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Monday, Oct. 31, 2011
A breakthrough in Brussels
European leaders agreed last week — at last — on a comprehensive plan to tackle the euro-zone debt crisis. The plan consists of three pillars — a real "haircut" by Greek debt holders, an infusion of capital into the European bailout fund and recapitalizes European banks. The program could break the back of the euro-zone crisis, if it is implemented with all due haste. Thus far, the record gives little reason for optimism. But for once, at least, a genuine solution appears to be on the table.
Europe has been moving toward financial catastrophe — and the potential collapse of the euro itself, which could, like dominoes, take down the dream of a united Europe — for months. The catalyst has been the Greek financial crisis. A nation that has lived beyond its means for years, Greek debt has reached 160 percent of GDP; if current trends continue, it would reach 180 percent of GDP by 2020. Yet Greek debt is held by other European financial institutions. If Athens could not repay its bills, then a default would drag those banks down as well. That concern prompted markets to look hard at other sovereign debtors and Italy, a far larger economy, appeared vulnerable too. The prospect of contagion, both among sovereign debtors — governments — and the continent's banks, compounded a bad situation.
European leaders have been divided on how to respond. While recognizing that Greece had to live within its means, they also acknowledged that a default would hurt their own banks. Germans in particular have been conflicted: they do not want to encourage moral hazard and are especially troubled by bailing out Greeks with their hard-earned savings, but German banks are also quite exposed.
That fault line has kept European leaders from forging a real plan to tackle this problem despite over a dozen summit meetings and statements. Each move has been haphazard and half-hearted; subsequently, they have been dismissed by markets and the crisis only deepened. After a summit failed to reach agreement in mid-October, Europe's leaders recognized that another failure could doom the dream of a united Europe. Backs to the wall, the meeting produced a real plan at last.
The proposal rests on three pillars. The first is a pledge by euro-zone governments to top up the European Financial Stability Facility. The EFSF is a state-funded fund that supports governments that fall behind on debt payments. It should lessen fears of default. That boost of confidence will ease pressure on debtors when they are forced to restructure. Currently the EFSF has €440 billion ($610 billion); its size will increase to €1 trillion ($1.39 trillion), to better prepare it to tackle problems posed by large economies such as Italy. Second, holders of Greek debt will take losses — a "haircut" — of 50 percent. This more than doubles the 21 percent cut agreed by the banks this summer; they resisted bigger reductions for fear that it would erode their own creditworthiness. Reportedly, and the details are not yet clear, banks will receive guarantees to ensure that additional losses on Greece do not occur.
That brings us to the third pillar, which requires banks to increase their own capital by as much as €106 billion by June and to hold reserves equal to 9 percent of their capital at risk. These reserves will help protect against losses from the Greek "haircut," although it is not clear where the money will come from. Again, details are not clear, but it appears that governments will help out if the additional funds cannot be raised elsewhere.
The agreement is potentially a breakthrough. It looks like European governments are finally taking the hard measures needed to restore confidence and break the back of the crisis. European Commission President Jose Manuel Barroso said the measures proved that "Europe will do what it takes to safeguard financial stability." Markets seem to agree: they rebounded sharply around the world the day after the agreement was announced.
Questions remain. A lot of details still have to be filled in and many of them will determine whether the program can succeed. Who will top up the EFSF? European governments head the list, but there are calls for other cash-rich creditors to help. Why should they? And if they do not, will European governments take up the shortfall? How will gaps be filled in bank recapitalization efforts if investors prove reluctant or assets do not sell as anticipated? Will €106 billion be enough? Some analysts believe that that is less than half the amount at risk. Bank balance sheets are sufficiently opaque to leave that question unanswered. More significantly, however, there are doubts whether the pledges will be implemented as promised. Greece has been slow to push through much needed reform, and Italy is facing a crisis of its own because of its failure to do the same. Failure to take steps will ensure another crisis when future repayments are due. And with Greek debt scheduled to hit 120 percent of GDP by 2020 even with this arrangement, another crunch is likely.
European leaders deserve credit for finally conceding the enormity of this crisis and for constructing a comprehensive plan to address it. Now, they must ensure that the program is implemented as designed. Continuing progress, slow but steady, is the key to creating the confidence needed to crush this crisis.