The euro solution: the wash-up

It’s been an eventful past few weeks, capped of course by the summit to end all summits last week, where euro-zone leaders unveiled the plan to solve the region’s financial crisis (again).

Perhaps it’s nasty to be too critical. This plan does contain many of the steps which markets wanted to see; principally a Greek bond haircut, a bank recapitalisation plan and the beefing up of the bailout fund, plus there’s another 130 billion euros for Greece. But as has been the case with previous solutions put forth by euro-zone leaders, the devil is in the details and it doesn’t look pretty.

The primary concern is the expansion of the bailout fund. Instead of contributing further cash to the fund (which might have justifiably impaired the credit rating of France and others), it will be ‘leveraged’ up to four or five times its present size (implying an increase in its capacity to around 1 trillion euros), and will be used to provide insurance for new bonds issued by struggling euro-zone economies. The obvious question is: what about the existing bonds? If any new bonds carry the insurance but not any existing bonds, why would you want to hold the existing bonds? Presumably any existing bonds will trade at a significant discount to reflect the lack of insurance, though that would probably only concern existing bond holders. The other concern is the reliance on ‘private investors’ to step up and put money into the fund – also quite unlikely to materialise. Despite China repeatedly stating it would help bankroll Greek and euro debt, there has been little sign of actual $$.

Other criticisms concern the size of the bailout fund and the bank recap. There was an expectation for an increase in the bailout fund to 2 trillion euros, and the 100 billion euro bank recap is also seen as about half of what was needed. The markets were expecting a bazooka, and what they got was more akin to a heavy-duty shotgun.

And within days of the announcement of the plan, the markets have begun to react negatively. Italian bond yields have continued to rise, and at an auction on Friday of 6 billion euros of bonds Italy had to accept a 6.06% interest rate – simply unsustainable. So despite having just had the 13th summit to fix the euro-zone, it looks like the issue hasn’t gone away.

Chart below of Italy’s ten year bond yield illustrates what the markets think of the plan:

Advertisement