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New decisions from Europe
Even less critical accounts stress that the plan can only save time for the European leaders.
The decisions Eurozone leaders announced on October 27 towards morning initially received a positive reaction from the markets. This tendency is continuing while I am writing these lines, on Friday morning. On the other hand, the views of some experts renowned across markets as well as of academicians who recently have been making important assessments on the crisis in the European Union were not in line with that of markets. The decisions announced can be summarized as follows:
1. Leaders agreed on a “hair-cut” of 50% on Greek debt held by private investors. This will reduce Greece’s debt. Calculations suggest that the debt to national income ratio will decrease to 120 percent by 2020.
2. Banks which faced capital losses so far will encounter further losses due to the hair cut. It was calculated that €106 billion is needed to ensure that banks have a reasonable amount of capital. This contribution is to be made by banks and respective governments. Applying to the European Financial Stability Fund (EFES) will be a means of last resort.
3. Available resources at the EFSF worth around €250 billion which is insufficient given the borrowing requirement of Italy and Spain. It is planned to use the said amount as bank capital so that the mentioned countries and others will not have to difficultly in borrowing for the next couple of years, that is, the crisis in the Europe will not spread. In this context, two ways of leverage is planned through the EFSF:
First, the EFSF will be used as an insurance for 20% of state bonds. In short, if the entire amount of remaining funds is used for this purpose, state bonds worth €1.25 billion can be guaranteed. This is deemed to be sufficient to cover Spanish and Italian bonds to be issued until the end of 2013. At the same time, it is estimated that the guarantee will lower the risks and thus the interest on newly issued bonds.
Nevertheless, the insurance will not be applicable for already issued bonds. To prevent existing bonds to become non-performing, the following scheme is planned: a certain proportion of the funds in the EFSF and the additional capital to be asked from the IMF will be regarded as bank capital and borrowing, from China for example, will be made in exchange for the capital (as bank deposits). It will be possible to purchase (in the secondary markets) existing bonds via the additional funds generated this way. Therefore, a possible loss of value or the risk of non-performing bonds will be prevented. I have compiled some critics about the plan from several reports and commentaries:
1. 120 percent debt ratio by 2020 estimated for Greece is too high. Moreover, “voluntary” hair-cut is not binding on banks. Some banks might prefer to activate the insurance they bought against the risk of default by Greece. However, the activation of these insurances will be problematic in the case that voluntary hair-cut is imposed. What if the same path is taken also for Portugal?
2. Some accounts argue that the declared capital needs of banks do not reflect the actual capital needs which are much higher.
3. How will the EFSF step in for leverage? When borrowing at amounts above their capital allows, banks are aware that when they cannot repay their debt, they will have the implicit support of the central banks. Germans, however, oppose to European Central Bank support to the EFSF. How will the system function without such support? Why would third-party countries such as China agree to lend to the EFSF? Another criticism is that even if it is assumed that the remaining funds at the EFSF will be used only for the first leverage, the estimation that 20 percent of new bonds Italy and Spain will issue until the end of 2013 can be guaranteed implies that new problems are to appear again after 2013. For markets, this is a present concern.
Even less critical accounts stress that important technical details are yet to be declared and that the plan only saves time for the European leaders. Moreover, many commentators emphasize that the essential problem (single monetary policy – multiple fiscal policy) is yet to be solved.
This commentary was published in Radikal daily on 29.10.2011