European policymakers have been trying to get a handle on the sovereign debt crisis for almost two years, holding summit after summit to little avail. Was the 14th time a charm?
Wednesday’s crucial meeting of Eurozone leaders managed to produce a plan that was broadly in line with what markets hoped for, which set off a powerful rally. This rally was appropriate, in my view, as the deal mitigates some of the more dire risks that had been haunting markets. We should acknowledge, however, that many of the key problems facing Europe are not “solved”—and won’t be anytime soon.
Nuts and bolts
A few words on the terms of last night’s agreement: owners of Greek debt agreed to write down 50% of the value of their holdings, which will help ease the nation’s crushing debt burden to 120% of gross domestic product (GDP) by 2020, from an expected 170% of GDP next year. To mitigate the damage to European banks—major holders of peripheral European debt—banks will need to raise EUR110 billion in new capital, preferably from the markets, but failing that, from national governments. As a last resort, the banks can tap the European Financial Stability Facility (EFSF), whose capacity leaders agreed to increase to EUR1 trillion. To beef up the EFSF’s firepower, the fund will start providing insurance on certain bond sales and create a separate vehicle to raise money from outside investors—likely including some emerging market governments.
The devil’s in the details
Many specifics of last night’s agreement still await clarification.
The Greek “haircut” was necessary, but it’s still unlikely that Greece will be able to create enough economic value to become solvent. The banks, meanwhile, may not be able to raise the necessary sums to recapitalize themselves. They have until June 30, 2012 to build their core capital reserves to 9% (guess they read my op ed in the Financial Times last week), but the rules specifying what types of assets will constitute this type of capital have yet to be settled. Additionally, should the banks need to tap the EFSF, the governments that fund it will likely need to adopt further austerity measures, which could dampen economic growth. As for increasing the EFSF’s firepower, only now are policymakers starting in earnest to work out the mechanics. French President Nicolas Sarkozy is to meet with Chinese officials to appeal for their financial support, but such support won’t be charitable. The Chinese (and others) will expect something in return. What will that be?
More gray areas
Other pieces of the puzzle remain missing, as well.
Italy must come up with budget cuts totaling about 5% of GDP within two years, but doing so will likely hinge on the fate of scandal-ridden Prime Minister Silvio Berlusconi, whose hold on power is increasingly tenuous. Adopting what are sure to be deeply unpopular additional austerity measures could prove extremely difficult in such an environment, yet Italy must overwhelm credit markets with a virtual wall of money to convince them of its viability.
Meanwhile, away from the spotlight (for now), Portugal faces potentially Greece-like solvency problems, which it must address.
Bottom line: An important step, but not the end of the journey
Overall, yesterday’s agreement is welcome and, importantly, alleviates the immediate risk of a major banking crisis and financial market meltdown. The agreement also demonstrates that European policymakers, despite their past dallying, have the capacity to take effective action when necessary.
We need to remember, however, that Europe still faces major structural problems. One of the most significant is that most European countries are either entering a recession or already in one, with varying degrees of severity. Calls are growing to re-examine the structure of the Eurozone itself, specifically its lack of fiscal union.
Although markets are celebrating the progress policymakers made with yesterday’s agreement, we should remember that one cannot solve major economic problems with political deals alone. Europe still has a way to go toward restoring itself to health.
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