instalment, money could run out by early July
Our central scenario is that Greece will have a viable government after the June
elections with a pro European approach. However, the probability of the country
being driven to a full blown default and an exit from the euro is non trivial. If no
government is in place before June, when the next instalment from the EU/IMF is
due, we estimate that Greece would run out of money sometime between the end
of June and early July, at which point a return to the drachma seems to us
inevitable.

Could a Greek exit lead to a breakdown of the single
currency, and what are the potential policy responses?
A Greek exit would significantly affect the Greek economy as well as the whole
euro zone through various contagion channels. However, there is no reason to
believe that a Greek exit would lead to a breakdown of the single currency, if
contagion could be stopped, or at least diminished by forceful policies.

Greece
Given the current political and market environment, we think an exit from the euro
zone would likely happen at the same time as Greece defaults on its sovereign
commitments. Such an exit and disorderly default scenario would then impact the
real economy through several channels:

* Real economy: although Greece is currently expected to run a primary
deficit of 1%, the fiscal contraction would likely be more severe as receipts
would fade away as households and corporate try to increase their savings.

Consumption and investment would contract sharply. Exports would fall but
imports would likely stumble even more. By comparison, when the Czech
Republic departed from the Slovak Republic (1991), consumption contracted
by 21.4%, investment 29%, and imports 33%. Overall, GDP contracted
11.6%. Greece has never known such a severe contraction. The worst
recession was in 1974, when GDP contracted 6.4%, mostly on the back of a
collapse in investment (-24%). The IMF estimates Greece would go through
a 10% GDP contraction in the first year of departure from the euro zone.

* Exchange rate and inflation: The same IMF report estimates the real
effective exchange rate could depreciate by 50% before recovering (over the
course of four years) to about 85% of its initial level, thus boosting inflation by
about 35% in the first year, recovering slowly to below 5% in about 4-5 years.

* Default and the ECB: the ECB is exposed to Greece through two channels,
repo operations of various maturities and emergency liquidity assistance
(ELA). The respective amounts are €109bn and ca. €60bn. Should Greece
default, we think it is highly likely that the ECB would terminate the repo
operations. And, the ECB could veto the ELA, which would cause the Greek
banks to run out of liquidity. In this case, looking at examples from various
emerging market precedents suggests two types of measures may help to
avoid a massive run or limit the liquidity crunch: 1) Close exit channels, ie,
ring fencing the banking system, limiting access to cash and prohibiting
transfers to foreign banks; and 2) using the central bank, in this case, the
Bank of Greece, to provide liquidity by becoming the lender of last resort.
That being said, it could also be the case that the ECB decides to keep some
liquidity lines open to avoid a bank run (with possible spillovers to other euro
periphery countries), or to let Greece pursue ELA under some monitoring.

Finance: private sector balance sheets would be damaged by cross-exposure
(which is very difficult to estimate), and then subsequently by inflation. Greek
banks, significantly exposed to their sovereign would collapse in the wake of
bank runs, the collapse of capital values and not having access to ECB liquidity
(see below for a discussion of costs to the private sector in the euro zone).

Implications for the euro zone
As discussed above we think an exit from the euro zone could happen at the
same time as Greece defaults on its sovereign commitments. We note there
would likely be direct costs due to European exposures to the private sector in
Greece, and indirect costs through the banking sector and the sovereign bond
markets. We discuss direct costs in more detail below. Here we will focus on the
indirect costs.

Indirect costs
We believe the highest risk for the euro zone is effectively that of indirect costs,
arising from contagion to the banking sector in the form of deposit flights and the
sovereign bond markets. We look at the two main channels and possible policy
actions by relevant players to estimate potential economic costs.

Policy measures to halt contagion through the banking system
We believe that the most likely contagion mechanism to banks is through the
liability side of the balance sheet. Most European banks already have no or very

limited access to senior unsecured funding and in a Greek exit scenario, in our
view, funding markets are likely to be completely shut, even for the strongest euro
zone banks. While this can be (and has been) alleviated to some extent by
unprecedented liquidity from the ECB, in our view the main risk is to deposits as
this accounts for some 50% of euro zone banks’ funded balance sheets. As can
be seen in Table 2 below, to date the deposit outflows have been relatively limited
with the exception of Greece with a 30% reduction since December 2009, and
Ireland with a 12.4% drop. However, should Greece leave the euro, there is a risk
that this could spread to other countries as depositors fear redenomination at
unknown terms.

Deposit flows for euro zone countries for the period January 2009 to March 2012

If Greece were to leave the euro, in our view further policy measures would be
required to avoid potential contagion. Such measures would likely focus on
ensuring that the banks are adequately capitalised and can find liquidity. The
ECB could provide the liquidity but not the capital.

One option for policymakers could be to do as Sweden did during the banking
crisis in the early 1990’s. When funding completely dried up, the Swedish
government offered an unlimited guarantee on all bank liabilities (September
1992). Banks then had to submit their balance sheets to a full independent
valuation, and any shortfall identified had to be covered by capital raised from the
private sector. Banks that were unable to do so were nationalised.

The bank rescue plan had the intended consequences and restored access to
funding markets. This was due to a combination of 1) guarantees, and 2) better
confidence that assets were appropriately marked. In our view there is a parallel
development in this crisis, with many banks relying on issuing state guaranteed
bonds, and BlackRock Solutions which has made independent valuations of
banks’ loan exposures in Ireland and Greece, and is in process of doing the same
in Spain.

However in a scenario of contagion, some sovereigns may not be in a position to
reassure markets. Ideally, the Swedish option would need to be implemented at
the euro level, with possible nationalisation or cross-border mergers to ensure
maximum credibility.

Another tool could be the implementation of capital controls. However, in our
view, this solution has its own risks. If imposed at the national level, they would
likely be seen as a step toward fragmentation of the euro zone rather than
consolidation (e.g. putting capital controls around Portugal would weaken the
country as compared to Europe guaranteeing Portuguese deposits, because the
country would be seen as fighting by itself and not with the support of the euro
zone). We would not expect capital controls to be imposed at the euro zone level
either if there were joint and several guarantees for bank deposits. The ECB
could cut rates to 0.50% and renew its liquidity provisions (most likely in the form
of expansion of the LTRO programme, with lower rates).

Policy measures to limit damage from Greece-related exposure through
the sovereign markets
Another possible tool to limit the damage from Greece-related exposure could be
through unlimited purchases of sovereign bonds. The ECB may not even have to
proceed with significant purchases if it could commit in advance to purchase as
much sovereign debt as necessary.

In our view, such a commitment would likely need to be supported by all
remaining euro zone countries to be credible and would require a renouncement
of the ECB’s senior creditor status.

Impact on the real economy
Under this Greek exit and disorderly default scenario, we think the shock to
confidence in the euro zone would be at least as high as that of fallout from the
Lehman Brothers collapse, with consequences for consumption, investment,
exports and imports. If all the damage limitation measures described above were
put in place, they might prevent the disruption that could occur in Greece upon a
Greek exit from the euro. In our scenario, though, we would expect euro zone
GDP to contract by at least 4% of GDP as in the Lehman episode. However, at
that time, when EU imports collapsed, emerging markets and developed
economies had room to absorb the shock with fiscal stimulus programmes that
allowed them to weather the storm. We also note that in the Lehman episode,
exports contracted even further than imports, but that consumption contracted
little (1% only).

In a Greek exit scenario, we would expect as much of a contraction in exports –
because roughly half of euro zone countries’ exports are directed to their euro
partners – and much more consumption contraction, with a collapse of
confidence. Looking across countries, the biggest consumption contraction in the
euro zone [in the Lehman episode] was in Spain, where it contracted by around
4% in 2009. We estimate that a 4% drop in consumption would translate into an
additional 3% (at least) GDP contraction (as consumption is between 60 to 80%
of GDP on average). In addition, there is less room today for fiscal support, which
could worsen the contraction compared with 2008.

Exchange rate and inflation
Following a Greek exit, but with significant quantitative easing, we estimate the
euro would likely depreciate significantly, which would translate into higher
inflation, albeit not necessarily rapidly and not necessarily by a large amount
given the extent of the slack in the economy. According to the latest OECD model
(OECD WP 768, The OECD New Global Model, April 2010), a 10% depreciation
in the euro would increase inflation by 1% after three years (along with GDP by
1.7% over the same period).

What are the direct contagion risks, and financial implications of a Greek exit?

According to Greece’s International Investment Position, Greece’s international
liabilities amount to ca €370bn, of which the government represents €156bn, the
central bank €105bn (Target 2 liabilities) and the private sector represents
€107bn. Clearly, a Greek exit from monetary union and concurrent debt
moratorium would trigger substantial losses at the EFSF and the ECB (see next
section). Here we will focus on the likely contagion effects arising from private
sector exposures to Greece. Since the market value of Greek government debt
that remains outstanding following the PSI exchange is less than €20bn, we
believe the main concern for the market should be the exposures to the private
sector, about which there is much less visibility.

According to the IIP data, Greek private sector liabilities to non-domestics amount
to €107bn. This seems to square with the BIS data which suggest that foreign
banks’ exposure to banks and non-banks in Greece is ca. €73bn (of which the
euro zone represents €68bn). The European Banking Authority (EBA) exposureat-
default data collection effort suggests international banks have €71bn of total
Greek exposure, of that figure €51bn is at four banks – Credit Agricole, Marfin
Popular, Bank of Cyprus, and BCP. There are problems with using the EBA data,
the most obvious of which is that it reflects year-end 2010 data. However, we
believe it provides a good basis for directional analysis. Table 3 below shows the
disclosure from the 2011 EBA stress test.

