Issues that divide


Greece, the bailout and the banks

GREECE: The Haircut

AT ISSUE is the extent of the losses imposed on Greek bondholders as part of the effort to bring its ever-increasing national debt down to a sustainable level.

In July, EU leaders stuck a “voluntary” deal with global banks to cut the value of their holdings by 21 per cent. The deal didn’t work for two reasons. First, the manoeuvre failed to convince markets that the debt cut was sufficient to give Greece a fighting chance of recovery. Second, a worsening recession cast an even-darker pall over its ailing finances.

Under discussion now is whether the bondholders’ “haircut” should be increased to 50 per cent, as favoured by the EU authorities, or 60 per cent, as per the International Monetary Fund.

Sources involved in the summit say there is some support for the suggestion that it would be better to target a higher figure. Now that Europe has taken the previously unthinkable option of debt restructuring, the argument goes that the time for half-measures has passed.


The biggest question here is the stance of France, whose banks have the greatest exposure to Greece. Any radical increase in the haircut and French banks take a big hit, increasing their requirement for new capital. This is bad news for French president Nicolas Sarkozy, who faces a difficult presidential election next spring. France has been arguing against any significant increase the Greek haircut, saying such a manoeuvre risks further undermining confidence in the euro zone. However, Mr Sarkozy seems increasingly isolated on this front. The ECB was long opposed to the notion of any bondholder losses within the euro zone. Having reluctantly accepted the July deal, the sense right now is that the bank will not be able to stand in the way of the growing political clamour for a bold move to reduce the burden of Greece’s debt.

At the highest level in Europe, the argument goes that the wider sovereign debt crisis cannot be tackled definitively without a realistic rescue programme for Greece.


Any investor loss of the scale now under discussions means that Greece will soon default on its debt.

Europe hopes, however, to deliver a “voluntary” deal with investors, something which might avert the threat of a credit event which would trigger payments on the insurance investors take out against default. To do that the authorities need the agreement of global banks, whose lobby the Institute of International Finance is resisting pressure for a bigger haircut. Even if a deal is reached with the lobby, the danger remains that markets panic over the initiative sending shockwaves of contagion through the global financial system.

It is for this reason that moves are under way to boost the euro zone rescue fund and the capital of vulnerable banks throughout the EU. The idea here is to create “firewalls” against any explosion of contagion, with the aim of convincing the doubters in the markets that there is enough water in the tank to douse down the flames.


BAILOUT: Boosting the fund

AS GERMAN chancellor Angela Merkel holds out on any big increase in Berlin’s exposure to the crisis, this remains the source of the greatest political tension in the euro zone.

In July, EU leaders increased the lending capacity of the European Financial Stability Facility (EFSF) to €440 billion. In view of the increased contagion risk from Greece, efforts are now under way to increase its firepower significantly.

The aim is protect the wider euro zone from a financial earthquake akin to the one that followed the decision of the US authorities to allow Lehman Brothers to go bust in autumn 2008.

This is particularly so given that the ECB is already in the market for bonds of Italy and Spain, two of the biggest euro-zone countries. The bank wants to stop this contentious campaign, with a view to handing over responsibility for such interventions to the EFSF.


Merkel is willing in principle to increase the fund’s firepower to €1 trillion but many of her counterparts believe about €2 trillion is needed to shake off the relentless turmoil in markets.

This flows from the severity of the haircut contemplated and the likelihood that aid from the bailout fund will be required to help some countries recapitalise their banks.

In short, the fear remains in many countries that the fund will still be perceived to be too small.

Led by Germany but excluding France, Europe’s AAA countries think otherwise. They make the greatest contributions to the fund. Every time its firepower is increased, therefore, their exposure to the turmoil rises. This explains their preference to keep the increase to a minimum.

The issue remains seriously contentious as Europe strives to finally stamp out the crisis.

The problems don’t end there. Europe is working to boost the EFSF by “leveraging” its core assets, a process in which the resources available to the fund would be multiplied without increasing its financial guarantees from euro-zone countries.

However, sources say some countries believe the only realistic way to increase the EFSF’s firepower is to increase the level of the guarantees themselves. The chancellor and many other countries are reluctant to go down that road, as any such move would require parliamentary approval.


While seven “leveraging” proposals were on the table before the weekend, these have now been narrowed down to two. The first would see the EFSF offer first-loss insurance to investors who buy sovereign bonds from member states or the market. The second would see the EFSF create a special purpose vehicle which would have a mandate to seek private and sovereign wealth fund investment. This vehicle would then buy bonds from member states and the market, with any losses up to a certain threshold insured by the EFSF.

Both suggestions raise the question as to whether there would be a two-tier market for euro-zone sovereign bonds, increasing borrowing costs when countries issue bonds without the protection of EFSF insurance.

For the moment at least, such questions are overshadowed by the contentious debate over the EFSF’s actual firepower.


BANKS: Reinforcing against losses

THE AIM is to reinforce banks against losses from the increased Greek haircut and the threat of contagion. No one disputes the need for more bank capital. The question is by how much, by whom and by what criteria it should be done.

The European Banking Authority, a new pan-European regulator, says the banks need roughly €100 billion. It bases this assessment on a new examination of stress test data which takes account for the first time of the real market value of sovereign bonds in euro zone countries.

The EBA’s estimate of the capital requirement is about half the estimate of the International Monetary Fund. However, the EBA has been arguing that IMF figure does not account for the elevated market value of bonds issued by financially secure countries like Germany. In the EBA assessment, this is a counterweight to the collapse in the value of Greek bonds.


Spain has pushed back heavily against the EBA assessment. Short of cash and already in the grip of a severe economic crisis, the country faces the danger that it might need money from the bailout fund to boost its banks. It has little scope for state support.

Similar issues arise for Italy and for France, whose triple-A rating is under pressure. Mr Sarkozy has sought the right to seek money from the fund before the supply of state aid expires. Dr Merkel rejects that. Further tensions surround the timeframe for the proposed recapitalisation, with France pushing for a nine-month process while others target a six-month process.


The question remains as to whether the markets decide that a €100 billion recapitalisation – or a sum close to that – persuades the doubters in the markets that a credible solution to the debt crisis is to hand.

This issue will not be settled in isolation. The more convincing the overall package, the easier it will be for some banks to raise private capital. If markets have little faith in the package, then it will be more difficult to secure private investment.

If they cannot do that, increased state aid will lead to increased nationalisations. In addition to that, the cash crunch in the weakest euro zone countries increases the likelihood that they will need help from the EFSF. That leads to consequent pressure to increase its firepower.