After a flurry of late-night summits, rumours, speculation, and presumably a lot of coffee, the EU revealed its grand plan to nip the sovereign debt crisis in the bud late Wednesday night. The market cheered the result, but was the exuberance premature? The plan was certainly a step in the right direction, but it left many important questions unanswered, and there are still plenty of flash points on the horizon.
Last week I looked at the five hard truths the bailout plan had to address if it was going to have any impact on the crisis. Here's how the current plan stacks up.
Greece Is Broke
Greece will never be able to pay back its current debts. Any plan has to find a way to reduce the burden so the country can grow again and not collapse under the weight of its debt load. European leaders came as close as they ever had to admitting that Greece is completely insolvent with their announcement last week. But the plan doesn't quite go all the way.
The headlines trumpeted that creditors were going to take a 50% hit to the face value of their Greek sovereign bonds. But that headline should have come with one, or maybe two asterisks. First off, the plan continues the fiction that Greece hasn't defaulted by making participation in the write-down voluntary. This is a useful fiction, because it will minimise some of the side effects of a true default, but it also adds a few new wrinkles.
The EU made the deal with a bank lobbying group, Institute of International Finance (IIF), but there is no guarantee that the member institutions of the IIF will all sign off on the write-down. If a few banks feel like it is possible to extract an even bigger deal and a bigger bailout, they might try to hold out for more money. The bankers know full well that the EU doesn't want to create a formal default, which gives them some leverage. Remember, it wasn't that long ago that many banks were rejecting the 20% haircut that was mooted during earlier talks. I think it is possible that this negotiation is not yet a done deal.
And there was no formal agreement as to what the write-downs would even look like. What kind of claim would the banks have on Greece going forward? Would there be insurance if it turns out Greece can't even pay the renegotiated loans? Who would pay for that? All of these points could potentially derail this deal and re-ignite fresh worries.
The plan to cut Greek debt is a start. It is an official admission that the country can't pay back its loans and that its creditors are going to need to accept losses. But it is incomplete in its current form until we see what the voluntary uptake is and exactly how everything is structured.
Banks Need More Capital
Europe has called on banks to boost their core capital ratios to 9%. This is a fairly credible plan that should give banks some breathing room if the crisis escalates or another credit crunch materialises. However, the lack of plan around exactly how the banks are going to get that extra capital is troublesome. The EU is hoping that most banks will be able to find the extra capital cushion in the private market. The problem is that it is easiest to get capital when you need it the least. The banks that are in the most trouble will have the biggest problem in finding fresh cash.
So if a bank can't get to the 9% threshold on its own, it is going to need to turn to national governments and to the broader EU community. But where is that money going to come from? What will the terms be? If confidence leaves the banking sector, the amount of money needed to keep the financial system afloat is going to be eye-popping. And there isn't a clear set-up as to how those bailouts would happen.
These are solvable problems--with enough cash. But confidence can leave the system very quickly, so it is critical that these open questions get answered sooner rather than later. Trying to create a bank stabilisation mechanism in the midst of a crisis is not something we want to try again.
It Is Going to Be Fantastically Expensive
Policymakers also edged towards reality in terms of the total cost of the bailouts. The eurozone has committed to leverage the EFSF to make its resource 4 to 5 times larger than its current EUR 440 billion. They can either do this by using the fund to insure bonds instead of buying them outright, or to add resources using funds from outside investors, likely the developing world.
But yet again, there wasn't much detail given as to exactly how the fund would be expanded. There were rumours that China was on board to invest money, but any deal is far from sealed. Still, the realisation that the initial fund was too small to take care of the problem is crucial, and this is another step in the right direction.
Long-Term Thinking Is Needed
The plan mostly fails on this front. There were several platitudes across the entire document about needing to bring the EU closer together on fiscal policy in order to save the euro, but there was very little in the way of proposals that have any teeth. Ideas such as "holding regular meetings" and a commitment that "external expertise will be drawn upon as appropriate, on an ad hoc basis" don't exactly create confidence that there is a long-term solution to the problem.
If Europe doesn't want the debt crisis to keep popping up over time, we will need to find a way to keep everyone's interests aligned and create real penalties for profligate spending.
The Plan Must Be Flexible
All of the open questions above mean that the plan scores reasonably high on the flexibility front. Given that almost everything the leaders agreed to is either to be determined, negotiable, or mere rhetoric, it should be fairly easy for new proposals to emerge as the situation on the ground changes. Now if the European community will actually be able to get together again and make those changes is another story. But at least this deal doesn't rule out too many remedies. The notable exception is the resistance to allowing the European Central Bank to be involved in the bailout. However, that could very well change as the situation becomes more dire.
All in all, this deal was much better than it could have been. But given the enormous number of question marks surrounding the plan and the number of things that can still go wrong, investors may want to hold their applause until the plan becomes more concrete and there is more detail on how Europe plans to get back on the growth track.
What do you think? Does the plan have a chance to fix the crisis? What else will the EU need to do to stop the debt contagion from spreading?
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invite you to share yours in the comments box below.
