Gauging the Fallout of Another Rescue
Another European plan to fix its sovereign debt problem has initiated another sharp market rally. But will the enthusiasm over the latest rescue effort last longer than the optimism that greeted past plans, only to slowly fade away?
The market’s quick embrace of the latest effort to tackle Greece’s mammoth debt burden and restore confidence in the continent’s banks reflected hope that this plan was broader and more robust than previous ones.
“It’s not a silver bullet, but it makes things manageable to some extent,” said Gilles Moec, co-head of economic research for Deutsche Bank. Though vague on details, others said, it is clearly a step in the right direction after many missteps.
But skeptics quickly emerged, saying some of the main elements of the plan may not be as good as they looked initially, starting with whether it will truly deliver as much debt relief to Greece as promised, and whether it is sufficient to buttress potentially troubled banks.
Moreover, they add, plenty of things will have to go right to ensure its success, and plenty could go wrong to derail it.
“It’s another patchwork effort,” said Richard Cookson, global chief investment officer of Citi Private Bank. “It’s trying to tide things over for the euro zone, and it has worked a bit today. But the half-life of the euphoria seems to diminish with every package that comes along.”
And David Watts, senior European strategist for CreditSights, said, “It’s certainly hard to see this as the bazooka that the market has been calling for. There are very real risks that this will prove to be just another divot in the road.”
The yield on Italy’s 10-year bond, which recently hit a high of 6 percent on concern over the country’s debt and commitment to fiscal reform, remained uncomfortably high at 5.8 percent after the agreement was announced. And the interest rates on Spanish and French bonds narrowed only slightly as well, reflecting a deeper concern that this plan would not provide a magic cure for Europe’s debt problems.
Finally, even if all the components fall into place for Greece, looming on the horizon is the debt burden of other countries, including Ireland, Portugal, Spain and especially Italy, which owes more than $2 trillion and is the world’s fourth-largest borrower after the United States, Japan and Germany. “Everything depends on Italy,” said Lüder Gerken, director of the Center for European Policy in Freiburg, Germany.
The cornerstone of the latest plan, which helped feed investor enthusiasm, is a 50 percent reduction of Greece’s government debt.
But this — the simplest part of the blueprint — comes with asterisks.
Of the 340 billion euros in Greek government debt, only about 200 billion euros — most of it owed to banks — falls under the scope of the accord, meaning the country’s total sovereign debt would be reduced by about 30 percent at best. The rest of the debt is controlled by the European Central Bank , the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring.
But even a 30 percent reduction in Greece’s debt load is not assured. That is because the 50 percent write-off on the value of Greek debt, the so-called haircut that policy makers want banks and other financial institutions, to accept, is voluntary. Since Greek government bonds are trading at about 40 percent of their face value, officials from the Institute of International Finance, which represented the banks in the marathon negotiations with European leaders, said the number of participants was “very likely to be very high.”
Still, it is far from certain all those volunteers will materialize.
Antonio Garcia Pascual, Barclays Capital’s chief economist for southern Europe, said he feared that many hedge funds and non-bank investors would hold out for better terms. If enough of those investors balk, the deal could fall through.
That may leave European officials in the unenviable position of either filling in the financing gap with government-backed funds or forcing an involuntary loss of 50 percent on private creditors, in turn initiating a default on the bonds, which policy makers fear would make it harder for Greece to raise money from public markets in the future.
“You cannot have a lot of holdouts,” Garcia Pascual said. “If you want to get the debt relief you need for Greece, you may be forced to impose a haircut.”
Even if most private lenders and investors sign off, and the restructuring is completed voluntarily, Greece will still be heavily burdened with debt.
The 120 percent debt-to-gross-domestic-product goal for 2020 assumes that Greece will be generating a budget surplus equal to 4.5 percent of G.D.P. by 2014, and that the Greek economy will be growing at 3 percent annually by 2016, said David Tan, lead portfolio manager of the international fixed income group at J.P. Morgan Asset Management.
In reality, the I.M.F. expects Greece’s economy to contract by 5.5 percent this year and 2.5 percent in 2012, as austerity measures imposed as part of earlier restructuring efforts go into effect. “If you make less heroic assumptions on growth, debt doesn’t come down very much at all,” Tan said.
Another main element of the plan is to shore up 70 of Europe’s biggest banks by requiring them to raise 106 billion euros in fresh capital, to help them offset the losses they will suffer in taking haircuts on Greek bonds and the drop in value of other sovereign debt they own.
But that is not a sure thing, either.
In contrast to bank rescue plans in the United States and Britain, European governments are not injecting funds directly into financial institutions. Instead they are asking banks to turn to private investors to significantly raise their capital level, to 9 percent by next year. Raising money from private investors will be difficult, though, especially as many of the likely sovereign fund candidates are the same ones that suffered deep losses from investing in troubled American banks in 2007 and 2008.
In addition, some economists say that European banks are so burdened with bad sovereign debt that they need to raise far more than 106 billion euros to become healthy. Some estimate they need to raise 300 billion euros, or three times that amount.
Mark Luschini, chief investment strategist at Janney Montgomery Scott, said that 106 billion euros might allow European banks to absorb losses stemming from a Greek debt restructuring, “but I’m not sure that it is enough to deal with write-downs on Italian debt if that country runs into trouble.”
Then there is the question of whether the answer to the euro zone’s debt crisis is taking on even more debt, which this plan requires.
The main bailout fund of 440 billion euros known as the European Financial Stability Facility , relies on the sterling credit of Germany and France for its borrowing power. European leaders have promised to use the fund to provide insurance for investors looking to buy risky Italian and Spanish bonds.
In addition, they hope to leverage their contribution by turning it into an insurance program as well as obtaining additional private investments to increase the facility’s borrowing capacity to about 1 trillion euros. But, just as with the money Europe hopes to get from private investors to help recapitalize its banks, it is not clear that there is enough appetite from outsiders to take on this risk.
Moreover, although it is a large number, the 1 trillion euro facility would cover only about three years of financing needs for Italy and Spain, while they endeavor to return their weakened economies to health so they no longer need a handout.
Similarly, the initial bailout package for Greece fashioned by European and I.M.F. officials last year was intended to give Greece relief for a three-year period, with the aim that it would then be back on its feet economically.
“Clearly that didn’t work,” noted Watts of CreditSights. Allowing a mere “three years to grow the Italian economy back to the point where it can underpin market confidence is probably optimistic.”
Besides being unequal to the scale of the Continent’s debt burden, critics add that the financial stability plan is too reliant on France, which may well see its AAA rating taken down a notch because of its own debt and deficit problems. That would make it harder and more expensive for France to make its expected contribution. A downgrade for France would hurt the bailout fund’s ability to issue bonds and attract capital from investors.
And, just as with the money Europe hopes to get from private investors to help recapitalize its banks, it also remains unclear if Europe will be able to entice Asian and Middle East investors to put money into investments that would be linked to the bailout fund, and allow it to leverage up its existing assets.
“It’s not a solution to the crisis,” said Nicolas Véron, a senior fellow at Bruegel, a research organization in Brussels. “It doesn’t address the weak links in the banking system.”