Don't Uncork the Champagne

We have seen this play before. It was the summit to end all summits, the one that would offer a decisive solution to Europe’s Hydra-like sovereign-debt and banking crisis. Once again, there were intense pre-negotiations, op-ed exhortations, and breathless anonymous briefings. This time, reaching a resolution took two EU summits in the space of four days—the last one, on Wednesday, lasted into the wee hours of Thursday. And once again, victory, in the form of a deal, was snatched at the last minute from the jaws of defeat, setting off triumphalism in European capitals and a buying frenzy in world markets.

The thrill is likely to last even less this time than during the Eurozone’s earlier “comprehensive solutions.” The main reason is that the agreement fails to deal with investors’ worries about the viability of debt in countries at the European periphery, outside of Greece. This group includes Italy and Spain, the third and fourth largest economies in the Eurozone, respectively.

It's all the more frustrating because European policymakers realized very clearly that this was their main task. In the summit communiqué, they made a point of restating the position taken in July that “Greece requires an exceptional and unique solution.” In other words, no other country would be led to restructure its debt in a way that involved losses for private bondholders as Greece was—first in July, to a minor extent that allowed many banks to make riskless profits from the deal, and much more deeply now (the deal reached on Thursday early morning calls for a voluntary "haircut" for private investors of 50 percent).

So far, though, the promise that no other country’s bondholders will suffer the same fate as those who hold Greek debt is pretty empty. The Wednesday-Thursday summit produced a plan to increase the firepower of the European Financial Stability Fund (EFSF), which is currently at between 200 and 225 billion* euros, by leveraging it to cover part of the potential losses of private investors from debt restructuring in other parts of southern Europe. The idea is that the EFSF, by insuring a percentage of the losses, can increase its size without further burdening the taxpayers of the member-states of the Eurozone. This was necessary because a proper increase in the fund’s size, with bigger commitments from its AAA-rated members, above all France, would seriously threaten its AAA rating and hence its ability to borrow cheaply in the markets.

But this will do little to assuage investors’ fears of default in other Eurozone countries. Why would an investor buy an Italian bond if the EFSF promised to cover, say, 20 percent of his losses (a number that is being discussed as the appropriate level of insurance) in case of default, when the haircut is likely to be larger? Setting aside all other spending the EFSF might be called on to do (on Portugal, Ireland, and banks than cannot raise capital themselves), this sum is grossly inadequate to cover Italy’s and Spain’s lending needs, which, as The Economist points out, have to refinance, between them, about 1 trillion euros worth of bonds.

The communiqué also mentions the possibility of attracting more funds to the EFSF from sovereign-wealth funds of countries outside the EU. This refers in particular to the emerging economies, especially China, which have a lot to lose if Europe falls back into recession and reduce its intake of Asian and other exports. But the price China may extract for this may be too high for the Europeans. It is certain to include a rebalancing of voting rights in the IMF in favor of the emerging bloc and at the expense of Europe. The Economist reports that it might also include granting market-economy status to China by the EU, which will then find it a lot harder to protect its own producers from Chinese competition.

So the new deal does not really break the chain of contagion, from restructured Greece to illiquid but probably not (or not-yet) insolvent countries at the periphery of the Eurozone. Things will be made even worse by banks’ efforts to meet the EU’s stringent 9 percent core-Tier 1 capital ratio by next June. They are likely to attempt to do this by slimming down their balance sheets, thus removing credit from the economy and accelerating the slide of the European economy back into recession.

The problem facing the Eurozone, in a nutshell, is that the sum of individual guarantees of member-states’ debt is not enough to calm markets. Italy, which makes up 19 percent of the EFSF, is teetering on the brink of a liquidity crisis. France’s AAA rating is under threat. Germany cannot bear the burden alone.

Hence only two solutions are really viable. One is for Eurozone countries to jointly guarantee the debt of each individual member, a move that would in essence constitute the birth of eurobonds. The other, and more immediately accessible one, given that eurobonds require changing EU treaties, is for the ECB to become the lender of last resort to countries. The communiqué makes no mention of this and the Germans in particular are allergic to the idea. But Mario Draghi, the Italian who takes over at the helm of the ECB on November 1, knows that such a move is unlikely, in this environment, to prove inflationary (which is what Berlin fears). He may soon find himself in a position where he faces a stark choice: Either print money or stick to the central bank’s rules and risk killing the euro.

*An earlier version of this story mistakenly stated the amount of the EFSF at between 200 and 225 million euros.

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