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The Globe and Mail

Why Europe's plan to end the debt crisis won't work

A woman walks by a monument presenting the last Greek drachma coin in Athens on Nov. 1. The drachma currency was used by Greece before the euro. Greek Prime Minister George Papandreou plunged the euro back into crisis and sent share prices into a tailspin on Oct. 31 with a shock announcement that he would put a hard-fought rescue deal to a referendum.


Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

The most recent EU plan is too little, too late and involves too much wishful thinking. There's no reason to believe that the recent euro zone summit will be the last.

Greece has an unsustainable level of debt. The only way that the country's solvency can be restored is by writing off a portion of this debt. On Oct. 27, banks and investors holding Greek bonds, agreed to a 50 per cent haircut.

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At best, the reduction of €100-billion is less than 30 per cent of outstanding debt, as only private investors were covered. The 50 per cent haircut reduces debt to 120 per cent of GDP and funding requirements to €114-billion through 2020. While the writedowns were needed, it is unclear whether the quantum is sufficient and whether Greece's residual debt burden is sustainable.

The Greek writedowns may create speculation for Ireland and Portugal to follow suit, especially if economic condition deteriorate.

The EU plans calls for €106-billion in recapitalization of European banks, primarily to cover losses on holdings of sovereign debt such as Greece, by June 2012. The amount is at the low end of what is required. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalization is around €200- to €250-billion. The writeoffs, covering the cost of recapitalization and the general de-leveraging (reduction in debt) is likely to reduce economic growth resulting in increasing credit losses that must also be covered.

It is not clear where the additional capital is coming from. Recapitalization funded via a loan from the European Financial Stability Fund ("EFSF"), the European bailout fund, is apparently only available as the last resort.

An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. The EFSF will provide loans to or purchase bonds in order to support market access for euro zone member states faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency.

The EFSF does not have adequate resources to perform its functions. The amount available can be compared to the financing requirements of beleaguered European countries. Over the next three years, Spain and Italy will need to find around €1-trillion to meet their financing requirements. After accounting for existing commitments to Greece, Ireland and Portugal, the fund's available capacity is around €200- to €250-billion.

In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund. In the absence of details, it is widely assumed that this will entail the EFSF guaranteeing against losses on bond holdings, up to an unconfirmed amount of around 20 per cent. It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy.

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The enhanced EFSF plan does not address fundamental problems of its structure. The EFSF is guaranteed by individual euro zone member states (up to a stated amount). Major guarantors are Germany 29.07 per cent, France 21.83 per cent, Italy 19.18 per cent, Spain 12.75 per cent, Netherlands 6.12 per cent and Belgium 3.75 per cent. Given that Italy and Spain as well as others may need to avail themselves of the assistance of the EFSF, the circular nature of the scheme remains an issue with weakened nations undertaking to rescue themselves and their banks.

A second option proposed is to enhance the EFSF using money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. Support for the idea amongst potential investors is uncertain. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different -- China must give money to Europe to get its house in order.

China has considerable "skin in this game". Europe is China's biggest trading partner. China has around $800-billion to $1-trillion invested in euros and European government bonds. Continuation of the European debt problems will have serious effects on China's economy and its investments. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.

Time will determine whether the plan creates "confidence" or is just a "con".

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