EBA data – exposure at default to corporates financial institutions and retail as of YE 2010

Looking at Table 3, assuming 50% levels of non-performing loans (above the
levels seen in Thailand following devaluation) and a 50% recovery rate, even
ignoring that some of this exposure will be governed by international law, in our
view it is difficult to see the direct impact of Greece leaving the euro being
detrimental to all but a small handful of international banks.
And a word on insurance…
The issues outlined above clearly extend beyond the banking sector into the
insurance and asset management industries. Given their importance as major
institutional investors any significant shift in investment policy is likely to have
implications for global capital markets, in our view.
Like banks, the direct exposure of insurers to Greek sovereign debt is small – we
estimate a net exposure of €1bn at the industry level. But the indirect impact
could be significant, especially for life insurers, and particularly in the event of
asset flight out of countries if policyholders become fearful of a euro exit and
subsequent currency depreciation.
Even a well matched life insurer would struggle to predict and cope with uncertain
policyholder behaviour, particularly increased lapse rates caused either by asset
flight out of the country or for other reasons. This could lead to insurers selling
assets, particularly fixed income assets, at inopportune times, which could
exaggerate already weak trends in these asset classes at this time; and for the
insurers could lead to losses that are unlikely to be recouped from exit penalties
written into policies. This becomes particularly meaningful if the contagion risk is
extended to Italy and/or Spain given the size of operations in these countries
relative to Greece, Portugal and Ireland.

More generally, any significant spread widening and elevated default risk would
be negative for insurers, as would any further decline in core government bond
yields, in our opinion.

In the event of a Greek exit, what are the official
exposures and might the ECB require recapitalisation?
The ECB holds about €55bn notional of Greek government bonds (note that we
do not know at what average market price these bonds were purchased through
the SMP programme and subsequently exchanged just before the PSI). The
ECB’s exposure to Greece via repo operations directly amounts to €79bn and
indirectly via the ELA €48bn. However given the debt swap between Greek
banks and the EFSF, total losses may be €35bn under the €182bn total
exposure.

Either way, for the consolidated ECB balance sheet these amounts are modest.
The consolidated ECB balance sheet amounts to €2971bn. The ESCB’s capital
position is €85bn, and revaluation reserves (unrealised gains primarily in Gold
reserves) amount to €400bn. In addition the ECB will always be able to issue
additional eurocurrency or increase euro bank reserves and deposits held with
the ECB by any amount required to maintain its solvency. The ECB could only
become insolvent if it had too large a stock of liabilities denominated in foreign
currency. But the stock of liabilities in foreign currency is €342.8bn today. Overall,
we think the adequacy of the ECB capital would only become an issue if a
significant number of large countries were to leave the euro zone.

Total exposure of official sector lenders is €183bn. The IMF has so far distributed
€21.5bn, the EU on a bilateral loan basis has distributed €53.1bn, and via the
EFSF €108bn. However, the EFSF’s disbursement includes €25bn for the bank
recapitalisation, of which €18bn will be used for now, as well as €35bn for the
collateral swap to allow Greek banks continued access to the ECB. Retracting the
latter, however, clearly risks shifting losses to the ECB from the EFSF. A default
by Greece on these payments, however, would not crystallise an immediate
funding need, but would do so over time, as the EFSF paper pays coupons and is
redeemed.

What would a Greek exit mean for the euro and euro rates?
When analysing the likely market reaction in either the currency or rates, it is
important to distinguish between the initial market reaction to a Greek exit from
the euro zone and the market reaction following the potential policy responses
outlined above.

To reiterate, the three main channels of contagion that we are concerned about
and that a policy response would need to address include:
* Deposit flight spreading from Greece to other peripheral European crisis.
* Concerns about exposures of European banks to the private sector in
Greece aggravating funding pressures arising from deposit dynamics.
* Further reduction in peripheral government bond exposures by non-domestic
investors leading to rising spread levels.
Even though the ECB’s LTROs have injected enough liquidity into the European
banking system (on our estimates) to cover wholesale funding risks at least for
this year, concerns about deposit dynamics and solvency arising from exposures
to the Greek private sector will likely lead to renewed risk aversion in the
interbank market (link). In our view, the likely market reaction would include:

* A sell-off in Euribor rates, led by red contracts (1y1y forwards).
* A rally in general collateral (GC) repo rates for triple-A collateral, richening
high quality cash curves to the point where yields would likely trade negative
in the front-end of the German curve.
* A resultant widening of Schatz Asset Swap Spreads (ASW) to at least the
wides seen in 2008 and 2011.
* A sharp flattening of both swap and German cash curves, led by a sell-off in
the front-end of swap curves and a rally in the belly in cash curves.
In our view, any widening in peripheral spreads would likely be driven by a further
reduction in non-domestic positions on the realisation that EMU membership is
not irrevocable, as well as an increased focus on ALM management, with
domestic liabilities being matched by domestic assets leaving current account
deficit countries at a disadvantage. The initial reaction would likely include a
significant outperformance of German Bunds as the safe haven asset both on a
relative and an absolute basis. However, the caveat here is the question of
whether or not this latest escalation in the European crisis would trigger capital
flight from the euro zone that would actually put selling pressure on Bunds, also
richening Gilts and US Treasuries.
Since the euro zone as a whole remains in current account balance, we would
expect intra-eurozone flows to dominate and Bunds to fall further in yield terms.
When considering standard Bond Risk Premia models, we believe that Bunds
trade cheap compared to euro zone fundamentals relative to either US Treasuries
or UK Gilts (Chart 5). There clearly is scope for Bunds to richen further on this
metric.
Following the potential policy response outlined above (rate cuts, additional
LTROs, resumption of the SMP, European deposit insurance scheme), we would
likely see a reversal of some of these moves:
* Euribor rates would rally hard, resteepening the swap curve and tightening
Schatz ASW.
* Triple-A GC repo rates would cheapen, peripheral GC rates would richen.
* The Bund curve would likely bear steepen, as some of the flight-to-quality
risk premium gets unwound in the back-end of the curve, while the front-end
remains supported on the back of an accommodative ECB.
If Greece exits the euro zone, we would expect the euro to weaken initially,
reaching levels below 1.20 to the USD (keeping everything constant in the US),
for the following reasons:
* We would expect risk aversion to weaken the EUR-USD. As we discussed
above, a euro exit by Greece would likely be disorderly. As a result, we
would expect it to cause market turmoil beyond Greece and increase global
risk aversion, which in turn could strengthen the USD through safe haven
flows.
* The ECB policy response would likely be euro negative. As the ECB reacts
to contagion risks for the rest of the region and recession risks for the whole
euro zone, we think it would likely loosen its policy stance. Although the ECB
has been more supportive for growth under the presidency of Mr. Draghi than
before, it has stayed away from quantitative easing, while its policy rates
remain above those of the monetary authorities in the US, Japan and the UK.
However, a looser ECB policy stance would weigh on the euro.

* Inadequate funding in the euro zone crisis response framework and policy
coordination problems could reduce confidence in the euro. Although the
euro zone authorities have been praising their recent steps to address the
crisis, most of these steps remain plans for now. The ESM has yet to be
approved by national parliaments. Likewise, the fiscal compact and the
reform six-pact need national approvals. And the European banks have yet
to raise new capital following their stress tests last year. Markets could also
get concerned by delays in agreeing on an emergency policy action plan
after a Greek euro exit, as 16 governments try to decide on the appropriate
path in uncharted territory.

* Central bank reserve managers could sell euros in response, removing a key
supporting factor for the euro almost since its introduction (see The confused
Maestros in the FX music hall). Indeed, central banks sold euros in the
second half of 2011, when Italy and Spain came under severe market
pressure. This coincided with a sharp weakening of the euro. Central banks
could sell euros again in a Greek exit scenario if they are concerned about
ECB quantitative easing to address the shock, or contagion that could
eventually threaten the euro zone as a whole.

An effective policy response by the euro zone authorities could lead to a stronger
euro, in our view, with the euro reaching closer to 1.40 with respect to the USD. If
the policy response to a Greek euro exit succeeds in stopping contagion, the rest
of the periphery continues reforming and, more importantly, the remaining euro
zone countries move toward banking and fiscal unions, we would expect a
stronger euro. However, all these steps are politically very difficult and may
require a sense of urgency.

What are the broader portfolio implications across asset
classes of a Greek euro exit?
According to our recent Fund Manager Survey many investors are already
underweight many European assets. Nevertheless, domestic European investors
retain significant exposure to the region, so navigating any euro exit is an
important consideration. While the immediate reaction to a Greek exit of the euro
would be risk-off it is likely to prompt major policy response. This may leave some
assets at risk of short squeezes, particularly where positioning is at an extreme.

In our view, the longer-run direction of risky assets would depend on whether a
Greek euro exit was seen as the end of the process, or the first step in a wider
unravelling of the single currency. A coordinated response from central banks
around the globe, together with appropriate steps towards EU fiscal union, would
likely create the ingredients for a powerful short squeeze, in our view. By contrast,
we think a delayed or insufficient policy response would likely lead to widespread
derisking both in euro zone assets and in risky assets around the globe as growth
expectations are cut.

Summary of anticipated impact by asset class

Positioning in some EU assets is already at extremes
Our recent Fund Manager Survey suggests that many investors are already
underweight EU equities. Unsurprisingly, European bank stocks are among the
most underweight sector but, so far, many cyclical sectors have remained
resilient. EU industrial proxies such as the OMX and DAX indices have
outperformed the SX5E by 580bp and 1440bp respectively year-to-date. This
suggests, in our view, that hopes for better global growth continue to dominate
fears of a worsening euro zone crisis. In the event of a Greek exit from the euro,
we think cyclical equity sectors are at risk of a sell-off, particularly if investors
conclude that global growth will suffer. Emerging market stocks too continue to be
widely held by investors. This may mean some of the more growth geared Asian
indices have scope to fall sharply in the immediate aftermath of a Greek exit as
global growth assumptions are reassessed. By contrast, we think banks are
probably most prone to a short squeeze on any comprehensive policy response.

In rates and currency markets, positioning is somewhat contradictory. Despite
growing investor unease duration exposure in G4 bond markets remains
underweight (Chart 6). Simultaneously, investors have built up large short
positions in both periphery bonds, particularly Spanish Bonos, and in EURUSD
(Chart 7). This positioning raises the possibility of German Bunds strongly
outperforming in the immediate aftermath of a Greek euro exit as investors
address their duration underweights. Despite prevailing yields <150bp, Bunds are
cheap relative to both US treasuries and UK Gilts given expectations for growth.
Even with policy support, we think the growth outlook for the euro zone remains
poor; so with positioning light the outlook for Bunds appears skewed toward lower
yields in most scenarios.

