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Crisis Averted?

The news this morning is full of praise for the deal which the eurozone leaders have hammered out overnight to deal with the debt problems. The purpose of the deal is to try and stop the Greek debt crisis spreading to larger eurozone economies like Italy and Spain.

The deal is set to tackle the problem through three separate mechanisms. Firstly, private banks that are holding Greek debt will accept a write-off of 50% of their returns. This move alone is expected to cut Greece’s debt-to-GDP ratio to 120% by 2020. If this were not done, the ratio would have grown to a staggering 180%. Of course, the banks have been reluctant to agree to this, offering a 40% reduction initially.

Secondly, the firepower of the main euro bail-out fund, the European Financial Stability Facility (EFSF), is to be boosted from the current level of €440 billion to €1 trillion. This has been achieved through leveraging the remaining €250 billion – by offering insurance to purchasers of eurozone members’ debt and setting up a special investment vehicle for public and private sector investors, such as China.

The third measure is bank recapitalisation, whereby European banks will be required to raise approximately €160 billion by June 2012. This, it is hoped, would help shield them against losses resulting from any government defaults thereby protecting larger economies like Italy and Spain.

Many market commentators are questioning whether these measures will provide the security necessary to prevent contagion and help Greece recover. The consensus appears to be that EU leaders have certainly bought some time, and the deal has already had significant impact on the euro which has rallied some 0.75% against the dollar and 0.7% against sterling. The question remains, though, whether the €1 trillion available to the EFSF will be sufficient. Many wanted not only to see double that figure, but also wanted to see the the European Central Bank as part of the deal – a course which has been ruled out because of German fears about possible inflationary consequences.

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