EU's entire strategy hangs in the balance

ANALYSIS:Greek contagion threatens to bring crisis to the core from the periphery

NO ONE knows how this will end. Euro zone finance ministers have provided a little more clarity over their divisive plans for a second Greek bailout, but a sudden build-up of pressure on Italy and Spain threatens to overwhelm them. As ministers left Brussels after two days of talks, it was an open question as to whether they would be back within a week or whether their leaders would be called to an emergency summit as soon as Friday.

If the heightened volatility recalls the uncertainty over Europe’s swaying steps towards the first Greek rescue last year, it reflects mounting concern over Italy and Spain.

The big fear is that a nightmare scenario could unfold, with the single currency bailout fund shown to be way too small to protect Rome and Madrid. As Greek contagion threatens to bring crisis to the core from the periphery, Europe’s entire strategy in the debt emergency hangs in the balance.

The publication on Friday evening of the results of a new round of stress test on European banks introduces a further element of uncertainty. The idea is to promote transparency about the vulnerabilities in the banking system, restoring the credibility of an exercise tarnished by flawed tests last year – most particularly evidenced by the subsequent failure of the Irish banks. Any weakness in the new tests would be punished by the markets, but the greater of the severity of the tests, the greater the call on fresh government capital.

Around the vast Justus Lipsius complex in Brussels, where ministers hold most of their meetings, key officials spent the day dipping in and out of market news for the latest word from the front. Hour by hour the news changed – with new records reached, only for the tension to abate a little – but the clear sense remains that a treacherous frontier is not far away.

Even as the political and financial stakes rise, doubt and division over a second Greek rescue fans the turmoil. Open hostility between Italian prime minister Silvio Berlusconi and his finance minister Giulio Tremonti is another big factor, with euro zone officials saying internal government discord in Rome is glaringly at odds with European pressure on the Greek opposition to join the national recovery effort.

There was no deal on a new plan for Athens, but the meeting did mark a step forward in the agonising effort to stitch something together with enough private creditor lock-in to keep the Germans, Dutch and Finns sweet. That’s a riddle Europe has not yet fully solved, but the architecture of the new arrangement is coming into view.

Three things are now clear. First, the ministers are willing to run the gauntlet of a “selective default” rating on Greek debt as the price of securing private creditor bail-in. This is highly risky and opposed by the European Central Bank but it is the price of advancing a German debt-swap initiative.

Second, in return for their consent to go down the debt-swap road, private investors have extracted a quid pro quo in the form of the ministers’ agreement to examine a new the use of European Financial Stability Facility (EFSF) loans to enable aid recipients to buy back their own debt at market rates. The aim is to reduce the overall burden of Greece’s sovereign debt.

The potential benefit depends on the price at which the country’s bonds trade. According to a senior EU official, however, the objective will be to reduce the ratio of Greek debt to GDP to a level equivalent to Italy’s 120 per cent from 143 per cent last year.

Third, the deployment of the EFSF for this purpose will increase the requirement for aid for Greece. While such an initiative will retire debt, easing the weight on Athens, the country will still need emergency loans to keep the wheels of state turning. That is not without significance for naysayers of Berlin, the Hague and Helsinki. Anything that increases the upfront cost of the bailout – even if it improves the overall prospect of success – is contentious in those cities.

Still, a new range of EFSF reforms has clear potential to make life easier for the Government. The overhaul brings an interest rate cut closer, it means the loan repayment burden can be spread over a longer period, and the bond buyback option could be deployed to lessen the debt load on Dublin. All of that is for the good, with benefit to be gained over the medium term.

But the clouds of contagion are overhead. Ireland will remain stuck until the debt storm is finally contained.