The starting point for corporate credit markets is one where cash balances have
rebounded sharply and spreads in Main and Crossover are close to giving up
their YTD gains. Nevertheless, in the event of a Greek euro exit, there is scope
for some perverse moves in credit spreads as contagion fears take hold across
the euro zone. In our view, credit investors are likely to further flee anything
peripheral denominated. We think this label extends to French credits now, given
the recent volatility in these names. Investors are likely to rotate further into "safe"
credit assets, but this only really leaves German, UK and Scandinavian credits as
safe havens. Such a safety bid could result in very strong technicals for these
names, and we could see a scenario where spreads widen relatively little here as
a result. Certainly, the experience of the last month has shown that the safe
haven bid for AA and A rated credit has been sufficiently big to pull spreads
tighter, while BBB and BB rated credits have widened meaningfully.

For financial credits, the timeliness and extent of the ECB’s response is the key
factor, in our view. A third 3yr LTRO is a possibility to demonstrate that the ECB
is committed to backstopping bank funding, and countering deposit flight.
Government-guaranteed bank funding schemes, along the lines of the Italian
scheme, could be introduced in other countries as well. This should reinforce our
long-held view that senior bank bonds are "money good" via the ECB. We don't
think senior spreads will be immune from contagion, but a swift ECB liquidity
response should ensure itraxx senior spreads don't revert to last year's wides
again. Sub spreads, however, could be much weaker as bank’s capital levels will
undoubtedly be called into question.

Banks could still go lower, and exporters could still outperform
Despite positioning already being at extremes, we think there is scope for assets
such as periphery bonds and EU bank stocks to suffer in the event of a Greek
euro exit. The euro zone banking sector is already back towards its credit crisis
lows in Price-to-Book terms at about 0.4x, and is reflecting a similar degree of
stress that US banks experienced post-Lehman. Nevertheless, in the event of a
Greek euro exit a key risk that the ECB must address is that of a deposit run. If
deposit flight were to take hold across the euro zone then we would anticipate a
sharp and rather indiscriminate decline in bank share prices. Positioning in the
banks certainly leaves the sector very exposed to a short squeeze in the event of
a coordinated policy response. Nevertheless it is sobering to reflect that Korean
banks dipped to just 0.15x book during the Asian crisis of 1998, and in the early
1990s Finnish and Swedish banks dropped to about 0.25x book (Chart 8).

Another trend that has scope to extend is the outperformance of export oriented
stocks. Chart 9 shows that since 2010 EU exporters outperformed domestically
geared firms by around 50%. The pattern repeats the experience of Japan during
the “lost decade” that began in the mid 1990s. While Europe’s domestic economy
is likely to be fragile for some time, regardless of how the Greek situation is
resolved, European firms are attractively geared to global growth. Looking
beyond any possible Greek euro exit, if EU policymakers can respond decisively
to the event and act to stabilise the region, then we think equity investors would
likely begin to treat Europe as a proxy play on global growth.

Other portfolio considerations
In our view, the portfolio risks associated with a potential Greek euro exit come
down to the policy response from the ECB and other central banks. Nevertheless,
there are other factors that may affect portfolios in what is likely to be a volatile
period:
* EURUSD, bank equities, and periphery bonds are already at extreme
underweights; while they may fall further in the immediate aftermath of an
exit, they are probably the most prone to a short squeeze on ECB action.
* Cyclical equities and Emerging market stocks have not responded fully to the
growing crisis, in our view; cyclical sectors and growth geared Emerging
market indices are prone to selling off sharply if the global growth outlook is
seen as compromised.
* Equity volatility in many regions is reacting slowly so far; we note it is still
relatively inexpensive to buy options in some regions, notably Asia and the
US; examples include HSCEI and Nifty where put option costs are at
6-month lows.
* In the US, technicals in the VIX market could exacerbate the spill over effects
from any Greek exit; historically in previous US and European volatilities in
European crises, VIX curve flatteners have paid out positively with a
probability of over 85%.
* Investors are underweight duration, and despite record low yields, Bunds
may not be reflecting the weak growth EU outlook; even with a substantial
ECB response the EU growth is likely to remain subdued; previous liquidity
interventions have pushed Bunds up along with other assets so, in our view,
risks are skewed towards lower German Bund yields in most scenarios.
* Credit market flows are likely to be initially dominated by a flight to safety with
German, UK and Scandinavian credits outperforming. Senior financial
spreads have scope to tighten sharply on an ECB response, but
subordinated bank credits remain vulnerable even in the event of central
bank support.

* Bulk commodities and energy are at risk if a Greek euro exit leads to
downgrades to global growth forecasts; however oil weakness is likely to be
met by cutting supply. This would put a floor to Brent prices at around
$80/bbl; bulk commodities remain at risk if global growth outlook deteriorates.
* Gold, though seen as the ultimate safe haven asset, tends to fall along with
many other assets in times of acute crisis; in the event of a QE style policy
response, there is scope that gold rallies as real interest rates come down.

Apple and new local OEMs lead the growth
According to Gartner data published on May 16, China’s smartphone
market grew by 19% q-q to 33mn units in 1Q12 (23% of global demand).
The growth rate slowed down from 39% q-q in 4Q11, in line with telecom
operators’ strategy to focus on quality in 1H (higher ARPU user) and
quantity in 2H (larger volume).
Here are our initial findings from the data regarding the market share
dynamics among vendors:
• Apple doubled its smartphone market share in China, to 17% thanks
to the launch of CDMA iPhone for China Telecom during the quarter.
• Chinese handset OEMs continued to expand their market share to
44% in 1Q12 (+7%), mainly from Nokia (-9%), by leveraging their
strong RMB1,000 smartphone portfolios.
• But the additional share was mainly contributed by new domestic
smartphone suppliers (under “others” category such as TCL, Tianyu,
Xiaomi). This indicates fragmentation and intensified competition in
the China smartphone market.
• Exports have become a growth driver for Chinese smartphone players,
especially Huawei and ZTE, and accounted for 37% of the two
companies’ total volume in 1Q12.
Among Chinese smartphone OEMs, we remain bullish on ZTE for its net
profit margin recovery in 2012F driven by its breakthrough in overseas
smartphone market and SG&A control.

ZTE/Huawei remain in No.4/6 position in global handset market
Globally, ZTE and Huawei maintained their market positions (No.4 and
No.6) and volume shares in both the handset and smartphone market.
On the other hand, TCL/Alcatel experienced a decline in volume share
as well as market share due to slower feature phone to smartphone
transition.

Global Smartphone market share

Meeting Basel III Targets: Fitch Ratings estimates that, as of end-December 2011, the 29
global systemically important financial institutions (G-SIFI), which as a group represent
$47 trillion in total assets, might need to raise roughly $566 billion in common equity in
order to satisfy new Basel III capital rules, which represents a 23% increase relative to these
institutions’ aggregate common equity of $2.5 trillion. Although Basel III will not be fully
implemented until end-2018, banks face both market and supervisory pressures to meet these
targets earlier. Banks will likely pursue a mix of strategies to address these shortfalls, including
retention of future earnings, equity issuance, and reducing risk-weighted assets (RWA) (see the
text box on page 3). Absent additional equity issuance, the median G-SIFI would be able to
meet this shortfall with three years of retained earnings, which might constrain dividend payouts
and share buybacks.

Falling ROE Pressures: This potential capital increase would imply an estimated reduction of
more than 20% in these banks’ median return on equity (ROE) from about 11% (over the past
several years) to approximately 8%–9% under the new regime. Basel III thus creates a tradeoff
for financial institutions between declining ROE, which might reduce their ability to attract
capital, versus stronger capitalization and lower risk premiums, which benefits investors. For
banks that continue to pursue mid-teen ROE targets (e.g. 12%–15%), Basel III creates potential
incentives to reduce expenses further and to increase pricing on borrowers and customers where
feasible. Additionally, since it is impossible for regulators to perfectly align capital requirements
with risk exposure, banks may seek to increase ROE by favoring riskier activities that maximize
yield on a given unit of Basel III capital, including new forms of regulatory arbitrage.

Potential G-SIFI Response: G-SIFI’s face a trade-off, with higher capital requirements
potentially offset by competitive advantages stemming from their official status as systemically
important institutions. Some investors and counterparties might perceive these institutions
as more likely to receive government support in a distress scenario. This perception, coupled
with the G-SIFI’s higher capital standards, could in turn reduce funding costs and stimulate
business flow from more risk-averse customers. Conversely, institutions that deem G-SIFI
status as a regulatory burden might seek to reduce or limit their size and complexity in order
to avoid this designation.

Basel III Higher Capital Requirements to Pressure ROE

• 29 G-SIFI banks (with $47 trillion in total assets) subject to higher Basel III capital ratios.
• Potential equity capital increase of about $566 billion to meet Basel III standards.
• ROE decline (median) to 8.5% from 10.8%.

Deleveraging Affects Broader Markets: Given the global scale and scope of the G-SIFI’s, their deleveraging in preparation for Basel III will likely affect credit markets and the financial system more broadly. First, since Basel applies relatively higher capital charges to riskier activities, institutions are likely to focus on reducing their exposure to lower rated and more volatile sectors. For example, a high-yield corporate loan subject to a 150% risk weight would command a more than 14% Tier 1 common equity charge under Basel III (assuming a 9.5% G-SIFI minimum common equity ratio). This exposure would consume significantly more minimum required equity capital than Basel II, which in effect only requires a 3% equity charge on the same asset (based on a 2% minimum Tier 1 common equity ratio). Higher Basel III capital charges for these activities could result in increased borrowing costs, diminished availability of credit, reduced asset liquidity, a shift to securitization and capital markets funding or migration to less-regulated segments of the financial system (e.g. “shadow banking”).

Basel III Overview Changes Relative to Basel II

Basel III — Measuring the Road Ahead
Although Basel III will be phased in over time, with the fully phased-in rules set to take effect in end-2018, banks are already well underway in planning and preparing for implementation (see the “From Basel II to Basel III: Same Concept, More Capital” text box for background on Basel III on page 5). Many banks will likely seek to achieve and demonstrate full Basel III compliance prior to this deadline given both market and supervisory pressures, as exemplified by the European Banking Authority stress tests requiring major EU banks to achieve a 9% Tier 1 common equity ratio by end-June 2012.

To assess where banks currently stand in their Basel III preparations, this study quantifies the capital shortfall of the 29 global financial institutions identified as G-SIFI’s by the Financial Stability Board (FSB). This cohort of banks represents a global mix of institutions spanning a range of banking models, including traditional credit intermediation, trading and market making, processing and custody, and universal. From a systemic risk perspective, these banks are interconnected with other important financial institutions, asset markets and sectors of the economy. Finally, given their significant role within the banking sector, the G-SIFI’s might represent a benchmark for other institutions working towards Basel III compliance.

