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Debt Restructuring Will Save the Euro


Participants will arrive at the World Economic Forum in Davos with Swiss francs in their wallets – but their minds will be on the euro and its future.

At least for this year, the European Monetary Union will remain united – in letter, if not in spirit – and no country is likely to renege on its debt obligations, analysts told

But debt restructuring is certainly on the horizon for later, they said.

"This year I don't expect a default," Gudrun Egger, an euro zone analyst at Erste Bank told by telephone from Vienna. "The assumption is that neither for the weaker nor for the stronger countries a break-up would be an advantage."

If weaker countries decide to leave the euro zone to regain competitiveness by setting their own monetary policy, their debt would still be in euros and it would actually increase, while if stronger countries leave, their new currency would appreciate, stifling exports, Egger said.

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Yields on the debt of periphery euro zone countries – Greece, Ireland, Spain and Portugal – have been rising as investors speculated that one of them, at least, will default because it will not be able to reduce high levels of debt and bulging budget deficits in time.

In May last year, the European Union, together with the , saved Greece with a bailout package totaling 110 billion euros ($147.4 billion).

Eager to calm the markets, EU officials swiftly created the (EFSF), which will be able to provide up to 440 billion euros in aid to euro zone countries in difficulty.

Blame Game

But the establishment of the fund was not enough for nervy investors, who continued to sell the debt of the four countries – dubbed "PIGS" (Portugal, Italy, Greece, Spain) by market watchers – and in November 2010 the EU and the IMF had to come to the rescue again, this time helping Ireland with an 85-billion-euros bailout package.

Debate about who is to blame for the crisis and who is going to pick up the tab is vociferous as the increasing problem pits poorer and richer members of the euro zone against each other.

Slovakia, the poorest, announced last year that it was not going to take part in the Greek bailout and recently its finance minister said Greece would do better to restructure its bonds.

Germany, the EU's growth engine, is against issuing a common Eurobond to consolidate euro-zone debt and scoffed at proposals of greater fiscal consolidation, for fear it will end up paying for less competitive countries. It also opposes boosting the EFSF.

On Monday, French Economy Minister Christine Lagarde told CNBC France was still opposing the common Eurobond idea, which, she said, would mean "putting the cart before the horses" as it would dilute the strength of some members of the euro zone.

In these conditions, it will be nearly impossible for EU policy makers to come up with a solution that will satisfy the markets, Stefan Schneider, euro zone analyst at Deutsche Bank, told

"The perception of the market is so wavered … I can't imagine a solution where the market will say 'yes, that's credible, this is it,'" Schneider said.

Too Small a Bazooka

Part of the problem is the fact that the EFSF, the European Union's emergency fund, is only a fraction of what it should be, Willem Buiter, a former member of the Bank of England's Monetary Policy Committee and currently an analyst with Citigroup, wrote in a recent research report.

To deter runs on sovereign debt or self-validating refusals to roll over maturing debt, there is a need for a safety net big enough to satisfy "any conceivable sovereign liquidity need" and this, for the euro zone, should be around 2 trillion euros, according to Buiter.

Euro's Direction

"The size of the financial envelope of the EFSF represents underwhelming force and far too small a bazooka to deter denial of market access to even the smallest sovereign borrowers," he wrote.

Orderly Restructuring

A break-up of the euro zone is highly unlikely, according to Buiter, but its likelihood could increase without the right reforms, which include debt restructuring.

He imagined four scenarios for the euro-zone's break-up: Greece being the only country to leave, Greece and other weaker members leaving, Germany and other strong countries exiting and a collective decision to dissolve the EMU altogether.

However, analysts agree that policy makers will do everything in their power to save the monetary union.

"The euro zone will survive," Schneider said. "In the spring of this year we'll see a stability mechanism that will foresee an institution of debt restructuring."

Orderly restructuring of debt is crucial to the survival of the single currency and it will have to take place, Buiter wrote.

"Despite the recent drama, we believe we have only seen the opening and second act (of the debt crisis), with the rest of the plot still evolving," he wrote.

Should Banks Pay?

In Buiter's opinion, Ireland, with its "too big to save" banks, is insolvent just like Greece with its spiraling debt, while Portugal is "quietly insolvent" at the current levels of interest rates and with its anemic growth.

Caught in a Debt Trap?

To prevent disorderly, "involuntary" defaults, European policymakers will have to set up a clear way for restructuring sovereign debt once a new, permanent European Stability Mechanism is put in place when the EFSF expires in mid-2013, he wrote.

EU finance ministers refused, in a recent meeting, to commit to increasing the EFSF and for the moment all countries – even Greece – deny that debt restructuring will take place, although murmurs have started to appear.

Don't Touch the Banks?

Policymakers are taking into consideration all kinds of solutions to come up with the cash needed. One recent proposal suggested imposing a one-off tax on banks to fund the European Stability Mechanism.

But, as some analysts point out, this could actually exacerbate the problem since European banks are so exposed to the sovereign debt.

"The proposal … would be counterproductive," Schneider said. "Banks also need to be recapitalized. If you weaken the banking system, there will be spillover effects."

The European Central Bank's credibility, already hit hard, is likely to suffer further as it will keep its central role in fighting the crisis.

"With EU leaders unwilling to take action to cure the sovereign solvency issues, the burden to maintain stability within the euro zone rests entirely on the ECB's shoulders," Peter Vanden Houte, chief euro zone economist at ING, said.

Because of this, despite signs of rising inflationary pressures, it is very unlikely that the ECB will be raising the rates in 2011, Vanden Houte added.

What happens in Spain, the biggest of the euro zone periphery countries, is now crucial. Spain is, according to some analysts, the most solid and if it manages to make it through the market turmoil without a bailout, the crisis will likely be contained.

"Spain doesn't have such a competitiveness problem, doesn't have such a huge public debt problem," Schneider said. "If there is a need to recapitalize banks, they could cope with that internally."

"Politicians hope to draw the line in the sand before Spain," he added.