Europe's debt plan won't solve the problem
Markets applaud and the deal buys time, but economists fear it lacks the firepower to ease the crunch over the long term.
By William L. Watts for MarketWatch
FRANKFURT -- Europe’s latest effort to contain the euro zone’s two-year-old debt crisis won applause from financial markets Thursday, but still falls short of a permanent solution, economists said.
The deal was hammered out in a marathon summit meeting in Brussels that stretched into the early hours of Thursday morning. It includes a commitment by banks and other private bondholders to accept a voluntary 50% write-down on Greek government debt, a boost in the lending power of the euro-zone bailout fund and a 106 billion euro ($148 billion) recapitalization of European banks.
European equity markets rallied; the U.S. stock indexes followed. The euro rose, topping the $1.40 level versus the dollar for the first time since early September.
However, economists fear the plan still lacks the heft and detail needed to ensure the debt crisis won’t again surface to threaten major euro-zone economies, such as Italy, and the region’s banking sector.
"The plans announced by euro-zone policy makers overnight look more like a pea shooter than the ‘bazooka’ previously promised to tackle the region’s problems," said Jonathan Loynes, chief European economist at Capital Economics. The firm still expects the crisis to deepen in coming quarters, ultimately resulting in a breakup of the euro, he said.
Others were less pessimistic, but portrayed the agreement as offering more of a breathing space that gives policy makers time to implement other needed measures rather than a lasting solution.
"To our minds, this is likely to prove sufficient to ease financial stress and give the euro area a window of opportunity to put its house in order," wrote economists Michala Marcussen and James Nixon at Societe Generale.
Financial markets have tended to rally in the wake of past crisis summits, only to see investors disappointed as subsequent events show policy makers remain behind the curve. The Wednesday summit -- the second gathering of EU leaders in four days -- followed a July 21 gathering that had been touted as a lasting solution.
Easing Greece's debt load
The plan, meanwhile, lacks any strategy to boost growth in the euro zone, where countries have been encouraged to emphasize austerity in an effort to bring down debt levels, analysts said.
The program "may offer some support for now, but the underlying economic dynamics of the deal imply a lot more economic misery, centered around pressure on banks and pressure on countries to deliver more austerity," said Steven Barrow, currency and fixed-income strategist at Standard Bank.
"And, whatever officials deliver in terms of support now, if the euro-zone economy weakens materially (as seems very likely), the debt dynamics will get worse and this deal won’t be sufficient," he said.
The biggest source of relief for markets appears to stem from an agreement by big banks to accept a voluntary 50% write-down on their holdings of Greek government bonds, up significantly from a 21% write-down implied in the July 21 agreement.
The talks had appeared deadlocked late Wednesday over the issue, raising fears European officials could move to impose an involuntary write-down on bondholders. That would have been likely to constitute a credit event, requiring the payout of billions of euros in credit default swaps, financial instruments used to protect debt against non-payment and potentially destabilizing the banking sector.
The write-downs aim to bring Greece’s public debt down to 120% of gross domestic product by 2020. It also forms part of a rescue plan for Greece that aims to keep the country funded through 2014.
Loynes from Capital Economics contends the reduction in Greece’s debt-to-GDP ratio, which has been forecast to peak north of 180% in 2013, won’t be enough to put its debt load on a sustainable footing. That still leaves Greece with a debt load similar to Italy’s.
Italy, unlike Greece, enjoys a primary budget surplus, meaning that it is servicing existing debt rather than creating new debt.
Meanwhile, the proposal to leverage the billion European Financial Stability Facility will provide it with around €1 trillion ($1.4 trillion) in firepower, near the low end of market expectations heading into the summit.
The EFSF plan, which will see more details worked out in November, will see its lending power boosted in two ways. It will be able to offer guarantees on the issuance of new sovereign debt on the primary market, insuring it against a certain percentage of losses.
It will also establish a special purpose vehicle to purchase government debt. French President Nicolas Sarkozy was reportedly set Thursday to phone Chinese President Hu Jintao about participating in the vehicle.
The insurance plan has long unsettled some economists, who fear it will foster unintended consequences, such as the creation of a two-tier bond market, with investors drawing distinctions between existing debt and new issues that are insured.
"If the market believes the government was solvent but illiquid, then one might hope that the insurance scheme would lower bond yields on all debt," wrote economists at HSBC. "But if the market fundamentally questions solvency, it will be perceived that the old debt will bear the burden and prices (for old debt) could fall further."
That wouldn’t be a problem for the government, but it could put larger holes in the balance sheet of the banking system, they warned.
Italy: A key barometer
Italy, the euro zone’s third-largest economy and home of the world’s third-largest bond market, remains the key barometer of the debt crisis.
"Contagion is still a huge threat and an Italian bailout could still break EMU" economic and monetary union, said Jane Foley, senior currency strategist at Rabobank in London. "Therefore, it is imperative to the health of the whole system that yields on Italian debt are reduced and fears of an Italian bailout are stamped out."
The yield on 10-year Italian government bonds pared an earlier decline but remained down 4 basis points at 5.79% in a bout of relief over the debt deal. Italy must pay 3.62 percentage points more than Germany to borrow for 10 years, down from around 3.66 percentage points Thursday.
With a trillion euros in firepower, the EFSF would appear to have sufficient firepower to guarantee the issuance of all Italian and Spanish bond issuance over the next three years, HSBC said. But a range of questions remain, including whether the guarantees remain large enough, it said.
Italy pledged to undertake further measures to bring down its debt levels. Prime Minister Silvio Berlusconi narrowly averted the collapse of his government this week as he sought an agreement with coalition partners to slowly raise the nation’s retirement age.
"The true success of the agreement will be seen in Italian bond yields six months down the line rather than from the sugar-rush reaction we might see today," said Gary Jenkins, head of fixed-income research at Evolution Securities.
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