The G-SIFI’s are subject to higher capital requirements than other banks under Basel III. In addition to the Basel III Tier 1 common equity ratio of 7%, G-SIFIs are subject to an additional Tier 1 common equity buffer of between 1.0% and 2.5%, depending on the systemic importance of the particular institution. Thus, the potential minimum required Tier 1 common equity ratio is 9.5% for some of these banks. Since the level of this G-SIFI surcharge for each institution has not been revealed publicly, this study assumes that each G-SIFI must achieve a 9% Tier 1 common equity and will hold an additional discretionary 1% buffer above the regulatory minimum, resulting in a projected Basel III Tier 1 common equity ratio of 10%.

To provide as current a view as possible of where these banks stand in relation to the Basel III requirements, this study analyzes financial reporting as of Dec. 31, 2011. An important component of the analysis is the use of Fitch core capital (FCC) as a proxy for Basel III Tier 1 common equity (see Fitch’s special report “Fitch Core Capital: The Primary Measure of Bank Capitalization”). FCC is the primary measure used by Fitch analysts to assess a bank’s capitalization. In calculating FCC, Fitch’s objective is to arrive at a comparable figure across countries, which measures a bank’s highest quality, “going concern” capital. FCC is broadly similar to Basel III’s Tier 1 common equity measure (see the “Fitch Core Capital” table on page 3), but it is not dictated by regulatory capital considerations. For the purposes of this

exercise, FCC provides a useful current approximation of how banks will ultimately measure Tier 1 common equity under Basel III.
The other important aspect of gauging the capital impact is to adjust RWA upwards to reflect the greater conservatism in Basel III’s treatment of counterparty credit exposure and other areas. For all but a few of the G-SIFI’s, Fitch was able to source banks’ own estimates of their anticipated increase in RWA under Basel III from investor presentations and other publicly available disclosures. In the instances where this information was not available, this study uses the recent Basel Committee quantitative impact study estimate of a 19.4% RWA increase and then nets out the impact from Basel 2.5, which European and Japanese banks in the sample have implemented as of end-December 2011.

The estimated Basel III capital shortfall is derived for each bank by calculating its ratio of Fitch core capital (numerator) to Basel III-adjusted RWA (denominator) as a proxy for Basel III’s Tier 1 common equity ratio. The projected Basel III capital shortfall for each institution is the amount of additional common equity needed to achieve a 10% ratio. The corresponding estimate of how much each bank would need to shed in RWA (as an alternative to increasing common equity) is calculated by dividing the projected capital shortfall by 10% (i.e. the assumed minimum ratio). In order to size the potential reduction in each bank’s ROE under Basel III, Fitch calculated the median average return on common equity for each bank over the 2005–2011 period and then adjusted this ratio downward by the percentage increase in common equity needed to fulfill the projected Basel III capital shortfall.

$566 Billion Projected Capital Shortfall, 8.5% Median ROE
According to these projections, the 29 G-SIFI’s in aggregate would have to raise roughly $566 billion of equity capital in order to meet a 10% Tier 1 common equity ratio, with the median institution needing to raise $18 billion (see the table below). The average shortfall is about $19.5 billion. These estimates are based on applying Basel III (whose formal implementation will occur in stages through end-2018) on G-SIFI financial results as of end-December 2011. For the median bank, equity capital would need to increase by 23% in order to meet

Capital Impact Similar Across Regions but Varies by Bank

this threshold, although there is some dispersion across institutions, with a 25th percentile increase of 10% versus a 30% increase at the 75th percentile. The median projected equity raise is roughly comparable across APAC (23% increase), EMEA (23% increase), and the U.S. (21% increase).

In addition to increases in the minimum required ratios, another important driver of the projected Basel III equity shortfall is the more conservative recalibration of RWA, which particularly affects banks with significant trading activity and counterparty exposure. Many of the G-SIFI’s, specifically the European and Japanese institutions, have recently implemented Basel 2.5, which on average increased their RWA by 6% (see the table above). The Basel 2.5 RWA increase ranged from 0% to 23%, with the Asian G-SIFI’s less affected than their European counterparts. The projected average Basel III RWA increase of 26% is much higher, ranging from a minimum increase of 3% to a maximum increase of 72% for the banks sampled. U.S. banks are most affected, with an average RWA increase of 46%, although this estimate includes the impact of both Basel 2.5 (which has not yet been implemented in the U.S.) and Basel III. As a reference point, the Basel Committee recently published a Basel III quantitative impact study, which estimated a 19.4% RWA increase for the roughly 100 large banks in their sample as of end-June 2011.

Banks are likely to pursue a range of approaches for achieving Basel III compliance (see the “Mix of Strategies to Meet the Basel III Capital Challenge” text box on page 3). Reducing RWA is a focal point for many banks. RWA reduction might involve selling, hedging, or winding down riskier assets (including exit from entire business lines); the application of less conservative Basel risk inputs and calculation methodologies; or regulatory arbitrage, in which the same or similar economic risk exposure attracts preferable capital treatment. Regulatory arbitrage includes tactics such as structuring or booking an exposure in a manner designed to minimize regulatory capital charges. Given the risk sensitivity of Basel capital charges, banks face a tradeoff in shedding riskier exposures that consume more capital, but are also likely to generate higher yields.

Retained earnings will also likely play a significant role in achieving Basel III compliance. As a benchmark, the ratio of the median projected Basel III capital shortfall to the median net income for 2005–2011 is 3.0, implying that three years of earnings, if fully retained, could satisfy the requirement. To the extent that future bank earnings exceed their 2005–2011 median, banks might be able to meet these targets more readily through retained earnings. Nevertheless, working to meet the Basel III target might constrain both dividends and share buybacks in the coming years.

Based on the projected Basel III increase in equity capital, median ROE could in turn drop to 8.5%, down from the roughly 10.8% median ROE for the period 2005–2011. The Basel III ROE estimate of 8.5% is based on rescaling each bank’s median ROE for the period 2005–2011 by the projected increase in equity capital needed to meet a 10% Tier 1 common equity ratio. The 10.8% median ROE from 2005–2011 encompasses a range of environments and, as a point of reference, exceeds the median ROE of 7.3% experienced in 2011.

In addition to considering a 10% Tier 1 common equity ratio, Fitch also performed this analysis based on a 9% ratio. Based on this lower threshold (which means that any G-SIFI subject to the full 2.5% surcharge would fall below the 9.5% Tier 1 common equity minimum), these banks, in aggregate, would face a $342 billion, rather than $566 billion, shortfall. Thus, relatively subtle differences in banks’ minimum requirements and target ratios can significantly affect the projected capital shortfall under Basel III. Under a 9% minimum ratio, the median capital increase is roughly 13% (versus a 23% increase under a 10% Tier 1 common equity ratio), it would take two years rather than three to meet this shortfall through median retained earnings, and median ROE would decline to roughly 9% (versus 8.5% median ROE under a 10% ratio).

From Basel II to Basel III: Same Concept, More Capital
Both Basel 2.5 and Basel III are essentially recalibrations of Basel II. The Basel II methodologies for deriving risk-weighted assets (RWA) remain largely unchanged, although Basel 2.5 and Basel III introduce additional conservatism in the RWA calculations for market risk and credit risk, respectively.
Basel 2.5, which Australian, European, and several Asian banks have already implemented, addresses market risk RWA by introducing:
• “Stressed” Value at Risk (VaR), which is based on a one-year historical period of significant market-related losses (e.g. 2007–2008 market volatility) and is additive to existing VaR calculations;
• A new incremental risk charge (IRC) within VaR calculations to capture default and migration risk for unsecuritized credit products in the trading book;
• Specific risk charges for securitization exposures held in the trading book based on the same treatment (e.g. ratings-based approaches) as applied in the banking book, higher risk weights on resecuritization exposures, and a more conservative treatment of liquidity facilities on asset-backed commercial paper programs.
Basel III, whose implementation formally begins in end-2012 and concludes by end-2018, strengthens the quality of regulatory capital, minimum capital ratios, and risk coverage, particularly for counterparty credit exposure.
• Basel III requires that the regulatory capital base consist predominantly of common shares and retained earnings, which provide the purest form of going concern loss absorption. Additionally, the rules harmonize deductions from capital and phase out the qualification of innovative capital instruments, such as trust preferred securities.
• Minimum capital ratios, particularly for Tier 1 common equity, increase relative to Basel II. Notably, while Basel II in effectively requires a 2% ratio of Tier 1 common equity to RWA (i.e. the “Tier 1 common equity ratio”), Basel III requires a minimum ratio of 4.5%, which in effect will be a 7% ratio when including the 2.5% “capital conservation buffer.” For G-SIFI’s, an additional Tier 1 common equity surcharge of between 1% and 2.5%, depending on the institution’s systemic importance, brings the Tier 1 common equity ratio up to 9.5%. While the Basel II minimum total capital ratio of 8% remains unchanged, the “capital conservation buffer” effectively increases this ratio to 10.5%.
• Basel III increases RWA for counterparty credit risk, for example on repo and derivatives exposures, including the use of stressed inputs in the calculation of exposure (i.e. effective expected positive exposure, or EPE) and a charge against credit valuation adjustments (or CVA) that arise from potential mark-to-market losses due to a counterparty’s deteriorating creditworthiness. While EPE addresses default risk, CVA is driven by migration risk. Basel III also increases RWA on exposures to financial institutions by increasing the asset value correlation parameter within the internal-ratings based capital formula. Additionally, banks must now risk-weight low-quality securitization exposures at 1,250% rather than deduct these positions 50/50 from Tier 1 and Tier 2 capital, which in effect amounts to a more conservative capital treatment since minimum total capital ratios exceed 8% under Basel III.
• The Basel Committee is also in the process of a fundamental review of trading book capital requirements, including the trading book/banking book boundary, calibration to stress periods, the metric used for quantifying market risk (i.e. VaR versus expected shortfall), and incorporating the risk of market illiquidity.
Other important elements of the Basel III revisions are the introduction of a leverage ratio, which assesses capital relative to accounting-based definitions (rather than risk weightings) of exposure, and new ratios for measuring both short-term and structural funding liquidity.

