Europe's Plan for Solving Debt Crisis

Dear readers, in the last post we talked about Eurozone crisis. The world was looking at the eurozone leaders to find solution to this crisis as it seemed to be a never ending problem which was driving the world economy to its limits. The long wait is finally over as eurozone has delivered its plan to curb this soverign debt crisis. Only time would prove its effectiveness but here we can discuss the plan itself. Three main things have been decided:

1. Current Greek debt holders would take a 50% voluntary ‘haircut’ i.e. an investor who has invested €100 in Greek debt would only receive €50 back. This step is to reduce the debt of Greece and make its debt level more sustainable. A voluntary write down by the debt holders was important to prevent the event from triggering the Credit default Swaps.
2. As banks are one the major debt holders of Greek bonds, taking such a write down would threaten their own stability. To prevent this from happening, banks would have to maintain a Tier 1 ratio of 9%. To achieve this, banks will have to raise €106 billion. Banks would first try to raise the capital from private investors, if they fail to do so they can go to their government for capital. The final point of help would be the ESFS (European Financial Stability Facility). The banks have until June 2012 to achieve this aim.
3. To restore the confidence of the market and to increase the firepower of the bailout funds, the funds in EFSF would be raised to €1 trillion. This would be done by leveraging the EFSF, but how exactly and on what terms money would be borrowed is not clear. China, the world’s largest foreign reserve holder has been approached for help. EFSF would support the sovereign debt by providing guarantee on the first 20% loss for investors. It would also help banks that would be under stress.

In my opinion calling the announcements made as solution is wrong as these are just promises which if implemented as said would lead to a solution, but even that won’t solve all the problems faced by eurozone. The reduction of the debt of Greece by forcing the debt holders to take a voluntary haircut would surely ease the problem of Greece but that leaves the already stressed banks in more problems. They have also been asked to raise more capital which is going to be very difficult in these conditions. What would they do if they can’t raise the capital form market? They would go to their government. If the government is strong enough to support their banks, why do we have debt crisis in the first place. If the government fails to support the banks, they have EFSF as their final resort. We did discuss in the last post that EFSF is a company backed by the eurozone. The plan of increasing its firepower from €440 billion to €1 trillion sounds good. But then we have to understand how the eurozone is going to back such a huge amount, provided Germany has already passed a legislation of not contributing more to the EFSF. Following all these arguments, I once again say that the announcements are just promises, until they are met, as it won’t be easy to implement all these promises. Here we also need to understand that market works on expectation and hope. These announcements were positive for the market, as we now expect that the crisis would be solved. This was seen as nearly 3% rise in all the major indices after the announcements. But is the crisis really over? I would say that this an attempt, a good one, but a lot of work has to be done to make it successful. The road won’t be smooth and we should be ready to have some bumps in our journey.

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