Europe’s governments are in the final stages of piecing together a new strategy to make Greece’s debts more sustainable, backstop the region’s banks, and curb contagion to larger economies. Deadline for delivery of the plan was Oct. 23, when Europe’s leaders convene in Brussels. The open question will sound familiar: Can it work?
The idea is to increase the firepower of Europe’s rescue fund to limit the risk that Greece’s woes will spread to Italy and Spain. The European Financial Stability Facility now boasts €440 billion ($606 billion) and can buy bonds, lend to cash-strapped governments, and aid banks. Authorities are considering leveraging the fund’s money, likely by partly insuring bonds issued by distressed sovereigns in the hope the insurance allays investor fears.
The risk is that the facility may still prove too small to deter investors from shorting the bonds of the bigger economies and driving their yields to unsustainable levels, according to David Mackie, chief European economist at JPMorgan Chase. Mackie figures that Italy, Spain, and Belgium face funding needs of more than €1 trillion over the next three years and that the rescue fund is already stretched by other loans. In those circumstances, guaranteeing the first 20 percent of losses on newly issued bonds from the most beleaguered states would leave less than €100 billion for other emergencies. “This might be sufficient, but it’s not exactly a bazooka,” he says. What’s more, Tamara Burnell, an analyst at M&G Investments, says investors doubt the ESFS’s insurance could actually be paid out, given it would be “provided by the very same, or, at best, a related group of stressed sovereigns.”
The French government would have to contribute to any effort to beef up the rescue fund, even though France is already heavily indebted. Its rating is already under pressure, Moody’s Investors Service said on Oct. 17, and investors are demanding a record yield to hold its bonds rather than German notes. A system “where France effectively insures Italy’s and Spain’s debt will probably be the catalyst for France to lose its top rating,” analysts Pierre Lapointe and Alex Bellefleur at Brockhouse & Cooper wrote clients on Oct. 18.
Placing Greece on a more viable path by persuading investors to accept more losses on existing debt is also fraught with difficulties. European policymakers are debating the need for banks to write down 50 percent of the value of their Greek bonds. Economists such as Joachim Fels of Morgan Stanley argue that such cuts could hand investors another reason to dump European bonds. Big writedowns could also be viewed as an actual Greek default, triggering insurance. Such developments would threaten “another wave of contagion,” says Morgan chief economist Fels.
Governments also want banks to boost their stockpiles of capital to insulate them against further market tremors. Banks may be forced to raise more than €200 billion, according to analyst estimates, with the money coming either from investors or from states, with strings attached. Financiers are pushing back, saying the need to take on capital may restrict lending. With so many unknowns, it seems likely the Europe crisis won’t end any time soon.