29 Institutions Designated as G-SIFI by the FSB
• Banco Santander, S.A.
• Bank of America Corporation
• Bank of China
• Bank of New York Mellon Corp.
• Barclays plc
• BNP Paribas
• Citigroup Inc.
• Commerzbank AG
• Credit Agricole
• Credit Suisse Group AG
• Deutsche Bank AG
• Dexia
• Goldman Sachs Group
• Groupe BPCE
• HSBC Holdings plc
• ING Bank NV
• JPMorgan Chase & Co.
• Lloyds Banking Group plc
• Mitsubishi UFJ Financial Group
• Mizuho Financial Group, Inc.
• Morgan Stanley
• Nordea Bank AB
• Societe Generale
• State Street Corporation
• Sumitomo Mitsui Financial Group
• The Royal Bank of Scotland Group plc
• UBS AG
• UniCredit S.p.A.
• Wells Fargo & Co.

The struggle to form a government in the aftermath of inconclusive Greek elections
last weekend has turned many market-watchers into micro-political analysts,
counting seats and attempting to decipher the platforms of new and sometimes
marginal Greek political parties for coalition-forming potential. At the same time,
assessing the prospects for France’s mid-June legislative elections has also begun
in earnest, with investors fearing that the strong performance from the far Right and
far Left in the first round of the French presidential elections could signal a
challenge for incoming President Francois Hollande in securing a legislative
majority.

We do not rule out the potential for a late-breaking compromise agreement or
caretaker national unity government to emerge in Greece, although we think such
an outcome is both unlikely and would be, at most temporary, with new elections
around June 17th more likely. For France, we are of the view that Hollande’s
Socialist Party is likely to gain either an outright majority or a working coalition with
parties such as the Left Front and/or the Greens. Still, we think that excessive focus
on these short-term outcomes misses the broader point: in the eurozone, the fragile
consensus behind austerity in the periphery and tolerance for bailouts in the core is
rapidly eroding as anti-establishment sentiment grows in both, giving way to a new,
more fluid political geometry.

The use of the term “new political geometry” is intended to convey more than simply
heightened political risks in the eurozone. Rather the sense of political dynamics in
flux, including in Germany, where weekend elections in Nordrhein-Westphalia saw
not only gains for the opposition SPD and a weak performance for Merkel’s centreright
CDU, but also a surprise boost for the government’s beleaguered coalition
partner, the Free Democrats. This result should not be over-interpreted to suggest
significant weakness for Merkel’s leadership, as her party was not expected to win.
More subtly, we think the combination of political changes elsewhere in the EA will
provide the Chancellor, one of the few leaders in the Advanced Economies to see
her popularity rise despite the challenges of the crisis, with a useful pretext to move
to the centre. In the months ahead, we believe she may move to position the CDU
for another of the Grand Coalitions with the SPD, which regarding the influence of
the SPD in the Bundesrat (upper house of parliament) is de-facto already at work.

Among the key components of the new political geometry are a revolving door of
leaders, constantly altering the power dynamics (enter “Frangela”), a host of
new/extreme/alternative political parties (NEAPs), and ever-shorter political
honeymoons, as voters become quickly disappointed with the meaningful absence
of alternatives to austerity.

Taken together, we believe we may be in the early stages of a sort of “political
adjustment” to accompany the processes of fiscal and structural adjustments. The
trouble is, the processes are on a collision course that could create political
paralysis at best and increase the risks of negative consequences at worst during a
particularly challenging period in the eurozone crisis, where the risks of a Greek exit
(“Grexit”) have risen to 50-75%, in our view .

Europe political map

What’s more, temporary emergency solutions, such as instituting unelected
technocratic governments, as happened in Greece and Italy in 2011, cannot be
expected to continue for an extended period. Instead, the dismantling of old political
parties and the emergence of new ones, or lists of individuals rather than parties,
could lead to a re-formulation of the political landscape of some countries. We
would also not be surprised to see calls for the restoration of the monarchy or other
highly unlikely “extreme” political responses in the most problematic cases. But
investors should not place much faith in the durability of political solutions that lack
popular legitimacy.

Trustbusters?
Since the global financial crisis, public trust in both government and business has
declined sharply, underscoring rising anti-establishment and anti-elite sentiment.
For example, in Italy, public support for political parties has dropped to an all-time
low of just 4% following a spate of prosecutions surrounding the improper use of
public funds in financing political parties. Such poor ratings for political parties at
large are likely a significant part of the reason that Italy’s unelected, non-politician
Prime Minister Mario Monti still enjoys approval ratings of between 40 and 50%.

The vacuum is also helping fuel the rise of Italy’s newest political party, the 5-Star
Movement, led by Genoan comedian Beppe Grillo, currently polling in 3rd place,
supplanting long-established parties.

As we noted in the wake of the Arab Spring, anger over perceived corruption and
cronyism is a frequent catalyst for galvanizing public sentiment, potentially unifying
segments of the population against regimes. This risk is not limited to dictatorships
or non-democratic regimes.

Public trust in government has declined sharply

In the European context, we think revolution remains unlikely, with elections and
protests allowing opportunities to vent political frustration. But public tolerance for
the fixtures of the political scene offering policies from the standard playbook may
be wearing thin. In Greece, 5 years into a sharp adjustment, this process is the
most advanced, with only 30% of the public voting for either of the two main parties
that have run the country since the end of military dictatorship in 1974. Elsewhere,
mainstream parties continue to command a majority, albeit in most cases a
shrinking one.

We think the Greek outcome is unlikely to be replicated in other eurozone countries
and reflects the country’s specific circumstances, but note that all around Europe,
protest parties of various stripes are gaining momentum, even though with
seemingly unformed platforms and unclear policy agendas. The potential for new,
extreme and alternative political parties to influence Europe’s political geometry may
be under-appreciated by markets focusing on each outcome as a discrete event
rather than as part of a wider macro trend (and one not limited to Europe: witness
the continuing influence of the Tea Party movement in the US). Such parties may
make inroads at the local and parliamentary level for many years before they might
be expected to win higher political office.

2012: Revenge of the Protest Party?
The backlash against austerity that was abundantly clear in the electoral outcomes
in France and Greece, preceded by the centre-right Dutch government’s collapse
over its failure to pass an austerity budget and the stirrings of pre-election dynamics
in Germany and Italy, which must hold elections by 2013, points to a new and more
uncertain phase in the eurozone’s political geometry, four years into the crisis. With
few eurozone countries governed by the same leaders they were last year and amid
the sharp uptick in public anger against mainstream politicians, we fear it will
become increasingly difficult for leaders to enjoy the degree of legitimacy necessary
to demand sacrifices from the public — let alone pass controversial crisis-related
legislation.

This new, more risky political phase represents a reversal of the 2011 trend along
the eurozone periphery of government collapses followed by electoral victories by
mainstream opposition parties, who had actively campaigned on pro-austerity
platforms, typically winning parliamentary majorities (Portugal, Ireland, Spain). In the
core countries, the rise of alternative parties was evident during the same period,
with the True Finns and the Dutch Freedom Party (PVV) entering parliament for the
first time, albeit with relatively small numbers of seats.

The collapse of the “moderate middle” and rise of alternative, new and extreme
parties has been well documented as consistent with the aftermath of financial
crises generally (Mian, Sufi, Trebbi, Resolving Debt Overhang: Political Constraints
in the Aftermath of Financial Crises, NBER 2012). We have been tracking this trend
for the past 12 months and note the emergence of 3 broad categories of political
alternatives in the European context.

1. Unaligned Alternatives: “Alternative” parties, such as Germany’s Pirate Party,
often described as an “Internet-based” party, with a vague platform advocating free
Wi-Fi access and free public transportation, and Poland’s Palikot’s Movement, also
popular with the under 40s and offering a secular political alternative. At this stage
these parties do not present a challenge to the established political order in terms of
their political priorities. Nevertheless the Pirates’ rapid rise — gaining 7.5% of the
vote in Germany’s largest state, Nordrhein-Westphalia, in the May 12 regional
elections — is a result that allows them to enter their fourth state parliament.

2. New Nationalists: The second type of party gaining strength is a re-branded
existing political party, frequently one with a historically nationalist agenda, such as
Ireland’s Sinn Fein, the Scottish National Party, France’s National Front, The
Netherlands’ and Austria’s Freedom Parties, Finland’s True Finns, and Greece’s
Golden Dawn. These parties have broadened their base and increased their share
of voter support by expanding beyond their core “brand proposition” to include anti-
EU and/or anti-euro sentiment (or, in the case of the SNP, anti-Whitehall sentiment).

This strategy has brought disenchanted voters from both the Left and the Right, and
likely helped deliver the National Front’s strongest performance to date in the first
round of the French presidential elections, an outcome the party’s leader will aim to
build upon in the upcoming legislative elections in mid-June.

3. Anti-Establishment Heroes: Greece’s Syriza, France’s Left Front, Italy’s 5-Star
Movement. It is the success of Greece’s Syriza party that has most rattled markets,
with its promise to tear up the Memorandum of Understanding with the Troika and
attempt to negotiate more favourable terms. Syriza’s surprise success in the May 6
elections, where it came second in the polls, appears to have accelerated its
support in the election’s aftermath. The party seems likely to increase its share of
the vote in the event of new elections, a factor that may have the effect of helping
the mainstream and pro-MoU parties to overcome their differences.

With the exception of Syriza in Greece, the proportion of the vote controlled by
NEAPs typically remains small, yet their growing success in attracting disaffected
voters produces a number of effects. Most notably, NEAPs are altering the electoral
arithmetic, granting them influence beyond their relatively small numbers, which can
be used as either spoilers or dealmakers. The Freedom Party in the Netherlands
was able to trigger the collapse of the government over its austerity budget despite
the fact that the Dutch politicians are among the most pro-austerity in Europe.

Greater popularity for NEAPs also serves to fragment parliaments, making the
passage of legislation more problematic.

The Agony of Austerity
As unemployment levels continue to rise, economic recovery falters, and citizens
increasingly blame the political establishment and Brussels for their predicament,
we think 2012 will see further erosion to the “moderate middle”, providing an
opportunity for more new and extreme parties gain additional support.

