Markets Cheer Euro Deal But Questions Remain

By and | October 27, 2011

The euro and stocks rallied on Thursday after European leaders struck a deal to provide debt relief for Greece, but analysts warned the plan would fail to halt the euro zone’s two-year-old debt crisis unless crucial details were resolved soon.

After a summit in Brussels, governments announced an agreement under which private banks and insurers would accept 50 percent losses on their Greek debt holdings in the latest bid to reduce Athens’ massive debt load to sustainable levels.

Reached after more than eight hours of hard-nosed negotiations between bankers, heads of state and the IMF, the deal also foresees a recapitalization of hard-hit European banks and a leveraging of the bloc’s rescue fund, the European Financial Stability Facility (EFSF), to give it firepower of 1.0 trillion euros ($1.4 trillion).

European stocks surged to a 12-week high and the euro shot above $1.40 to reach its top level against the dollar in seven weeks following the deal, which had appeared at risk due to deep differences between Berlin and Paris.

But economists noted that key aspects of the deal, including the mechanics of boosting the EFSF and providing Greek debt relief, would take weeks to pin down, meaning the plan could still unravel over the details.

“There is plenty of room to doubt whether each of the key aspects of the package will deliver within its own space,” said Malcolm Barr, an economist at J.P. Morgan. “The hope of EU policy makers is that the whole will be perceived as more than the sum of its rather questionable parts.”

Three months ago, euro zone leaders unveiled another agreement that was meant to draw a line under the debt woes that threaten to tear apart the 12-year old currency bloc. But they realized within weeks that it was inadequate given the depth of Greece’s economic problems and the vulnerability of their banks.

The new deal aims to address these holes.

Under it, the private sector agreed to voluntarily accept a nominal 50 percent cut in its bond investments to reduce Greece’s debt burden by €100 billion [$140.3 billion], cutting its debts to 120 percent of gross domestic product (GDP) by 2020, from 160 percent now.

The euro zone will offer “credit enhancements” or sweeteners to the private sector totaling €30 billion [$42.09 billion]. The aim is to complete negotiations on the package by the end of the year, so Greece has a full, second financial aid program in place before 2012.

The value of that package, EU sources said, would be €130 billion [$182.4 billion] — up from €109 billion [$153 billion] in the July deal.

“The debt is absolutely sustainable now,” Greek Prime Minister George Papandreou said in Brussels after the deal was struck. “Greece can settle its accounts from the past now, once and for all.”

A top lawyer for the International Swaps and Derivatives Association said that because banks had agreed to accept the losses, the deal was unlikely to trigger a “credit event” in which default insurance contracts would be paid out.

In a bid to convince markets that they can prevent larger countries like Italy and Spain from being swept up by the crisis, euro zone leaders also agreed to scale up the EFSF, the €440 billion [$617.3 billion] bailout fund that they have already used to provide help to Ireland, Portugal and Greece.

Around €250 billion [$350 billion] remaining in the fund will be leveraged 4-5 times, producing a headline figure of around €1.0 trillion [$1.403 trillion], which will be deployed in a variety of ways.

The EFSF will 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.

The methods could be combined, giving the EFSF greater flexibility, the euro zone leaders said.

But EU finance ministers are not expected to agree on the nitty-gritty elements of how the scaled up EFSF will work until sometime in November, with the exact date not fixed.

There is also concern about Italian Prime Minister Silvio Berlusconi’s commitment to implementing reforms seen as crucial for restoring confidence in the bloc’s third largest economy.

Dogged by scandals, Berlusconi has promised to raise the retirement age to 67 by 2026 and attempt other reforms, but the EU is reserving judgment.

Japan and Canada welcomed the euro zone agreement. China’s official Xinhua news agency said the outcome was “positive but filled with difficulties”.

A spokeswoman for China’s foreign ministry confirmed that President Hu Jintao would speak with French President Nicolas Sarkozy by phone later. An EU source told Reuters the conversation would centre on Beijing’s possible participation in the bailout fund.

Beijing has so far been a big buyer of bonds issued by the EFSF, which is triple-A rated by credit agencies.

As with the July 21 agreement, the concern is that Thursday’s deal will only work if the fine print can be promptly agreed with the private sector, represented by the Institute of International Finance (IIF).

Charles Dallara, the managing director of the IIF, said those he represented were committed to making the deal work.

“We believe (bank take-up) is likely to be very, very high,” Dallara said on Thursday. “All parties recognized not only that the future of Greece but also the future of Europe and the future of the world economy was at stake.”

Josef Ackermann, chairman of the IIF and CEO of Germany’s largest bank Deutsche Bank, described it as an “acceptable compromise”.

Alongside the hit to the private sector, euro zone leaders agreed the banking sector needs recapitalizing to the tune of around €106 billion [$148.8 billion].

German sources told Reuters that four German lenders — NordLB, LBBW, Commerzbank and Deutsche Bank — would be asked to shore up their capital. Three leading French banks ruled out the need for government help in meeting tougher capital requirements.

“While the headlines look good, the devil is in the details,” said Damien Boey, equity strategist at Credit Swisse in Sydney. “We don’t actually know how they are planning to increase the bail-out fund size from €440 billion [$617.3 billion] to a trillion. On top of that, there are some questions as to whether one trillion euros in itself is enough.”

There were corporate doubters, too. Oil giant Royal Dutch Shell said it planned to curb its investments in the European Union in future due to doubts about the bloc’s chances of recovering from the crisis.

“Europe’s macroeconomic position can only recover and the sovereign debt crisis can only be addressed through underlying economic growth,” Simon Henry, chief financial officer, told reporters on a conference call on Thursday.

“We do not see the European Union creating the conditions for that, in fact quite the opposite,” he said.

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