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German Chancellor Angela Merkel, right, and Greek Prime Minister George Papandreou talk after speaking to reporters at the Chancellery in Berlin on Tuesday. (TOBIAS SCHWARZ/REUTERS)
German Chancellor Angela Merkel, right, and Greek Prime Minister George Papandreou talk after speaking to reporters at the Chancellery in Berlin on Tuesday. (TOBIAS SCHWARZ/REUTERS)

European split dims hopes for Greek rescue Add to ...

A rift between European leaders threatens to derail a second Greek bailout and crush any appearance of unity on the eve of a crucial German vote.

At issue is another €109-billion ($148-billion) rescue for Greece, the poster child of Europe's debt crisis. In July, private bond holders of Greek debt and European governments agreed on a plan to offer Greece more money, provided the debt holders took a haircut on their positions. Just as Germany prepares to vote on Thursday to ratify this deal, a report said at least seven countries in the 17-member euro zone could oppose the agreement.

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Word of the split immediately took the fizzle out of North American markets Tuesday, after a strong day of stock gains around the world. Before the news, markets were soaring on the determination of European leaders to address the root of the region’s debt troubles, rather than continue on a path of piecemeal solutions to plug holes in the system. But the rally faded and North American stocks ended the day only modestly higher.

Europe’s policy makers have been stuck in a stalemate for months, squabbling over what to do about Greek debt and the spreading fear of the potential impact on banks. Hoping to stave off any big restructuring, they planned to offer Greece more money and pray the country’s austerity measures would be counteracted by global economic growth. Now they are cooking up a much bigger plan.

“Finally, European leaders realize the task that lies ahead,” said Michael Hewson, market analyst at CMC Markets. But that’s only half the battle. “Does it mean the path to a resolution is any clearer? No, it doesn’t.”

Through much of Tuesday, investors were largely buoyed by the actions of Europe’s leaders.

“Up until now, we’ve had little evidence that [policy makers]wanted to acknowledge ... what problem they’re facing and, more importantly, how to deal with it,” said Simon Ballard, global credit strategist at RBC Dominion Securities.

“In the short term, there’s a greater degree of optimism that we are starting to address the underlying issues, rather than just throwing good money after bad,” he said.

Plans for dealing with Europe’s debt problems have included offering Greece more money, injecting capital into the region’s biggest banks and leveraging Europe’s rescue fund, the European Financial Stability Facility, by tacking debt onto the €440-billion that has already been committed so that it would be worth over €1-trillion. However, the 17 euro zone members must first approve the second Greek bailout, and at least seven of them are in opposition, according to the Financial Times.

Levering the EFSF has become a hot topic. But while it sounds like a juicy idea, no one has any idea of how it would work, or if it’s even feasible.

“I can’t wrap my head around it either,” Mr. Hewson said. “Leverage is what got us into this mess. And now we’re considering leverage to get us out? You cannot be serious.”

Then there is the issue of who would lend to lever up the EFSF. Asked if he had any ideas of who would lend to a fund that is used to bail out banks, Mr. Ballard said “I don’t have the answer to that question, I don’t think anybody does.”

One plan that is much more palatable involves injecting capital into banks that have lent to Greece and would take a hit from a Greek default. Mr. Ballard refers to this as “ring fencing” an outbreak of losses, and it is something he has been promoting for some time. Rather than continue to throw money at Greece and hope it can restructure and grow its way out of its mess, injecting capital into solid banks helps them stay afloat.

“There is no V-shape recovery [for Greece]to fall back on,” he said. “The only way is to cut the debt once and for all.”

At this point no one knows what will unfold. Although plans to reduce bank exposure to Greek debt have been put forward, there is still a big question mark around how long it would take to approve and enact them. Then there are issues such as whether a Greek default is politically palatable and if Greece should stay a part of the euro zone.

Nariman Behravesh, chief economist with IHS Global Insight, was in Toronto Tuesday and his best guess is that Greece will default by early next year, and that banks and other private creditors will have to absorb a 50 per cent haircut. But if Greece pulls out of the euro, something he places the chances of at 30 per cent, the entire region would plunge into a deep recession. “That would be a ‘Lehman moment’ for Europe. It could be pretty awful,” he said.

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