We believe this trend will be found in both core and periphery, and will produce
increasingly weaker multi-party coalitions that are more prone to collapse and less
amenable to coalescing around the kind of “just in time” last-minute policy
compromises that staved off adverse outcomes in 2011. A cycle of electionscollapse-
elections-collapse, with each election bringing a weaker coalition, is
therefore a distinct but unwelcome prospect at the very time when continued
commitment toward the fiscal integration agenda is most needed.

Incoming French President Francois Hollande’s campaign promise of growth
instead of austerity is highly unlikely to translate into concrete, near-term results,
suggesting that any concessions he is able to win from Berlin and the European
Central Bank on pro-growth measures could be little more than political gestures,
unlikely to change the reality for the man on the street. But he is not alone in his
desire to focus on a growth agenda: the participants in the new anti-austerity chorus
have grown more credible, numerous and louder, spanning Mario Monti in Italy,
Mariano Rajoy in Spain and now France’s Francois Hollande.

We do not see a change of approach in respect of the front-loaded fiscal austerity
measures that have been mandated, and his supporters are likely to be
disappointed in the slow rate of return on structural reforms. But we think that
Hollande’s victory on a campaign platform of an alternative to austerity, however
unlikely to transpire, could breathe new life into the defunct European Social
Democratic parties, and possible Syriza-clones elsewhere in Europe. Such a policy
stance would, of course, invite the immediate discipline of the bond markets.

Perhaps counter-intuitively, we think that the heightened calls for growth could well
be met with more emollient words from German Chancellor Angela Merkel, who
faces elections by 2013 amidst rising popular opposition to bailouts. Never one to
miss a political opportunity, the Chancellor will, we suspect, use Hollande’s victory
and the advent of their new working relationship, inevitably to be called “Frangela”
(replacing “Merkozy”), to endorse aspects of his pro-growth agenda, thereby
stealing a march on her center-left rivals, the SPD. In any case, we see adopting
the language of growth if not committing significant additional funds, as a low-cost
political option in an election year. And domestically, Merkel might use the
increasing fiscal room on Germany’s own budget to put in place some growthsupporting
measures.

With the Irish referendum on the EU fiscal compact due on May 31st and looking
likely to be a referendum on the incumbent government, and possible new elections
in Greece in June alongside French legislative elections in two rounds, the coming
months will continue to feature political signposts — opportunities for disgruntled
citizens to voice their frustrations. With Italian and German elections due by 2013,
the eurozone’s political geometry will likely continue to shift and reformulate in new
and potentially unexpected ways.

What are the economic consequences of a rejection of
current austerity policies?
Austerity is painful because it depresses economic activity (typically referred to as
growth in this debate, although the term ‘growth’ really ought to be reserved for
matching expansions of actual output and potential output). Less austerity (and
perhaps the same NPV of austerity measures spread out over a longer period of
time) would be less painful, if it could be implemented. Unfortunately, in Europe, the
reason that so much austerity is implemented in the periphery is not that someone
forgot to push the growth button. Growth is not a policy but an outcome produced
by good policies, good institutions, good initial conditions, good funding conditions
of the public and the private sector, a good external environment, and good luck.

Restoring fiscal sustainability is always painful and will (almost) always depress the
level of economic activity. There may be an optimal speed of correction of a fiscal
imbalance of a given size. If European countries pursue fiscal tightening very
aggressively and with a significant negative impact on output and employment,
does this mean that the timing and speed of fiscal austerity is wrong? Only, in our
view, if the optimal fiscal consolidation programme is conceptualised without
imposing a key constraint: the ability to fund the transition from fiscal
unsustainability to fiscal sustainability on affordable terms.

Once the funding constraint is recognised, anti-austerity is a powerful web of
emotions, but not a coherent set of policies unless (a) the markets will fund you at
sustainable rates if you reduce the severity of the austerity and/or (b) there are nonmarket
sources of funds available to fund the larger deficits almost certainly
associated with ‘less austerity’. (a) is relevant only for the US, Japan and Germany
(of the economically significant players). None of the periphery countries (Greece,
Ireland, Portugal, Spain, Italy, Cyprus), or the soft core (Belgium, Austria, France,
the Netherlands) would be able to fund themselves on affordable terms in the
markets if they relaxed their austerity programmes substantially. So for them, a call
for less austerity is a call for additional concessional funding from the
EFSF/EFSM/ESM/EIB, the IMF or the ECB/Eurosystem.

The resources available to the EFSF/EFSM/ESM are not going to be increased
significantly in the foreseeable future. The EIB may get what’s left in the EFSM
(about €12.5 bn or so) as additional capital, which it can then leverage to boost
infrastructure or green investments. But even if it were to double the lending
capacity of the EIB (about €80bn a year), the increase would be less than 1 percent
of euro area GDP. The IMF now has probably $389bn + $430bn = $819bn to play
with, but it will not do more than 1 euro for every 2 or 3 lent by the EFSF/ESM. That
just leaves the ECB/Eurosystem as not merely the lender of last resort to periphery
sovereigns, but a lender of last resort that takes considerable sovereign credit risk
exposure when it purchases sovereign debt outright in the secondary markets
(through the SMP) or when it lends to zombie banks that offer periphery sovereign
or sovereign-guaranteed debt as collateral.

The ECB can be pushed where it does not want to go to some extent, but probably
not enough to permit a meaningful relaxation of fiscal austerity in the periphery. It
should continue to intervene to prevent disorderly sovereign defaults, but not
necessarily to prevent orderly sovereign debt restructuring involving PSI, as in the
case of Greece. It will continue to intervene to prevent the collapse of systemically
important banks and other financial institutions (SIFIs), but it may reluctantly agree
to the restructuring of unsecured bank debt (subordinated first, but if necessary also
senior) if the alternative is the ECB/Eurosystem getting stuck with an ever-growing
exposure to weak sovereigns and weak banks. It is significant that both Draghi and
Constancio have recently called for a European Bank Resolution regime and a
European Resolution Fund (bank recapitalisation fund) for the 34 largest banks. No
doubt, before senior unsecured bank debt can be restructured, depositors will need
to be given preferred creditor status to other senior unsecured creditors. The ECB
leadership will likely also want Commissioner Barnier’s proposals for a pan-EU (or
pan-euro area) bank resolution regime (the bail-in model) to be formally presented,
submitted to the EP and put in place.

But a political mood increasingly inclined towards a rejection of austerity without
matching funding is bound to mean more sovereign debt restructuring in the euro
area periphery and more unsecured bank debt restructuring.

It is true that there is an obstacle to less austerity other than insufficient funding.
That is the prevailing orthodoxy on the part of the Commission, which reflects the
Teutonic consensus that austerity alone may be expansionary and that austerity
combined with structural reforms that liberalise labour markets, deregulate the
professions and other over-regulated industries, privatise state-owned enterprises
and reduce red tape everywhere is definitely expansionary. As regards the first
proposition, that contractionary fiscal policy is expansionary, there is no evidence to
support it and lots of evidence against it. Contractionary fiscal policy is indeed
contractionary. Not self-defeating, in the sense that there is a Keynesian Laffer
curve (fiscal tightening actually increases the government deficit because it has
such negative effects on the level of activity), but definitely contractionary and costly.

If more resources were to become available, from whatever source, to fund a
relaxation of austerity policies, it is possible that the Teutonic Consensus would
prevent a renegotiation of the existing fiscal agreements between euro area
member state governments and the Commission, either as part of a troika
programme (for Greece, Ireland and Portugal) or as part of the regular surveillance
of national economic policies of EU and especially euro area member states by the
Commission. The change in the political climate reflected in the victory of Hollande,
the popularity of no-to-austerity parties in the Greek election and the fall of the
Dutch government over a dispute concerning fiscal austerity among the parties
supporting the coalition government may weaken the influence of the Teutonic
consensus. Mario Monti as early as November 2011 (please see Europe:
Economics Daily – 25 November 2011) stated that should Italy’s government deficit
overshoot the benchmark agreed with the Commission not because of bad faith by
the Italian policy-makers but because of bad luck (that is, not because of wilful nonimplementation
of agreed-upon measures but because of a weaker-than-expected
performance of the real economy), he would not want the original targets to be met
within the originally planned time horizon by implementing yet more austerity
measures.

The IMF, through the interventions of its Chief Economist Olivier Blanchard,
supports the view that fiscal policy should not be perversely pro-cyclical by insisting
that the original targets and target dates for fiscal consolidation continue to be
adhered to even if the fiscal outcomes disappoint through no fault of the country
implementing the austerity programme.

We are therefore likely to see some willingness by the Commission and the troika to
let the automatic fiscal stabilisers work when there are ‘good faith’ budget deficit
overshoots, as long as the existing resources of the troika are adequate to the task
and as long as the necessary supportive actions of the ECB/Eurosystem do not
exhaust the ECB/Eurosystem’s willingness to take on additional exposures to the
periphery sovereigns. This could be through SMP purchases of periphery
sovereign debt in the secondary markets or, to us more likely, through further
LTROs that, combined with financial repression in periphery countries that either are
not yet on troika programmes or that are on troika programmes but continue to fund
themselves in part in the markets (our central scenario for Spain this year and a
likely scenario for Italy at some stage), permit the sovereigns of countries such as
Spain and Italy to fund themselves in the primary markets on affordable terms.
None of this is, however, likely to eliminate the high probability (50-75% in our view)
that Greece could exit the euro area. Around 70% of the Greek electorate wishes
to stay in the euro area but 70% of that same electorate also rejects the
Memorandum of Understanding (the next installments of the troika programme with
its further fierce fiscal tightening and its radical structural reforms of politicallysensitive
institutions). The fact that rejecting the MoU means saying goodbye to the
€90bn of additional troika funding is either not part of the public’s awareness or is
denied. The deputy leader of Syriza has stated publicly that the troika “will be
begging Greece to take the money”.1 We believe him to be mistaken. Austerity and
structural reform fatigue in Greece are real, but so is the growing awareness in the
rest of the euro area (and not just in the hard core) that it makes no sense to throw
good money after bad. Better to use all available resources to limit the fall-out for
the rest of the euro area from a Greek exit, than to postpone the inevitable,
increasing the expected loss to the troika and the ECB conditional on a Greek exit
occurring and undermining any incentives other periphery countries may have to put
their fiscal houses in order and restructure the inefficient and unproductive parts of
their economies.

