Big hurdles ahead of Europe’s debt deadline

European leaders must make a one-week deadline for coming up with a solution for their sovereign debt crisis. European leaders were given til Sunday to get their act together and take on their debt crisis which is being seen as a threat to global growth.

Oct. 17, 2011, 12:14 p.m. EDT
By William L. Watts
MarketWatch

FRANKFURT (MarketWatch) — It didn’t take long on Monday for doubts to emerge over European leaders’ ability to meet a one-week deadline for coming up with a comprehensive solution to a nearly two-year-old sovereign debt crisis.

A weekend meeting of Group of 20 finance ministers underlined international frustration over Europe’s inability to get a grip on a crisis that is seen as a potential threat to global growth. A joint statement was seen as effectively giving European leaders until Sunday, when they will gather in Brussels for a summit, to get their act together.

That triggered a bout of follow-through euphoria in financial markets, with risky assets such as equities posting solid gains in Asia and opening higher in Europe. Equities had rallied last week in large part due to hopes Europe was moving toward a fix.

But the rally was later cut short as German officials moved to control expectations.

A spokesman for German Chancellor Angela Merkel implied that investors were getting ahead of themselves if they expected a comprehensive solution Sunday in Brussels.

“The chancellor has pointed out that dreams building up that this package will mean everything will be solved and over by Monday cannot be fulfilled,” the spokesman, Steffen Seibert, told reporters, according to Reuters.

Solving the Greek debt issue

Namely, economists say, the euro zone needs to come up with a three-pronged plan that effectively leads to a controlled default for Greece while ensuring banks and other sovereigns, such as fellow bailout recipients Portugal and Ireland and more important economic juggernauts such as Italy, don’t fall prey to contagion.

German Finance Minister Wolfgang Schaeuble over the weekend acknowledged the need for private bondholders to take a larger writedown on their holdings of Greek government debt, news reports said.

Under the second bailout plan approved by euro-zone leaders in their last major summit meeting on July 21, bondholders were set to voluntarily take a 21% haircut, helping to trim Greece’s debt burden and lifting some of the bailout burden off of governments.

Now, a haircut of as much as 60% is seen as a possibility, noted Michael Derks, chief strategist at FxPro in London.

“With the economy in freefall and debt-to-GDP set to reach 190% very soon plus interest rates at astronomical levels, Greece’s ability to service such a debt mountain was destroyed long ago,” he said.

Before they can get to anything like a 60% haircut, officials must resolve what to do about Greek banks that would see their capital nearly wiped out, Derks said. And they must also find a way to convince investors that Portugal, Ireland, Spain and Italy won’t follow suit.

Meanwhile, the international banks that agreed to the 21% haircut in July aren’t likely to acquiesce easily to a much bigger hit.

Putting the EFSF to use

Presumably, efforts to halt the spread of contagion will center on the European Financial Stability Facility, the euro-zone bailout mechanism. With the Slovakian parliament’s vote last week, changes to make the 440 billion euro ($604 billion) EFSF more flexible were made operational.

The EFSF can now intervene in bond markets, provide lifelines to threatened sovereigns and help recapitalize banks. The only problem is that it’s still seen as too small to fend off an attack on the likes of Italy, the euro zone’s third largest economy, or Spain, its fourth-largest.

So European officials have been pondering ways to boost its firepower. Recently, a proposal to allow the EFSF to work as a type of bond insurance fund, thus leveraging its buying power, appears to be gaining traction. But some strategists say the concept would be unlikely to convince market participants that Europe wields a big enough bazooka to prevent a rout of peripheral sovereign debt markets.

“Such a solution risks generating a two-tier European bond market, and hence promoting contagion if markets begin to wonder whether an Italian bond with loss insurance is a better investment than an unsecured French or Belgian bond,” said Chris Scicluna, an economist at Daiwa Capital Markets. “Indeed, might Belgian (and potentially French) bonds also therefore ultimately need protection.”

Meanwhile, Germany and France appear far apart on the scope of any bank recapitalization effort, said Beat Siegenthaler, foreign-exchange strategist at UBS, in a note to clients.

Germany has pushed for an aggressive round of recapitalizations totaling as much as €250 billion, while France is expected to lobby for a figure closer to €100 billion, Siegenthaler said. In the end, a figure in the €150 billion to €200 billion range is likely.

Siegenthaler warned against expecting a comprehensive solution to the crisis to emerge on Sunday. A meeting of euro-zone finance ministers on Thursday will likely provide a “reality check” on progress toward a plan.

“There will likely be a bank recapitalization plan, the Greek [haircuts are] expected to be renegotiated, and the use of EFSF financing will probably be made ‘more efficient,’” Siegenthaler said. “But on all these elements, the market may get less than hoped for, as either national interests are diverging or implementation hurdles are plentiful.”

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