A Day Late, a Euro Short

In dealing with the European debt crisis, this week's European Union (EU) summit attempted the quantum leap forward called for a few months ago by the head of the European Central Bank (ECB), Jean-Claude Trichet. Following days of intense negotiations, European leaders agreed on a new, 109 billion euro loan package for Greece and a set of supporting measures aimed at laying to rest bond market worries about the credibility of the Euro in a grueling session that started at 2 in the afternoon and ended not long before midnight. In the next few days and weeks, as details of the agreement are fleshed out, it will become clear whether Europe has finally managed to get a grip on the crisis. Meanwhile, it is worth examining the main features of the new package, the things it leaves unsaid and the winners and losers that emerge from it.

The new package is made up of three parts: a loan from the European Financial Stability Fund (EFSF), a new contribution by the International Monetary Fund (IMF) and the "voluntary" -- as it is rather unconvincingly put in the official communiqué -- participation of the private sector. This private-sector "participation," estimated to account for 37 billion euros' worth of the overall figure up to 2014 (and 106 billion up to 2019), will be achieved by asking private holders of Greek debt to exchange bonds they have for ones that mature far in the future. The private sector will contribute an additional 12.6 billion euro by participating in a bond buyback program through which Greece can repurchase its bonds at current market prices (slightly more than half price), thus achieving further debt relief.

The European Council also decided to lengthen the maturity of the loans to Greece from the EFSF, from 7.5 years (the current maturity for Ireland and Portugal) to at least 15 years and as many as 30 years, with a grace period of 10 years. It combined this with a lowering of the interest rate to 3.5 percent for all three bailed-out countries, a 1-to-2- percent reduction.

The stated purpose of all this, according to the official statement, is "to decisively improve the debt sustainability and refinancing profile of Greece." Does the new agreement achieve this? Refinancing certainly looks a lot better. The country is now protected from disorderly default and its average annual financing for the next 40 years, according to the Greek Prime Minister George Papandreou, has been lowered to under 5 percent. As for debt sustainability, the new plan will bring down Greece's debt-to-GDP ratio by about 12 percent. This is not insignificant, but it would still leave the country with debt levels above 140 percent of GDP at the end of 2011.

Nevertheless, the outcome of the summit must be considered a great vindication for Papandreou. This is so especially given Trichet's eleventh hour volte face on the subject of ECB lending to Greek banks. The ECB president had repeatedly warned that a "selective default" classification of Greece by the rating agencies as a result of the involvement of the banks in the country's new rescue plan would mean that that he could no longer accept Greek bonds as collateral to lend to Greek banks. This, given that no one else will lend to Greek banks either, would pretty much have sealed their fate and might well have precipitated Greece's exit from the euro.

In the end, even though Greece seems sure to be classified as being in selective default, at least for a few days, Trichet relented, on the condition that private sector involvement not be extended to the cases of Portugal and Ireland. This allowed the French central banker to save face, and German Chancellor Angela Merkel to succeed in her central political goal of transferring a significant amount of the cost of the second Greek bailout from the taxpayers to the banks.

A final point relating to Greece was the call for "a comprehensive strategy for growth and investment" in the country. The European Commission has already created a task force that will aid the Greek government in quickly absorbing EU solidarity funds -- a pool of money set aside to help Euro member nations in case of a disaster -- for investment. The official statement's commitment to "relaunch the Greek economy" was welcome confirmation of the Europeans' realization that austerity alone cannot lead to fiscal health. The plan, however, remains vague, and the call in the statement for speedy fiscal retrenchment across the Eurozone will undermine the prospects of a continent-wide return to growth.

On the wider and absolutely critical issue of contagion, the threat of which to Italy and Spain was the cause of this week's emergency summit, it was decided that the EFSF and its successor as of July 2013, the European Stability Mechanism, will be able to intervene in the secondary bond markets to support troubled member-states. It was also decided that the European rescue funds would be able to recapitalize banks from all EU countries and they would to "act on the basis of a precautionary programme." This last bit clearly needs a lot of elaboration, but it could be the first hint of a euro-bond.

The new flexibility given to the EFSF (assuming it is approved by national parliaments) -- especially the ability to intervene in secondary markets -- is vital and has long been called for. But for it to truly convince investors, the rescue fund must be increased in size in a major way (some, like the redoubtable Wolfgang Münchau at the Financial Times, say it could need to be tripled in size from its current 440 billion euro limit). Otherwise it is hard to see how it can credibly be expected to support Italy and Spain through potential future borrowing hardship. And if the markets cannot see this, their initial enthusiasm about this week's summit will turn out like previous ones: It will be a short-lived crush, followed by a scornful rejection, of an object of desire that proved, behind its attractive exterior, to be quite vacant.

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