US and UK observers and commentators fall into two camps. One camp believes
that Greece will exit and that it will be impossible to ring-fence or firewall the
consequences. As a result there will be a de-facto unravelling of the euro area,
leaving a rump-Greater DM zone. The other camp believes that, at the last
moment, Mr Stratoulis will be proven right and some combination of Germany plus
the rest of core Europe, the IMF and the ECB will open their wallets and fund the
Greek sovereign despite a failure to comply with the fiscal austerity, structural
reform or privatisation conditionality of the MoU. Such a one-sided transfer union —
effectively an open-ended and uncapped commitment to fund a sovereign that is
unwilling or unable (and now also would have no incentives) to pursue fiscal
sustainability and structural reform — is not compatible with the survival of the euro
area, in our view, because it would drive Germany and the rest of core Europe out
of the euro area. But if the belief that the troika is bluffing becomes widespread in
Greece, a Greek exit could be near indeed.

Implications for European Equities
The three biggest risks to European equities continue to be: 1) debt, 2) politics, and
3) electorates. It has been rare, over the past many years, to have considered
political risk in a “Top 3” European equity risk list, rarer still to have two out of three
slots accounted for by political risk. Many investors ask us why we split out 2) and
3) as they both come under the same political risk banner. True, but status quo
political risk can shift quickly when electorates vote. We have seen that in practice
over the past week or so with market reaction from not all that surprising election
results in Greece and in France. German bund yields have been driven to record
lows and there has been a more general sell-off in risk assets.

Overall, political risk — the Eurozone’s New Political Geometry, the rise of the
NEAPs and stronger support for New Nationalists — presents an unhelpful
backdrop for Europe’s economy, the corporate sector and for equity markets.
Here, we consider the implications of recent political developments across Europe
on the outlook for European equity markets. There is a lot of bad news already
baked into share prices, but a disruptive Greek exit probably is not, nor is a collapse
in profits or global economic recession. Investors should also recognise that Europe
has many companies that have high levels of non-European exposure and strong
balance sheets. We think that Europe is a good place for global investors to come
shopping, but our advice is to “try on before you buy and stick to quality products”.

We also highlight the clear divergence of performance across Europe between the
“haves” and the “have-nots” and suggest a euro break-up hedge for more bearish
investors. In a world of de-leveraging and lower and divergent growth, our overall
strategy is still to back the structural re-rating of strong credit, growth and quality
within the equity market.

Europe vs
Recent events have put the spotlight back on a country that accounts for 0.3% of
global GDP and 0.1% of global equity markets — Greece. But, despite events in
Greece, investors should be careful before treating Europe as one equity market
bloc. We see both risk and opportunity in European equity markets.

Figure 6 shows YTD total returns for various equity market indices around the
world. German equities (DAX 30) have beaten US equities (S&P 500), with overall
European equities (Stoxx 600) not too far behind MSCI emerging markets. Spanish
equities, representing the periphery of Europe, have done poorly in absolute and
relative terms.

While investors may be surprised at the resilience of headline European markets so
far this year, given the depressing newsflow, they may also be surprised to learn
that European equities have also done better than US equities YTD.

Recent political changes in Greece mean that investors are increasingly viewing a
Greek exit from the eurozone as most likely. Current political dynamics suggest that a
new Greek government will have to rely on participation from left-wing parties, which
are calling for a renegotiation of Greece’s agreement with the Troika. A breakdown of
such a negotiation would likely lead to a cut-off in external funding. This would
effectively imply currency separation and transition towards a new national currency
in Greece. The implication for the euro is clearly negative in our view, as a Greek exit
would trigger additional instability in the eurozone banking system, further rises in
risk premia on eurozone assets, and additional deterioration of capital flow dynamics.
Our current forecast target for EURUSD in Q3 is 1.25. Should we fully adopt the
Greek exit scenario as our central case, we think a target range of 1.15-1.20 would
be more appropriate. We will make a final evaluation after a second round of polls,
and we remain short EURUSD from a trading perspective.

New consensus: Greek eurozone exit the central case
Following the surprising election results in Greece a week ago, consensus opinion
has shifted substantially with regard to the central case for Greece. The consensus
now believes that a Greek exit from the eurozone is likely over the next 6-12 months:
• We conducted an informal poll at the Euromoney FX conference in London
last week, and a large majority of the audience (around 70%) judged that
Greece was likely to exit the eurozone over the next 12 months.
• Bloomberg announced a more comprehensive poll of investors at the end of
last week, in which 57% of respondents thought that a Greek exit from the
eurozone was likely in 2012.

Political situation points to ‘renegotiation’
The political situation in Greece continues to point to a second round of polls, most
likely in mid-June. The sharp fall in support for the mainstream parties (PASOK and
New Democracy) and the increased momentum of fringe parties (especially on the
left) mean that it will be very difficult to form a functioning government.

In particular, the Radical Left is probably needed as a coalition partner to form a
sustainable government, but there has been little indication to date that the Radical
Left has any appetite to join a government with mainstream parties. Efforts to form a
broad coalition government have failed after the first week of negotiations. Moreover,
recent opinion polls suggest that a second round of elections is likely to produce a
result with even more support for the left-wing parties (especially if the left-wing
parties consolidate to secure the 50 bonus seats that are awarded to the biggest
party according to the Greek election system).

The most likely political scenario, in our view, is one where a government with a
strong left-wing influence is formed after a second round of polls, and thereafter tries
to renegotiate Troika demands (the Memoranda of Understanding).

In our opinion, there is little desire within the Troika (ECB, EC and the IMF) to
renegotiate. Certain symbolic concessions are feasible, but that is probably it. As
such, it will be hard to reach a compromise, and we could see a breakdown in
cooperation between Greece and its European/international partners in the months
following the second round of the election.

Breakdown in cooperation with Troika implies currency
separation
In this scenario, official funding for Greece could come to an end a few months after
a second round of polls. Such a cut-off would include both an end to funding for the
Greek government (from the EFSF and the IMF) and an end to funding for banks in
the form of special liquidity support for the Greek banking system (ELA assistance
from the Greek National Bank approved by the ECB). Based on current political
trends, the break point could happen around July/August, when the next quarterly
disbursement is set to take place.

Terminating this special liquidity support may sound like a technicality, but it is not.
Turning off such assistance would imply that Greek banks would lose access to
much-needed euro funding, which would leave them no longer able to provide euro
liquidity to the general public domestically. This type of separation of balances in
Greek banks from balances within other eurozone banks would lead ‘Greek euros’ to
trade at a discount to ‘normal euros’ and would effectively amount to the adoption of
a new national currency.

Over time, new currency laws would have to be approved by Greek lawmakers to
formalize the redenomination of contracts subject to local Greek law (such as
deposits, equities, and local law loans and bonds). This process would likely involve
significant problems associated with capital flight and potential domestic deposit runs.
Hence, bank holidays and capital controls (at least temporarily) would probably be
hard to avoid at that stage.

At some point in this process, new notes and coins would have to be created and
introduced to formalize the shift away from euros and into a new Greek currency for
cash transactions. This step would probably happen relatively quickly, as ‘valuable
euros’ in cash form would likely be quickly withdrawn from circulation by households
and other economic agents, following the logic of Gresham’s Law (which states that
agents will tend to avoid using superior currency for transaction purposes, and
instead use the superior currency as a store of value).

This process of currency separation has happened along these lines before. The
best recent example is probably the break-up of the Ruble Zone in the early 1990s.
In that example, the key breaking point happened when the Central Bank of Russia
refused to provide daily credit to the national central banks of the former regions of
the Soviet Union.

Implications for a new Greek currency and solvency
Over the past six months, we have comprehensively analyzed various aspects of
break-up scenarios. One element of this analysis was an initial attempt to quantify
fair values for new national eurozone currencies, including a new Greek currency
(see G10 FX Insights: Currency risk in a eurozone break-up: Valuing potential new
national currencies – 4 December 2011). Our estimates are derived from metrics of
current overvaluation of national real exchange rates as well as a framework to
quantify future inflation risk after eurozone exit and a move to independent monetary
policy.

Our initial estimates point to potential currency depreciation of 50-60% in the case of
Greece. We note that our framework is deliberately simplified and does not take into
account various factors which may impact short-term dynamics (such as possible
availability of bridge financing from international partners). Nevertheless, we think our
framework is a useful starting point for examining currency risk in break-up scenarios.
Moreover, we note that it is highly unlikely that the Greek sovereign would be able to
remain current on various debt obligations (primarily towards official creditors at this
point), and we would likely see some type of default if external assistance were cut
off. This would have significant spillover effects to Greek banks and Greek
corporations.

What to watch
There are many moving parts at this stage. But the main ones remain political, as
political factors will determine the path for Greece from here.

On the Greek domestic political front, we will be watching to see whether the opinion
polls show any signs of a shift back towards support for the mainstream parties (no
evidence of that at this point). In addition, any evidence of a softening of the stance
of the Radical Left in terms of its demand for concessions from the Troika could be
important (evidence is mixed on this front at this stage).

On the eurozone side, we will have to watch whether key European leaders,
including the new leadership in France, have any appetite to compromise. At this
stage, the communication, especially from Germany, has been clear, and there has
not been much in the way of opening. But it is hard to tell whether this is posturing,
and whether this could change after a second round of elections, when Greece finally
sits down with international partners at a real negotiation table.

Beyond the Greece-specific state of affairs, it will also be important to monitor
whether there is any movement in terms of bolstering the infrastructure to reduce
contagion effects from turmoil in Greece, especially that around an actual Greek
eurozone exit. There is plenty of debate about the need for common eurozone bank
supervision and potentially even regional deposit insurance. But there is little
evidence that this debate is making any concrete progress. This process is further
complicated by the fact that the fiscal compact, agreed in January, has yet to be
ratified, making it hard to take significant steps towards additional integration.

Impact on the euro
Our central case for the euro has been one of gradual decline for some time (see
G10 FX Insights: The New Euro After the LTRO – 04 Mar 2012). Specifically, our
target for EURUSD in Q3 has been 1.25 for a while, and from a trading perspective
we have been short EURUSD for three weeks, targeting a shift down to the 1.26-1.28
area.

