the (new unprecedented) european rescue plan: on second thought

German Logo of the ECB.

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MAKATI, Philippines – The euphoria that greeted the announcement of an “unprecedented and  comprehensive solution” to the European crisis has now been replaced by a sense that it doesn’t nearly go far enough. The initial knee-jerk reaction is typical of markets because everything is relative. In this case, the first reaction was – at least they agreed on something.

The deal announced late last week essentially centered on three agreements – (1) Greece’s creditor banks “voluntarily” agreed to exchange their old Greek debt for new debt but at half the value of the original debt; (2) European banks would recapitalize their balance sheets to increase their Tier 1 ratio (ratio of capital to risk assets) to 9%; and, (3) using the European Financial Stabilization Fund (EFSF) to “guarantee” “new” sovereign debt issuances by allowing it to take on a certain amount of losses should these come to pass.

The first theoretically allows Greece to be able to afford to service its debt by reducing it to a manageable amount. The only problem is that this would largely depend on what and how Greece does. Previous agreements meant to stave off a Greek collapse imposed certain conditions very few of which have been met. In the meantime, the Greek economy continues to contract at an alarming pace leading one to surmise that this will not likely be the last of the Greek bail-outs.

The recapitalization of the banks is meant to shore up their balance sheets as a result of losses from this Greek “haircut” as well as losses stemming from the loss of value of other assets. This should be well and good except that who in his right mind would buy shares in European banks given the uncertain conditions that they face. This may put pressure on already strapped national governments and the fragile EFSF to top-up the banks’ balance sheets. One other alternative would be for banks to focus on the numerator side of the Tier 1 ratio which involves the reduction of their assets by reducing lending, among others. The liquidity squeeze that this would lead to will almost certainly result in the continued contraction of economic growth in already fragile areas of the Eurozone.

The EFSF agreement is by far the murkiest one. No one is really sure where it would get the funding to be able to provide the 1 billion euro firewall meant to protect the fragile European economies. The stronger European economies like Germany and France have not indicated any interest in providing additional capital. Non-European sovereign funds have been lukewarm to the idea, at best, with China already saying (in so many words) that it is not interested unless certain concessions can be extracted from Europe, none of which the Europeans are really willing to give.

It will not be a surprise if within the next few months or so, European leaders will again be forced to deal with this. It has already been broached that the only real and credible solution would be to grant the European Central Bank (ECB) the authority to print money. An ECB acting as the lender of last resort (similar to the US Fed), with no unreasonable limits could potentially restore confidence in the Eurozone. This will be easier said than done. First off, the Germans are strongly opposed to this. German Chancellor Angela Merkel was only able to sell this latest European deal to the Bundestag after their approval was made conditional on the ECB continuing its compliance with Article 123 of the Treaty of Lisbon. This article essentially says that ECB can’t print money. The fear of runaway inflation still nags the German psyche close to a century after the collapse of the post-World War 1 Weimar Republic.

The bottom line is that this will not be the end of this. No one has yet divined a credible solution to this crisis and things may actually get worse with Spain, Portugal and Italy also standing on precarious economic ground. Or, to put in another way, no one has divined a realistic solution acceptable to all parties. Having said that, any solution will necessarily be unpalatable to some parties. So – the wait continues.

If only the next World Cup were held in Europe…

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