Up Front

The Euro Summit: Turning Point or Mirage?

Douglas J. Elliott

It was not pretty, but European leaders succeeded around 4:00 a.m. today in announcing a package of steps addressing the euro crisis. European financial markets responded quite positively, with a 4% rally in European stocks and decreases in market yields on Italian bonds of about 0.15%. The market reactions are important, because this stage of the crisis resolution is about restoring market confidence while longer-term structural changes are worked out.

The announced measures could be the turning point in the euro crisis or just a mirage, because many questions remain both about the details and about how markets will respond once the initial relief rally passes. Each of the key pieces of the package can be viewed positively or negatively: 

Greek debt reduction: European leaders reached an agreement in principle with a representative of the banking industry for “voluntary” reductions of 50% in the economic value of Greek sovereign debt. In truth, the agreement is roughly as voluntary as when one hands over one’s wallet in response to the choice of “your money or your life.” This was underlined when President Sarkozy of France apparently threatened that the other choice was a 100% haircut, a complete refusal to repay any Greek sovereign debt. The theoretically voluntary nature is important for legal reasons, but creates the risk that the agreement in principle will fall apart when it comes times for each debtholder to decide whether to participate, especially as the actual exchange offer will be a complicated one.

Beyond the immediate issue of designing a successful exchange offer, there is the larger point that, if everything works out as planned, Greek government debt in 2020 will still be at around 120% of the size of its economy. This is not a level that is clearly sustainable, meaning there is a real chance that Greek debt will be restructured again in coming years, with more losses for bondholders. 

So, the good news is that this is a major step toward creating a long-term solution for Greece. The bad news is that it could fall apart in the short-run and there are considerable risks that it is insufficient in the long run. 

Bank recapitalization: European banks will be given until the middle of next year to bring their capital levels up by an aggregate amount of a bit over 100 billion euros. Each bank will be required to have a ratio of capital to risk-weighted assets of 9%, using current rules on calculating risk levels. This is roughly equivalent to the 7% ratio that will ultimately be demanded under the tougher calculations mandated by the Basel III agreement. Importantly, the 9% ratio is to be achieved after marking down all sovereign debt to approximately market levels.

Increasing bank capital is a positive and necessary step. Capital is the first line of defense against risks for banks and having more capital in the system is critically important to restoring safety and confidence to the European financial system. The forced recapitalization of banks in the U.S. in 2008-9 was extremely helpful in halting the financial crisis and recapitalization ought to help in Europe as well.

The size of the recapitalization, though, may not be sufficient to reassure markets for long. It represents only about a 10% increase in the approximately 1 trillion euros of capital already held at these banks and it is well below the IMF’s estimate that economic losses on sovereign debt exceed 200 billion euros for the European banks. It also represents less than half of a percent of the 27 trillion euros of assets owned by the European banks. (This is the straight balance sheet figure, without applying risk weightings.)

There is also the risk that banks will choose to meet the capital ratio test by shrinking their assets rather than increasing their capital. Apparently bank regulators are to discourage this, but that may not be easy in practice. If banks shrink, it means they will provide less credit and will be selling assets, which may make it harder or more expensive for companies to raise funds in the bond markets. In the worst case, Europe could see a credit crunch that could help create a new recession. (There are already some signs of a credit crunch anyway, as banks have been starting to downsize.)

Expanding the European Financial Stability Facility (EFSF): The EFSF was created earlier to provide resources to back up governments and banks in coping with the euro crisis. It has commitments of 440 billion euros from the national governments of the eurozone. However, it is now clear that the fund needs to wield much more money if it is to reassure markets that it can adequately respond should Spain, Italy, or both lose market access. The problem is that national governments do not want to commit any additional funds, in part because it would require new legislative approvals from the 17 eurozone nations, approvals that are far from certain.

The proposed answer is to augment the existing funds with money from the IMF and potentially other external sources, such as China or financial investors. The goal is apparently to reach a total of approximately 1 trillion euros that could be used to support the weaker governments. The plan appears to be to use the EFSF’s own money to provide guarantees or insurance to protect a portion of new debt issuance by the weaker eurozone countries. There is discussion of two funds, but it is unclear exactly how either would operate, although one would primarily be funded by external parties and the other would use EFSF money to backstop private purchases of government bonds.

There are many questions about this critically important part of the comprehensive package. What external parties might supply funds? How would they be induced to do this? How would the funds be deployed? What total amount could be raised?

I am concerned that it will be difficult for the guarantee/insurance plan to work. If, as advertised, the intention is to lever the EFSF money by a factor of four or five, this suggests that perhaps 20% of a new bond would be guaranteed. It is unclear to me that there will be investors interested in buying such partially-guaranteed bonds at the low interest rates that are presumably desired by the leaders. Watching holders of Greek debt lose 50% of their value now, with further risks to come, is unlikely to encourage investment in other weak eurozone countries.

Nor is it clear whether external official parties, such as the Chinese, will choose to invest more than token amounts in a fund to buy sovereign bonds. It is almost certain that the IMF could be brought into the picture in some manner, but the IMF is designed to help with situations such as the current problems. China, on the other hand, will need solid incentives to act. Ironically, if the other elements of the package continue to reassure markets, the Chinese will feel even less pressure to provide their own assistance.

Other items: The official announcement, and other statements by various officials, touched on other areas as well. There is clearly an intent to have greater coordination of fiscal policies in the eurozone, but this is still fairly vague. The European Central Bank is being informally encouraged to continue its program of buying sovereign debt of the troubled countries in the secondary market. There is a reluctance to make this an official statement as it might appear to infringe on the ECB’s political independence, but the encouragement is nonetheless important.

Market reactions: As noted, initial reactions were positive in the financial markets. However, a decrease in the market yield on Italian bonds of approximately 0.15% is not an overwhelming vote of confidence, especially as it leaves the interest rate near 6%, and the 4% rally in stock prices could prove to be fleeting. We shall have to see how sentiment develops as more details emerge about the plan and the markets have time to digest everything.

All in all, progress was clearly made. The degree of that progress should become clearer over time. We should all hope for the best, as another round of the euro crisis would be quite bad news for the world economy.

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