However, these forecasts and trading views have not been explicitly based on a
Greece exit scenario. Assuming a Greek exit happens in Q3, the right target for
EURUSD may not be 1.25, but rather something in the 1.15-1.20 range. The basic
premise behind our view is that a Greek exit would lead to further instability in the
eurozone banking system, a further rise in risk premia on eurozone assets, and
additional deterioration in external capital flows.

Such a scenario would also have implications for the relative performance of risk
assets, including risk-sensitive currencies. We would expect USD and JPY to be the
outperformers in that case, while the outlook for more risk-sensitive currencies is
much more uncertain, even for countries with superior fundamentals relative to the
eurozone.

Preparing for a Greek Eurozone Exit: Part II

Contagion Effects & Deposit Dynamics
In Preparing for a Greek Eurozone Exit (Part I) we discussed the political situation in Greece, how currency separation could happen after the second round of the election, and what it would mean for a new Greek currency and for the euro (see G10 FX Insights: Preparing for Greek eurozone exit (Part I) – 14 May 2012).

In this article, we focus on deposit dynamics and the contagion effects linked to a Greek eurozone exit, including those that may happen in expectation of an exit.

We start with the most tangible effects related to a Greek exit: the real and financial spillover effects to the rest of the eurozone, we then turn to deposit dynamic issues, which are inherently harder to quantify.

Spillover effects: Real and financial
Real effects through trade links: An exit from the eurozone and termination of external funding programs will undoubtedly have significant direct implications for the Greek economy. Without pretending to be precise about the effects involved, we think it is fair to say that a large swing in the current account balance would be forced by a lack of capital inflows and inevitable capital flight. The current account deficit was 9.8% in 2011, and it would be no surprise to us to see a swing to a surplus of 10% of GDP. Since exports are unlikely to respond much in the short term (the J-curve effect), the bulk of the change would probably happen through declining imports, driven by a forced drop in consumption. However, the spillover effects to trading partners is likely to be small, given Greece’s small share of its eurozone trading partner’s trade. For example, according to our estimates, the impact of a 30% drop in Greek imports would not exceed 0.3% of GDP for any eurozone country (see Figure 1).

Economic trade effect Limited real economy spillover effects

Financial sector links trough banks: The more important channel is likely to be the effects through financial losses on Greek assets held abroad. The potential private sector losses are substantially smaller than what they would have been two years ago. This is because private sector exposure has already been reduced through active sales of Greek assets and write-downs (including those related to the PSI in Q1). All told, eurozone banks have $65bn in remaining exposures, mainly to Greek corporations. Within this figure, by far the biggest concentration is within French banks, which have $40bn in exposure according to end-2011 BIS data (see Figure 2). These exposures have partially been provisioned for (for the most important entities, provisions are likely to be in the region of 20% of the loan book). When thinking about potential hits from Greek exposures, it is worth considering the option of abandoning Greek businesses entirely to limit hits to equity at the head office level. Nevertheless, a Greek exit could generate significant additional charges for some important eurozone banks.

Non-bank financial exposure: Other private sector exposures in Greece are fairly small at this stage from a macro perspective. In Figure 3, we show the full external balance sheet of Greece (the liabilities of the international investment positions as of end-2011). The column to the right shows our rough estimates of current exposures, taking into account write-downs on government bonds and official disbursements in 2012. The bottom line is that the private sector exposures through FDI, portfolio equity and bonded debt are moderate at this stage. The only larger exposure is through banking liabilities, which add up to $91bn. But the bulk of this (around $80bn) is accounted for by banks globally ($65bn by eurozone banks, and $14bn by other banks globally), leaving just slightly above $10bn in additional (non-bank) exposure to Greek banks.

Deposit dynamics: What is the state of affairs in Greece?
Yesterday, we received an unusually timely update on deposit dynamics in Greece. Dow Jones quoted a statement by Greek President Papoulias, saying that the Greek banking system lost EUR700mn of deposits and received an additional

Relevant bank exposures to Greece

EUR100mn in buy orders for German Bunds on Monday. It is hard to evaluate such a stand-alone daily figure, but it does look large relative to the monthly pace of decline in demand deposits, although perhaps not unprecedented on a daily perspective (see Figure 4). Recent „bad months‟ have seen a monthly drop in demand deposits of around EUR3bn. Hence, a few days of outflows close to EUR1bn should be seen as an early sign of increased instability of the Greek deposit base.

Given the elevated risk of a Greek eurozone exit, and the prospect of a 50-60% devaluation of a new Greek currency (not to mention the potential for bank holidays) it would be no major surprise to see such increased deposit flight. To recap key statistics on the size of the domestic deposit base: there were EUR170bn of domestic (non-government deposits) as of March, of which EUR66bn were in the form of demand deposits. April figures will be out in two weeks time, but as usual, the official data on deposits are likely to be too lagging, to provide much support for trading decisions.

Deposit dynamics: When will Greek banks run out of cash?

As always, in a situation of heavy deposit withdrawals, cash shortages can develop. This pertains to physical cash as well as liquidity more broadly. This point is generally reached when a bank runs out of eligible collateral for refinancing purposes. But within the eurozone, this may not always be a firm constraint. In Ireland, several troubled banks faced funding difficulties in 2010 and 2011 and relied on Emergency Liquidity Assistance (ELA) from the Central bank of Ireland to avoid failure. Such liquidity injections affect the money supply in the eurozone and require approval from the ECB, although the specific procedures around the approval process are not public information.

In Greece‟s case, it is therefore conceivable that the ECB would approve of the Bank of Greece providing Emergency Liquidity Assistance to troubled Greek banks up to some limit. This process is complicated by the political situation, however. In Ireland‟s case, a functioning government was cooperating with the ECB to secure the central bank‟s interest. In Greece‟s case, there is no functioning government, and the Radical Left, which is leading in recent opinion polls, has campaigned on a program of non-cooperation with the Troika, including the EU, potentially putting ECB assets – including the assets generated by ELA – at risk.

Monthly demand deposits are declining

Emergency Liquidity Assistance for Greece complicated by politics
This creates a very complex dynamic: by approving ELA funding for Greek banks, the ECB may risk funding a full-blown deposit run and incur additional exposure of increasingly questionable value. But by refusing ELA funding, the ECB could trigger currency separation (i.e. the eurozone exit) even before the final election result is known.

The alternative option may be to announce a full or partial bank holiday, until a viable government is formed to limit deposit withdrawals. But given that the election is roughly a month away, this may not be a practical option. To our knowledge, there is no precedent for a bank holiday lasting several weeks for an economy with similar financial development to Greece.

Cross-border contagion through deposit dynamics
In the past, it has been popular to argue that a Greek eurozone exit would generate uncontrollable capital flight, not only in Greece, but also in other eurozone countries with weak banking systems. But this thinking is currently shifting. Policymakers, including German policymakers, are starting to embrace the possibility of a Greek exit. The thinking is that sufficient fire-walls have been built such that the rest of the eurozone can manage a Greek exit. Time will tell whether this policy view is correct.

As deposit dynamics are very difficult to forecast, it is difficult to tell whether instability in the Greek deposit base will have implications for deposits in Portugal, Ireland, Spain and perhaps Italy too. But it is clear at this stage that the ECB and European policymakers more generally are looking to frame a Greek eurozone exit as a Greek decision. For that reason, the ECB would not want to be seen as making an active decision to cut off liquidity to Greece, and thereby „force Greece out of the Eurozone‟. This would set a bad precedent for other countries and could even be a catalyst for deposit withdrawals on its own in places such as Portugal and Spain. This would also further exacerbate the perceived asymmetry of risk associated with investments in the periphery, with negative implications for (institutional) capital flows, including the cross-border capital flows which matter the most.

This is especially the case as the notion of a cross-border deposit insurance scheme does not seem to be a realistic prospect in the near future (within the time-frame needed to be relevant in the context of the Greek exit debate).

Implications for the euro
Tensions surrounding Greece are escalating further. The key issue is that of deposit runs, which has potential to force a bank holiday. This is especially the case since the ECB may be politically constrained in approving emergency liquidity assistance for banks in an environment where Greece has no functioning government.

Moreover, as there is no cross-border deposit insurance scheme in place within the eurozone, and as there is little prospect of such a scheme being implemented any time soon, there is a risk of deposit instability spreading to other peripheral countries.

With this new risk looming, it seems likely that eurozone risk premia will continue to rise in the run-up to the second round of the Greek election, scheduled for June 17.

In relation to the euro, the risk premium is the dominant variable at this juncture, and we could well continue to trade lower as a result vs USD and JPY (other crosses are a different story).

We had been targeting a move to the 1.26-1.28 range when we initiated fresh EURUSD shorts a few weeks back, and we have reached that trading target now. But given the potential for further crisis escalation, including the fall-out from a potential bank holiday, we are holding on to shorts. We are looking to manage our EURUSD position with a trailing stop, rather than taking profits at the target level.

 China Mobile expects smartphone shipments of more than 35mn in 2012
 Huawei and Qihoo360 to partner in smartphone business
China Mobile expects smartphone shipments of more than 35mn in 2012
China Mobile revealed its handset strategy at an industry gathering last
week. Key highlights: 1) China Mobile is targeting shipment of ~70-80
million handsets this year (versus 30 million in 2011, up 150% y-y); 2) TDSCDMA
smartphones to touch over a 50% penetration rate of its total
handset shipments and China Mobile is aiming for a penetration rate of
60% – 70% for the year of 2012; 3) the focus this year is on mid-range
handsets (~RMB1,000); accordingly China Mobile is on track to launch a
4-inch smartphone with a retail price of less than RMB900, and a 3.5-inch
smartphone with a retail price of less than RMB600, and a dual-core
handset is set for debut in the third quarter of this year; 4) the company
plans further to enrich its high-end smartphone portfolio; 5) the company
intends to maintain a low-end feature-phone portfolio with 2.4/2.8 inch
screen CMMB handsets.

Huawei and Qihoo360 to partner in smartphone business
According to Yu Chengdong, chief executive of Huawei Consumer
Business Group, Huawei will cooperate with Qihoo 360 (QIHU US, not
rated), a Chinese online security software company, to produce
customized smartphones for Qihoo 360 users. Yu said Huawei would open
the door to other Internet companies as well. Other Chinese Internet firms,
including Baidu Inc, Shanda Interactive Entertainment Ltd., and Alibaba
Group, have already launched self-branded smartphones.

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