So, What’s the Plan Europe? The European Sovereign Debt Crisis and the October 23 Summit
October 21, 2011
On Sunday, EU leaders will meet in Brussels for yet another high-stakes summit on Europe’s escalating sovereign debt woes, with the future stability of the global economy in the balance. European officials have already dampened expectations about what they will be able to accomplish at this meeting and have added an additional meeting on October 26 to reach agreement on the most contentious issues. If the summits’ outcomes do not meet market or international expectations, the stage will be set for a potentially ominous November 3–4 Group of 20 (G20) meeting in Cannes, France. With riots raging in Athens and recent downgrades of Spanish sovereign credit and French banks, the crisis has now entered a new and more acute phase. Market uncertainty and transatlantic tensions will substantially increase in the coming days and weeks if Europe is unable politically to address a crisis that has now infected its largest economies.
Q1: What will be decided or not decided on Sunday?
A1: Previously, President José Manuel Barroso of the European Commission outlined a five-point plan for addressing Europe’s sovereign debt troubles. First, recapitalize European banks that are exposed to Greek and other periphery debt. Second, boost the lending capabilities and resources of the €440-billion European Financial Stability Facility (EFSF)—a facility designed to provide financial assistance to economically troubled euro zone members—by either insuring guarantees or borrowing against the resources of the European Central Bank (ECB). The EFSF was recently given additional powers to intervene in secondary bond markets and purchase Italian and Spanish debt, thus relieving the ECB of a function it had been carrying out. Third, seek a new bailout package for Greece, which will involve “voluntary” losses or haircuts by private-sector bondholders. Fourth, enhance European competitiveness. Fifth, bring forward the European Stabilization Mechanism (ESM), a €500-billion crisis fund that will require amendments to the Lisbon Treaty, necessitating parliamentary ratification of the ESM by all 27 EU member states by July 2012.
Two days prior to the summit, there is still no consensus on the most contentious issue: how to boost the resources of the EFSF. This disagreement has necessitated the additional meeting on October 26. Some suggest that there may be some initial consensus emerging about bank recapitalization, but this too may prove elusive. In addition, leaders have yet to decide the level at which private bondholders will be required to take losses. In a telling sign, Chancellor Angela Merkel of Germany was scheduled to give a speech to the German parliament on October 21 on the outline of the proposed plan but cancelled the speech underscoring the lack of agreement on a plan moving forward.
Q2: How deep is the divide between France and Germany on how to solve this crisis?
A2: Quite deep and growing deeper. Since the beginning of the sovereign debt crisis, President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany have had fundamentally different views on how best to resolve the crisis. France prefers a European, taxpayer-based solution; Germany prefers national austerity and private-sector oriented initiatives. Although they have managed to sidestep these policy differences at decisive moments, they immediately return to their fundamental disagreement.
As the crisis has worsened and as the contagion has spread to French banks, the leaders’ fundamental disagreement has intensified and focused on how to expand the firepower of the EFSF. President Sarkozy wants to turn the EFSF into a bank that is permitted to borrow against the holdings of the ECB, thereby maximizing its lending capabilities. Chancellor Merkel and her finance minister, Wolfgang Schäuble, strongly oppose using the ECB in this manner. Moreover, German officials have repeatedly said that Germany won’t increase its guarantees of €211 billion to the EFSF. Merkel faces severe political constraints at home. The negotiations over the EFSF are being closely monitored by those in the Bundestag, and few members are likely to approve an increase in Germany’s guarantees, on an effort that undermines the credibility and independence of the ECB.
As this policy standoff continues, a proposal under consideration suggests using a portion of the EFSF funds as collateral or insurance for the bonds of distressed nations. When distressed countries need to raise capital by selling bonds, they would borrow additional money from the EFSF (likely to be 20 to 30 percent of the value of the bond). These additional funds would be set aside to compensate investors in case the borrowing country defaults. The purpose of this scheme is to incentivize investors to buy bonds from these troubled nations while still inflicting some pain on the borrowing country.
Even if this alternative proposal is agreed on, there remains the question of whether the EFSF will have the requisite funds to carry the program out. According to the chief economist for Europe at JP Morgan Chase & Co, the EFSF has approximately €270 billion left after funds have been distributed to those countries with existing bailout packages (Greece, Ireland, and Portugal). If the EFSF guarantees the first 20 percent of losses on any bond, he estimates the facility would have less than €100 billion for all other crisis-related tasks. Thus, the EFSF would have insufficient resources to intervene in the secondary market to purchase Spanish and Italian bonds, if required.
Q3: Is this crisis fundamentally about the health of the European banking system? What is being done to strengthen European banks?
A3: The European situation has escalated from a sovereign debt crisis to both a sovereign debt crisis and a banking crisis. European banks hold a huge amount of periphery debt: about $637 billion in Spanish debt and $819 billion in Italian debt. Comparatively, their exposure to Greek debt is negligible; they only hold $128 billion. However, a write-down of Greek debt would invariably send the bond yields of Spain and Italy soaring. In total, European banks hold $2.165 trillion worth of sovereign debt from Portugal, Italy, Ireland, Greece, and Spain.
Some argue that these figures are contentious—that not even the European Banking Authority (EBA) really knows how much debt European banks actually hold on their balance sheets. While that might be true, we do know the amount is not negligible, and therefore any any further devaluation in sovereign bonds will have a monumental impact on the balance sheets of European banks. This, in turn, will impact banks’ lending abilities and ultimately impede the economic growth of European countries. Not to mention the fact that European banks are big players on the global financial stage; if their credit lines dry up or they cease to loan to one another, more countries than just those in Europe will be affected.
Clearly, European banks need to be strengthened to continue to lend. How that goal will be achieved is much less clear. One proposal is to raise the capital requirements of banks from 6 percent to 9 percent. Ironically to raise this capital, European banks are selling assets further driving down the values of the bonds they collectively hold.
Another proposal is to have all the banks value their sovereign debt holdings at current prices (so-called mark to market, which is a generally accepted accounting principle in the United States) and determine if they have sufficient capital to survive if the crisis were to spread or amplify. This act, in and of itself, could incite a crisis of confidence and further European bank downgrades.
Apart from implementing either of these proposals, European officials also want to include a debt haircut for Greece as high as 60 percent. As large holders of sovereign debt, European banks would take huge losses on their assets. Although European leaders may come to agreement on recapitalizing their banks, it is likely those funds would be largely used to cover the losses from the imposed haircuts. This vicious cycle is fast becoming a global financial sector vortex.
Heather A. Conley is a senior fellow and director of the Europe Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Uttara Dukkipati is a research assistant with the CSIS Europe Program.
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