This time is different. Really. That was the message from European leaders after the 11th debt-crisis summit in 17 months produced an additional €109 billion ($157 billion) in loans for deficit-bloated Greece, easier aid terms for Ireland and Portugal, and a retooled bailout fund to prevent markets from trashing Spain and Italy as well. The euro, as well as the distressed countries’ bonds, rallied.
Then doubts started to creep in and the markets teetered. The big concerns of investors and analysts are that the bailout fund is not financed well enough to handle a widespread attack on the bonds of several countries; that bondholders who had to sustain losses in the latest Greek bailout will suffer the same fate in Ireland and Portugal; and that the Greek crisis is far from over. Finally there’s the worry that Europe cannot act decisively enough to put this calamity behind it. As Graham Bishop, a London-based analyst, puts it, “The euro zone’s governance mechanisms seem only capable of achieving the barest minimum necessary to prevent an immediate meltdown.”
The situation for holders of Irish and Portuguese bonds is especially hard to untangle. In the first Greek rescue, private bondholders did not have to write down any of their debt or accept lower rates. This time around the plan offers a menu of options to rope bondholders into coughing up an extra €50 billion for Greece. They include swapping bonds that currently pay higher coupons for ones with a lower rate and later maturity date.
The European Union terms the costs of such deals “voluntary,” since bondholders technically don’t have to take a haircut. EU officials also say this is a one-off deal that won’t apply to bailouts of Portugal and Ireland.
Credit rating companies argue that holders of Greek bonds are under such pressure to share the pain that the haircut isn’t voluntary at all. The rating agencies also say that when Portugal and Ireland need more help, they will certainly want investors to take the same losses that they did in Greece. “The rating agencies are staring the EU in the eye and saying we don’t believe you,” says Gary Jenkins, head of fixed income at Evolution Securities. “And they’re right. Saying this is just for Greece is completely misleading.”
Greece is likely to continue to flounder, says Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group. He predicts a “rolling crisis” every time Greece faces a performance review by its European lenders and the International Monetary Fund. Greece is already signaling a privatization program may not be as bountiful as first imagined. Its economy is on course to shrink for a third year.
The structure and financing of the main bailout fund is the final source of concern. Called the European Financial Stability Facility (EFSF), the fund, launched last year, gained new powers at the summit to buy ailing countries’ bonds, extend preemptive credit lines to those suffering attacks by speculators in the bond market, and recapitalize troubled banks. German Chancellor Angela Merkel, trapped between her desire to save the euro and opposition at home to shoveling money into potentially bottomless pits on Europe’s fringe, had opposed expanding the fund’s powers. She finally agreed, yet made sure that each euro zone member could veto any bond purchase by the EFSF.
Nor did the fund get any additional punch. The fund raises money for its bailout activity by issuing AAA-rated bonds, which are guaranteed by euro zone members. In June member states agreed to expand the EFSF’s money-raising ability to €440 billion, from €255 billion. This time around, Germany, the Netherlands, and Finland are signaling they won’t grant the fund more firepower, for fear of jeopardizing their own AAA ratings. Take away what’s been doled out or committed to Greece, Portugal, and Ireland, and the fund has only €323 billion to protect Spain and Italy. “The European Financial Stability Facility has gone from being a single-barreled gun to a Gatling, but with the same amount of ammo,” says Willem Buiter, chief economist at Citigroup and ex-Bank of England policy maker. “It needs to be increased in size urgently.”
Economists at Bank of America Merrill Lynch reckon it would take an additional €700 billion to cover a bond crisis in Italy and Spain until 2014. RBS says the fund needs €2 trillion. “This tendency to undersize otherwise good initiatives has been a recurrent feature of European policies,” says Francesco Garzarelli, chief interest-rate strategist at Goldman Sachs.
The solution, says Michala Marcussen, chief economist at Société Générale in London, might be “deeper economic union.” One way to do that would be by selling euro bonds where high-deficit countries would enjoy lower interest rates, since the debt would be issued in union with top-rated sovereigns. Germany opposes this idea, fearing that its own borrowing costs would go up. If past is prologue, though, the Germans may eventually need to fall into line.