On Thursday morning last week, negotiations had finally come to a close. After a week of meetings between European leaders and parties involved in the continent’s sovereign debt crisis, a “comprehensive” package was presented to the world.
The summits were a response to three interconnected issues that had been discussed profusely before the summit — the worsening situation in Greece, recapitalization of European banks and safeguarding Italian and Spanish creditworthiness.
The situation in Greece has continued downward, where, despite parliamentary support for additional austerity measures, there has been an intensification of strikes and unrest.
The frictions that arose between European reformers and the Greek government in October revealed a slower pace than expected for implementing reforms and the difficulty of reaping the benefits of those reforms. The country’s economy is expected to contract by 5.5 percent this year and it may see growth again in 2013, when debt will peak at 186 per cent of gross domestic product.
This week’s negotiations saw the continuation of an agreement that was reached between eurozone leaders in July when they planned a 20 percent “haircut” of Greek debt. Last week, they ordered that private investors accept a loss of 50 percent. The bigger amount reflects the deteriorating situation in Athens and it is estimated that the writeoff will contribute to a debt level of 120 percent of GDP by the end of this decade.
The size of Europe’s temporary bailout fund is expected to increase from €400 billion to €1 trillion. Although the problems of Greece became known almost two years ago, it was not until this summer that fears over a big country defaulting reflected itself in increased lending costs. As long as the risk was contained to the smaller peripheral economies, there was no systemic risk to the whole system. However, an Italian or Spanish default would be disastrous and therefore policymakers have been looking for ways to implement a big enough “bazooka” so the bigger economies will be shielded from speculative runs.
Lastly, in order to shore up eroded confidence in European banks and safeguard them from a partial Greek default, a strenghtening of the banking industry will require a mandatory “temporary buffer” that will see a majority of Europeans banks implementing a core capital ratio of 9 percent (an extra €108 billion) over nine months. This capital is in line with the Basel III framework and is a relatively narrow and safe definition of capital.
Given the size and nature of the package, all three parts rely on factors which will be hard to live up to. For Greece, the stated aim of a debt level of 120 percent of GDP in 2020 (which, incidentally is the current level of Italian sovereign debt) means growth of 4.5 per cent in 2013, and then 3 percent up til the year 2020. This assumes that a fragile and complicated reform process will be successful at the current time frame.
The chosen method, a voluntary haircut of 50 percent of private bondholders, was the last part of the package to be agreed on and seen as a victory for German chancellor Angela Merkel and French president Nicolas Sarkozy. This left bondholders either to deal with an unorganized Greek default, which would prove catastrophic for the world economy, or a guaranteed loss of 50 percent in a relatively ordered environment.
Questions will remain regarding the consequences of this move. It is meant to make sure that the European Central Bank can keep lending to Greece (it will not lend to a country that has defaulted) and prevent cedit default swaps from being triggered.
However, investors use credit default swaps to hedge against risk and if expectations are risen that this avenue is not possible for other debt, investors may start demanding higher yields, raising the borrowing cost of other European countries.
The European Financial Stability Facility on the other hand has an uncertain future. Although there is a specific aim to bolster the size of the fund, it seems it will be done through the same financial engineering tools that developed a bad reputation during the financial crisis. Where this is not the case, it is hoped that developing countries will contribute through the International Monetary Fund yet there is fear in Europe that China’s participation will imply political bargaining as a price of participation, particularly changing the status of China to a market economy which would prohibit Europe from maintaining its anti-dumping barriers against it.
The biggest worry is that even with a €1 trillion fund, it would still not be able to safeguard a country such as Italy, with sovereign debt totalling €1.9 billion and €300 billion to roll over next year with rising borrowing costs. Italian ten year bond rose from 5.86 per cent to 6.06 after Thursday.
With a prime minister who has lost credibility in the eyes of all participants, there is a fear that the Italian government will not be able to implement the reforms that are needed to convince a risk averse market of its ability to improve its fiscal standing.
What makes this crisis so frustrating for the rest of the world is the fact that the tools for solving the eurozone crisis already exist. The ECB could be given many more powers to guarantee Italian and Spanish bonds; it could lend to the EFSF and provide it with virtually unlimited supply of funds. The issuance of eurobonds would essentially guarantee a more stable rate for the countries with high costs. The ECB could purchase the bonds of banks in the currency area. Yet, as the consequences are so far reaching, there is considerable political opposition.
The current process, led by Chancellor Merkel, is a gamble on how long Europe can muddle through and a test of the ability of euro countries to manage the reforms that are necessary to regain fiscal balance in the long term.