Will the enthusiasm over latest rescue effort last long

Written by New York Times | Updated: Oct 29 2011, 07:33am hrs
Another European plan to fix its sovereign debt problem has initiated another sharp market rally. But will the enthusiasm over the latest rescue effort last longer than the optimism that greeted past plans, only to slowly fade away

The markets quick embrace of the latest effort to tackle Greeces mammoth debt burden and restore confidence in the continents banks reflected hope that this plan was broader and more robust than previous ones.

Its not a silver bullet, but it makes things manageable to some extent, said Gilles Moec, co-head of economic research for Deutsche Bank. Though vague on details, others said, it is clearly a step in the right direction after many missteps.

But sceptics quickly emerged, saying some of the main elements of the plan may not be as good as they looked initially, starting with whether it will truly deliver as much debt relief to Greece as promised, and whether it is sufficient to buttress potentially troubled banks.

Moreover, they add, plenty of things will have to go right to ensure its success, and plenty could go wrong to derail it.

Finally, even if all the components fall into place for Greece, looming on the horizon is the debt burden of other countries, including Ireland, Portugal, Spain and especially Italy, which owes more than $2 trillion and is the worlds fourth-largest borrower after the US, Japan and Germany. Everything depends on Italy, said Lder Gerken, director of the Center for European Policy in Freiburg, Germany.

The cornerstone of the latest plan, which helped feed investor enthusiasm, is a 50% reduction of Greeces government debt. But this the simplest part of the blueprint comes with asterisks.

Of the 340 billion euros in Greek government debt, only about 200 billion euros most of it owed to banks falls under the scope of the accord, meaning the countrys total sovereign debt would be reduced by about 30% at best. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring.

But even a 30% reduction in Greeces debt load is not assured. That is because the 50% write-off on the value of Greek debt, the so-called haircut that policy makers want banks and other financial institutions, to accept, is voluntary. Since Greek government bonds are trading at about 40% of their face value, officials from the Institute of International Finance, which represented the banks in the marathon negotiations with European leaders, said the number of participants was very likely to be very high.

Still, it is far from certain all those volunteers will materialise.

Antonio Garcia Pascual, Barclays Capitals chief economist for southern Europe, said he feared that many hedge funds and nonbank investors would hold out for better terms. If enough of those investors balk, the deal could fall through.

That may leave European officials in the unenviable position of either filling in the financing gap with government-backed funds or forcing an involuntary loss of 50% on private creditors, in turn initiating a default on the bonds, which policy makers fear would make it harder for Greece to raise money from public markets in the future.

Even if most private lenders and investors sign off, and the restructuring is completed voluntarily, Greece will still be heavily burdened with debt.

The 120% debt-to-gross-domestic-product goal for 2020 assumes that Greece will be generating a budget surplus equal to 4.5% of GDP by 2014, and that the Greek economy will be growing at 3% annually by 2016, said David Tan, lead portfolio manager of the international fixed income group at JP Morgan Asset Management.

In reality, the IMF expects Greeces economy to contract by 5.5% this year and 2.5% in 2012, as austerity measures imposed as part of earlier restructuring efforts go into effect.

Another main element of the plan is to shore up 70 of Europes biggest banks by requiring them to raise 106 billion euros in fresh capital, to help them offset the losses they will suffer in taking haircuts on Greek bonds and the drop in value of other sovereign debt they own. But that is not a sure thing, either.

In contrast to bank rescue plans in the US and Britain, European governments are not injecting funds directly into financial institutions. Instead they are asking banks to turn to private investors to significantly raise their capital level, to 9% by next year. Raising money from private investors will be difficult, though, especially as many of the likely sovereign fund candidates are the same ones that suffered deep losses from investing in troubled American banks in 2007 and 2008.

In addition, some economists say that European banks are so burdened with bad sovereign debt that they need to raise far more than 106 billion euros to become healthy. Some estimate they need to raise 300 billion euros, or three times that amount.

Then there is the question of whether the answer to the euro zones debt crisis is taking on even more debt, which this plan requires. The main European Financial Stability Facility (EFSF) bailout fund of 440 billion euros relies on the sterling credit of Germany and France for its borrowing power.

Critics add that the financial stability plan is too reliant on France, which may well see its AAA rating taken down a notch because of its own debt and deficit problems. A downgrade for France would hurt the bailout funds ability to issue bonds and attract capital from investors.

And, just as with the money Europe hopes to get from private investors to help recapitalise its banks, it also remains unclear if Europe will be able to entice Asian and West Asian investors to put money into investments that would be linked to the bailout fund, and allow it to leverage up its existing assets.