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Resolving the Eurozone Crisis

Author: Christopher Alessi
October 27, 2011

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European leaders announced a long-awaited "comprehensive" plan (NYT) to tackle the escalating eurozone sovereign debt crisis. The move followed months of policy inaction that has undermined global economic stability and threatened the future of the euro.

Officials billed the deal as a "three-pronged" agreement (BBC) that would provide Greece with a second bailout package to meet its debt obligations, including a "voluntary" 50 percent write-down by private creditors; require $150 billion in recapitalizations for the continent's exposed banks; and leverage the $610 billion temporary European Financial Stability Facility (EFSF), bringing its lending capacity to around $1.4 trillion.

The EFSF will be reconstituted as an insurance fund (WSJ), able to guarantee investor losses on high-risk Spanish and Italian debt. Most significantly, a separate fund will also be seeded with EFSF monies and investments from international investors (Bloomberg), including the International Monetary Fund and cash-rich emerging markets like China.

While the contours of this morning's breakthrough plan encouraged analysts and investors, significant questions remain. CFR's Sebastian Mallaby is skeptical that Europe's banks will ultimately accept a write-down of 50 percent. Even if EU leaders were able to obtain such a haircut, he says, it would only bring Greece's debt-to-GDP ratio down to 120 percent by 2012, still failing to make it "viable as an economy that can borrow on the open market."

Der Spiegel's Roland Nelles points to other unresolved issues such as whether Europe will become dependent on China should Beijing invest in Italian bonds, and if Greece, Italy, and other countries will submit to Germany's austerity dictate.

Market actors (WSJ) also voiced concern. "We suspect that while this plan has provided a blueprint that reduces the tail risk of banking crisis in Europe (and limits global contagion), we doubt this is the end of the crisis and doubt this is likely enough to bring medium-term support for the euro," read a statement by investment bank Brown Brothers Harriman. Joseph Tanious, a market strategist at J.P. Morgan Funds in New York, told Reuters that while it was encouraging to see European policymakers agree in principle on what needs to happen, "how you actually execute on this plan and agree on all the details is like herding cats."

Even though global markets responded positively--the euro rose above $1.40 for the first time since September--Barbara Rockefeller, writing for FXStreet.com, cautioned that "the market is rewarding the euro for the appearance of decisiveness without regard for the quality of the decisions."

Investors and analysts also questioned whether the level of EFSF expansion would sufficiently safeguard Italy (Guardian), the eurozone's third largest economy. "We are not convinced that--in case of a severe crisis--a first-loss insurance on sovereign bonds of 20-25 percent would really be sufficient to entice investors to buy newly issued Italian bonds," said Holger Schmieding, chief economist at the German bank Berenberg. Unlike with Greece, the collapse of Italy--which is hindered by a political stalemate and a public debt worth $2.6 trillion--would signal the end of the single-currency union.

Nonetheless, Italian inaction may ultimately be a catalyst for greater centralization of European governance mechanisms. "The drama in Rome makes it easier for Brussels to build a case for new powers to rein in errant governments through budgetary and fiscal discipline," writes TIME's Leo Cendrowicz.

More broadly, the two-year sovereign debt crisis has instigated an important debate over whether the monetary union can survive without greater fiscal and political integration. "A key reason why the eurozone is under challenge is that markets have become conscious of a fundamental weakness in its design," argues Jean Pisani-Ferry, director of Brussels-based Bruegel, in the Financial Times. "In crisis times," writes Pisani-Ferry, "a perverse interaction between bank and sovereign weakness develops. And the central bank has no mandate to put a stop to it." After this morning, Merkel and Sarkozy hope they are finally on the road to changing that.

Background Materials

"Eurozone Rescue's Moment of Truth," CFR Analysis Brief

"Preventing the Spread of Greece's Crisis," Sebastian Mallaby, CFR Video

"Containing the Eurozone Crisis," Jacob Kirkegaard, CFR Interview

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