A spectators guide to the euro crisis

Updated: Oct 28 2011, 08:27am hrs
Following late night talks on how to move forward on the eurozone crisis and what to do about Greeces debt burden, European leaders have agreed upon a three-pronged strategy to resolve the crisis. The European leaders, after their meeting in Brussels, agreed that private banks holding Greek debt would have to accept a loss of 50%. The banks would also have to raise more capital to protect themselves against losses arising out of any government defaults in the future, to the tune of about 106 billion euros by June 2012. The leaders hope that this enhanced capital, while protecting against losses accruing from possible future government defaults, will also help protect larger ailing economies, like Spain and Italy, from the market turmoil.

The deal also put forward a plan to enhance the eurozones main bailout fund, known as the European Financial Stability Facility (EFSF), to 1 trillion euros ($1.4 trillion dollars) from the current 440 billion euros. The framework for this new fund is to be put forward in November.

Now, because the banks have agreed to shoulder some of the losses on Greek bonds, the countrys burden has been significantly reduced, cutting its debt down to 120% of GDP by 2020assuming Greece runs an annual budget surplus. At present, Greeces gross government debt is 166% of its GDP of $0.3 trillion. After the deal, Greeces debt-to-GDP ratio is higher than it was in 2009, when the debt crisis first erupted.

The leaders of the 17 eurozone nations had been in meetings since Wednesday, trying to hammer out the deal to put Greeces finances in order and underpin other ailing European economies, such as Italy. The euro climbed to a seven-week high against the dollar on the news of the deal.

The EFSF, which has said it is seeking private and public resources, is looking to get more Chinese investment. The details of how to leverage the EFSF are to be decided next month, and until Italy decides to embark on serious reforms, the EFSF is not going to be able to handle the crisis.There is considerable scepticism about the deal as far as banks are concerned as well. Banks could meet the recapitalisation target by shrinking balance sheets, which will contribute to lower GDP growth.

The immediate trouble

Greece has amassed a huge debt that it has scant hope of repaying. A chaotic Greek default could hurt all European banks and pension funds that have extended Greece credit and cause a wider bank panic. A financial firewall might halt contagion by backstopping the credit of four shaky nationsIreland, Portugal, Spain and Italy.

The risk of contagion

If there is no firewall or if it is inadequate, it would be easy to imagine a run on banks. The eurozones single currency makes it easy to shift money across borders from risky economies to safer ones. That and the lack of central banks in each countrythose went away in 1999 with the arrival of the euromake the eurozone the ultimate contagion machine, says Keneth Rogoff, a Harvard economist.

A possible scenario

If no preventive measures are taken, a chain of events like this could unfold: In reaction to a Greek collapse, investors become worried about their exposure to other risks in the region. Borrowing costs rise for Ireland, Italy, Portugal and Spain, adding to their debt loads.

Continental contagion

Italy may not be able to protect its banks if there is a loss of confidence. French banks, burdened with all manner of Italian debt, could totter. Money could flee to safer countries like Germany in a matter of hours.

Global reverberations

Losses could extend to American banks, which have larger exposures to debt in France and Italy. On top of this, American exports to the European Unioncollectively the biggest American trading partnercould suffer if the crisis slows European growth and causes the euro to depreciate against the dollar. Exposure to French banks could lead to other losses beyond the Continent.