On Wednesday, the heads of state of the 17 Euro-area countries made significant progress on resolving their sovereign debt crisis, especially the financial difficulties in Greece. The previous package of support for Greece, which was announced on 21 July 2011 broke down primarily due to a lack of political cohesion and support around the various components of the deal.
The following key announcements were made yesterday:
- The Euro-area leaders effected a deal with private banks and insurers for them to accept a 50 percent loss on holdings of Greek government bonds as part of a plan to lower Greece's debt burden. The private sector said it would voluntarily accept a nominal 50% cut in its investments to reduce Greece's debt burden by €100 billion, cutting its debts to 120% of GDP by 2020, from 165% currently. The details of the PSI still need to be finalised (Sarkozy and Merkel personally engaged in the negotiations with bankers.)
- The Euro-area will offer "credit enhancements" to the private sector totalling €30 billion. The aim is to complete negotiations on the package by the end of the year, so that Greece has a full, second financial aid program in place before 2012.
- There will also be a recapitalisation of the European banking sector by around €106 billion. The banks are going to be required to reach a higher capital ratio of 9% by 30 June 2012 (after accounting for market valuation of sovereign debt exposures as at 30 September 2011). Banks are asked to first use private sources of capital, including the restructuring and conversion of debt to equity, in order to reach the capital requirement. Banks should also be constrained regarding the distribution of dividends and bonus payments until the target has been met. If necessary, national government should provide the necessary capital, and if this support is not available, recapitalisation should be funded through a loan from the EFSF.
- The total value of support package for Greece will now be €130 billion — up from €109 billion when the 21 July 2011 deal was concluded.
- Euro-area leaders also agreed to scale up the European Financial Stability Facility (EFSF), (which is the €440 billion ($600 billion) bailout fund that was set-up last year). The fund has already been used to provide help to Ireland, Portugal and Greece, leaving around €290 billion available. Around €250 billion of that will be leveraged 4-5 times, producing a headline figure of around €1.0 trillion ($1.4 trillion), which will be used in a variety of ways, including the ability to directly support banks and sovereigns. Importantly, it is hoped that the fund will be enough to avoid any worsening of the debt problems in Italy and Spain, the region's third and fourth largest economies respectively. Italy is the most indebted country in the Euro-area – it represents 25% of all the government debt in the Euro-area.
- It appears that the EFSF could be leveraged in two ways, either by offering insurance, or first-loss guarantees, to purchasers of euro zone debt in the primary market, or via a special purpose investment vehicle that will be set up in the coming weeks and which is aimed at attracting investment from China and Brazil. (This could also include the IMF). These methods (insurance and SPV) could be combined, giving the EFSF greater flexibility. Crucially, in leveraging the EFSF, France and Germany would ideally like to avoid losing their current AAA credit rating status.
This appears to be the start of a more comprehensive and effective support package for Greece and the Euro-area generally – although important details still need to be resolved. This latest framework is likely to be presented at the G20 heads of state meeting in early November and then the EU finance ministers will meet later in November to work-on the detail. Jose Manuel Barroso, the president of the European Commission, said the final details on the Greek package would only be worked out by year-end.
Fortunately, the main stumbling blocks of the deal appear to have been resolved, namely the 50% write-down by the banks as well as the agreement to leverage the EFSF. While we still don’t know exactly how the EFSF will be leveraged, the plan will clearly get a major boost if Sarkosy can get China to contribute. (Sarkozy said he would talk to Chinese President Hu Jintao in the coming days). With China on-board there is a much greater chance of success (but also some embarrassment).
It also appears that the IMF will play a role in the EFSF. It is also going to be crucial that Italy moves forward on the structural reform they outlined in the EU summit statement.
Once this deal is finalised, then everything becomes about growth, I think this deal will be massively tested in 2012 if the Euro-area experiences a significant recession – which is becoming increasingly likely. Overall this deal is tentatively encouraging - but we need more detail and the time-table is still too long – but that has become the European approach to the financial crisis.
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