31 October 2011

Simon Nixon: Big euro crisis question has still to be answered

The best that can be said of last week's deal is that for the first time, eurozone leaders did at least try to come up with a plan that addressed all the major areas of strain: Greece, the banks, the size of the bailout fund and the eurozone's future governance arrangements. Progress was made on all four fronts even if important details were lacking. At a political level, the leaders took another step towards closer integration, rather than drifting farther apart. The prospect of a disorderly Greek default was at least taken off the table—for now. But scratch the surface and there are aspects of this deal that make a messy end to the euro crisis look more, rather than less, likely.

Consider the issue that proved the biggest obstacle to an agreement: the attempt to put Greek debt on a sustainable footing. Until the early hours of the morning, it looked as though there wouldn't be a deal. The eurozone wanted private-sector investors to accept a "voluntary" haircut of at least 50 per cent on their Greek government-bond exposure. The president of the Euro Group, Jean-Claude Juncker, said the banks only capitulated after the leaders threatened to trigger a disorderly default.

In fact, the truth was rather more complex. The real roadblock was whether or not the eurozone would provide high-quality collateral to underpin any bond swap. This time around, the eurozone was determined not to provide collateral, since it would have added to the cost of the bailout package, limiting the amount of debt relief for Greece. Crucially, it would also have capped any future losses for private-sector investors if the bailout proved inadequate.

In the end, it was the eurozone leaders who capitulated, agreeing to provide €30 billion ($42.4 billion) as a sweetener for bond investors. If this were used to buy zero-coupon bonds, as under the July 21 deal, then it might protect 80% of the principal of any new bonds, according to Barclays Capital. But it is a sign of the lack of trust between the two sides that the Institute of International Finance, which was negotiating on behalf of the banks, delayed issuing its own statement until it had seen the collateral commitment in the official summit communiqué, according to someone familiar with the negotiations.

Germany is understandably determined to cap its exposure to the rest of the eurozone's debts. Ms Merkel has made clear that Germany's exposure will remain at just over €200 billion. Germany is also strongly opposed to large-scale bond-buying by the European Central Bank, which it rightly sees as a back-door attempt to force German taxpayers to underwrite the entire debts of the eurozone. If incoming ECB President Mario Draghi overrides the clear political will of his largest shareholder, he risks widening the eurozone's political rifts.

That leaves the central uncertainty at the heart of the euro crisis unresolved: Who will bear the ultimate losses for the euro crisis? That's worrying because if current economic conditions continue, further losses will have to be taken, not only in Greece but probably in Portugal and Ireland and possibly Spain and Italy. So long as this uncertainty persists, markets are unlikely to resume lending to governments and banks, worsening the recession.

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