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French President Nicolas Sarkozy gestures during a press conference at the end of Thursday's euro zone conference. (Eric Feferberg/AFP/Getty Images)
French President Nicolas Sarkozy gestures during a press conference at the end of Thursday's euro zone conference. (Eric Feferberg/AFP/Getty Images)

Economy

Belatedly, Europe finds a quick fix to its financial woes Add to ...

Europe’s leaders staved off a full-blown financial crisis, but are still in pursuit of a lasting solution.

Investors cheered the plan to infuse €1-trillion of financial firepower into the ailing euro zone and erase much of Greece’s crushing debt load, sending markets soaring. But euphoria over the deal’s progress after months of political dithering and grim news on Europe’s bulging government debt and sagging economy concealed, for a day at least, some of the new risks and high costs of a bailout that relies on more massive borrowing and looks to China for help doing it.

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Even as investors celebrated the deal, analysts began to question the plan’s effectiveness and its potential risks.

In a move that underscores the shifting power in the global economy to emerging markets, Europe is looking to China to contribute its financial resources to the bailout effort. Within hours of sealing the debt pact, French President Nicolas Sarkozy called Chinese leader Hu Jintao to discuss the arrangement, and Europe bailout fund chief Klaus Regling was set to visit Beijing on Friday to meet with government officials and prospective investors.

“We support the European Union’s series of positive efforts to tackle the current financial crisis. We are also ready to work with the European Union to overcome the difficulty,” Chinese Foreign Ministry spokesman Jiang Yu said in Beijing on Thursday.

Reaching out to China is a humbling step for cash-strapped Europe, and underscores China’s role as a business leader in a shaky global economy. China’s role in backstopping Europe could eventually give it greater clout on trade, currency and other issues, some analysts believe.

At the same time, the crisis-fighting package is being attacked for failing to fix the core problem, since the fund, known as the European Financial Stability Facility, will be boosted with borrowed money, essentially fighting a debt problem with more debt.

“The EU is compounding leverage upon leverage here,” Bank of Nova Scotia economists Derek Holt and Karen Cordes Woods said.

Leaders provided few details on how the EFSF will be funded, but the bailout will need the support of nations outside the euro zone.

“It’s terrible for Europe to ask for this help. The only reason to mention China is because the EU can’t sort out its own affairs. This is a terrible admission of failure,” said Nicolas Véron, a senior fellow at Bruegel, a think tank in Brussels. Still, China recognizes the dire consequences of a euro meltdown if the continent lacks sufficient financial backing for its plan, he noted.

While China has made supportive gestures, how much it will follow through with is an open question.

Some economists think it will sit on the sidelines until it spots the right time to make a lot of money. Carl Weinberg of High Frequency Economics said “we think China is unlikely to step up the plate with a lot of cash for Euroland. Its interests are best served by waiting for Euroland to fall and then buying assets at the fire sale.”

Europe’s crisis package sets out plans in three main areas. The first is reducing Greece’s debt load by persuading banks to take major losses on Greek sovereign debt holdings. The second is boosting the capital base of the European banks so they are better insulated from economic and investment shocks. The third is the boost to the EFSF to about €1-trillion through borrowings and by creating special vehicles that would buy distressed government bonds.

But all three come with problems and risks, economists said.

The effort to knock down Greece’s debt to a sustainable level may not be ambitious enough. The banks have tentatively agreed to write down their Greek bonds by 50 per cent. The goal, outlined in the EU, is to reduce Greece’s debt, which was expected to rise to a crushing 160 per cent of GDP by next year, to 120 per cent by 2020. The question is whether that’s low enough, given that Greece is mired in deep recession.

“What if the austerity measures continue to reduce GDP and cause the Greek deficit to increase?” said hedge-fund strategist Marshall Auerback of Denver’s Madison Street Partners.

The other potential problem is that banks are being asked to accept the Greek-debt writedowns as “voluntary,” and some might not go along with the plan.

Economists and strategists are worried that the effort to bolster the banks will come at a cost to the greater European economy. The EU plan calls for the banks to boost their so-called Tier 1 capital – a key measure of financial health – to the equivalent of 9 per cent of their assets. The strongest banks will be able to do so on their own by selling shares or assets.

Those that can’t will seek financial backing from governments, putting a greater burden on the taxpayer and raising national debts when they’re supposed to be coming down.

Perhaps the clearest accomplishment of the debt plan is that it buys leaders time to do more.

“To our minds, this is likely to prove sufficient to ease financial stress and give the euro area a ‘window of opportunity’ to put it house in order,” said Société Générale economists Michala Marcussen and James Nixon.

With reports from Mark MacKinnon in Beijing and Brian Milner in Toronto

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