Europe averts financial disaster, but much remains to be done

Posted Oct. 27, 2011, at 8:36 p.m.

WASHINGTON — The compromise reached by European leaders Thursday was not as complete as it first appeared, and analysts say some of its key terms remain undefined, tenuous and could prove difficult to implement.

To be sure, the predawn announcement in Brussels that leaders of the European Union had struck a deal averted a looming disaster, rallied global financial markets and sent U.S. stocks skyward. But that was before all the reservations surfaced.

The big headline: Under the agreement, banks and other private holders of Greek bonds could voluntarily swap them for new ones that have an EU backstop — if they’re willing to take a 50 percent loss, or “haircut,” in the value of their current Greek debt. That appeared to be a huge breakthrough.

But terms of how the new bonds will work — what interest rate they’ll carry, and how long they’ll have to reach maturity — have not yet been negotiated. Those details will determine just how much current bondholders must sacrifice, if they choose to go along. Under the deal, those talks must conclude by January.

“We look forward to work with the Greek and European authorities to translate this framework into a concrete agreement that can deliver an early reduction in Greece’s debt and place it squarely on a path toward debt sustainability,” said Charles Dallera, chief negotiator for the private bondholders and managing director of the Institute of International Finance, the trade group for big international financial institutions.

Leaders also agreed to rules that will require European banks to hold more capital in reserve as a buffer against losses — but gives them until June to get it done.

And a special 1 trillion-euro bailout fund was boosted sharply — but through the use of creative finance that in part depends on support from larger emerging markets such as China and Brazil.

And the bailout fund’s exact size can’t be calculated until the Greek bond swap terms are finalized. “This is an approximate value,” said Angela Merkel, the German chancellor, according to newswire reports. “We don’t know yet how this works.”

Still, not unlike the U.S. budget impasse over the summer, the 27-member EU did enough to avert immediate disaster and put off the day of reckoning. But it also left enough undone that there’s likely to be drama when President Barack Obama and other leaders of the 20 most-industrialized nations gather next week for a G-20 meeting in Cannes, France.

“We welcome the important decisions made last night by the European Union, which lay a critical foundation for a comprehensive solution to the Eurozone crisis,” Obama said in a statement Thursday. Later, as he headed to an afternoon meeting with the visiting Czech prime minister, Obama cautioned that the compromise was but “an important first step.”

Despite all the reservations voiced by experts, U.S. investors were elated. The Dow Jones Industrial Average soared from the opening bell, finishing up 339.51 points to 12,208.55. The S&P 500 finished up 42.59 points to 1,284.59, and the NASDAQ added 87.96 points to close at 2738.63.

Thursday’s stock rally also was fueled in part by new data showing the U.S. economy grew at a 2.5 percent annual rate from June through September. If the rally lasts through Monday, the Dow could mark its best October ever.

However, wild mood swings on Wall Street have become the norm, so whether the relief rally has legs is an open question.

What’s clear to experts who follow Europe’s economy is this: There’s less to the EU compromise than meets the eye.

“I’m totally downbeat,” said Nicolas Veron, a senior economist for the European think tank Bruegel in Brussels. Veron and other experts are particularly unhappy with the European move to require banks to build a big buffer against future losses, but then giving them until June to do so.

“They’re sort of admitting you don’t have enough capital in the system,” Sebastian Mallaby, a senior fellow for economics at the Council on Foreign Relations, said during a conference call with reporters. “You are admitting that for the next eight months, when the markets are in high panic, you don’t have enough funds.”

The move to raise bank reserves came after an earlier round of so-called stress testing was criticized for simulating economic scenarios that were hardly stressful. Thursday’s agreement shows that criticism was correct, yet it gives banks a long lead time to get to safer ground.

“I think it would have been better to do nothing,” Veron said of the EU’s capital requirement.

Experts were also dubious of how EU leaders chose to bolster their bailout fund, known formally as the European Financial Stability Facility. Financial markets had viewed the prior EFSF as insufficient to calm fears about potential defaults by other struggling economies, such as Ireland and Portugal.

The new version of the EFSF would theoretically provide about $1.4 trillion in guarantees to ensure that panic over Greece’s debt problems won’t spread and infect other governments’ bonds. This is arguably the most important component of the deal, because by guaranteeing new bonds, the EU is trying to keep borrowing costs in check for bigger European economies that need to roll over a la rge amount of debt — Italy and Spain in particular.

On a parallel track, European leaders are trying to establish a special fund in which large developing nations such as China and Brazil would be encouraged to invest in European debt to help stabilize the region — and thus the global economy. The International Monetary Fund also is likely to be involved. French President Nicolas Sarkozy and other EU leaders planned to lobby Chinese Presi dent Hu Jintao this week. Their effort, however, smacks of “alms for the rich.”

“It’s an admission of failure, because the way it’s been structured has been a way to get money from emerging markets. I, as a European, find this deeply embarrassing,” Veron said.

Other experts said that at least European leaders, who concluded their 14th meeting in 21 months, are moving in the right direction.

“The Eurozone institutions have been in denial about the dire situation … and they no longer are,” said Benn Steil, also a senior fellow in economics at the Council on Foreign Relations.

Thursday’s compromise amounts to a new start, but it “is not the endgame by any stretch of the imagination,” Steil cautioned.

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