Eurozone Crisis Enters New Phase

Joonatan Jakobs is more optimistic about Europe’s ability to emerge from its debt crisis but many uncertainties linger.

The last two weeks have proven interesting for people who follow the unfolding situation in Europe for two separate events.

On July 15, the European Banking Authority released reports on the health of the European banking system. These “stress tests” measured the stability of banks by evaluating their ability to hold a minimum amount of core capital when set against economic situations similar to a prolonged recession. Another function for these tests was to establish which banks were exposed to Greek sovereign debt and thus enhance trust among financial institutions, as banks are wary of lending to each other if the extent of exposure is unknown.

On July 21, eurozone leaders came together and agreed on far-reaching measures that were the most convincing for rescuing Greece to date.

Although these two events have provided transparency, time and confidence, a number of issues remain unresolved. Indeed, the reason that a relatively weak compromise on averting bankruptcy for Greece could be met with great relief in financial markets may be a lack of clear political direction within the singly currency area. There are crucial questions still unanswered and there is real risk that the framework may be the seed of an unfavorable outcome.

The larger outlines of the deal are well known by now. Greece has been alleviated of the burden of relying on the market for funds for a considerable time. This was achieved by a combination of support from the European Union and the International Monetary Fund and a voluntary, private-sector rollover and debt swap.

After much controversy, private-sector involvement was introduced partly to make the resolution feasible in Germany to continue providing funds for Greece. Although this solution entails writing off a share of the original value due to investors, for the time being it effectively removes the fear of a disorderly default that would lead to contagion. Fear of a “Lehman Brothers” moment has disappeared for banks exposed to Greek debt.

Important was also the lowering of the interest rate of Greece’s debt to 3.5 percent which will apply to Ireland and Portugal as well, in the hopes that this relief can keep them safe from further intervention. Lastly, the summit saw a widening of the powers of the European Financial Stability Facility, a financial vehicle that was granted the power to intervene if a country in the eurozone is under financial duress. This “European IMF” may prove to avert the dangers of a self-fulfilling crisis for the countries that are still deemed to be at risk.

Positive news as this is, the foundation which this solution relies upon is fragile. Although Greece will have funds at its disposal for the time being, it does little to increase the competitiveness of the Greek economy. Even with the latest package, debt-to-GDP ratios will still be higher than those of Italy at 120 percent. If Greece’s economy is not reformed in the coming years, it could need another bailout in the future.

A worry with wider implications is found in the words of the summit’s communiqué (PDF) which states that,

As far as our general approach to private-sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

All other euro countries solemnly reaffirm their inflexible determination to honor fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms…

This is currently the only guarantee that private investor debt in countries with similar problems will not face a similar write off as was the case with Greece.

For the market this will create uncertainty as the promise comes from the same leaders whose credibility is in shatters. What market uncertainty implies is hard to say at present yet when Moody’s recently further downgraded Spanish sovereign debt, it cited the possibility of future private-sector involvement as one of the main concerns. Also worrying is that since Greece’s write off will be voluntary, it does not trigger credit default swaps. The trigger may have the effect of raising borrowing costs for other highly indebted economies as investors shift to the CDSs of their debt, thus leading to higher volatility in debt spreads and increased market jitters.

What emerges from the past weeks is that no scenario is impossible. Although many important steps were taken in bringing clarity to the situation, we have yet to see the final outcome. Many saw these resolutions as a step toward further integration of the eurozone however it is unclear how strong the popular mandate is for such a development. The short-term outcome will likely entail more last-minute compromises, high stress put forth by the markets and a new financing plan for Greece. The depth of last week’s political efforts does offer some optimism for a more coherent path forward.