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October 26, 2011
Europe Agrees on Plan to Inject Capital Into Banks

BRUSSELS — European leaders agreed Wednesday on a plan to force the continent’s banks to raise new capital to insulate them against potential sovereign debt defaults, but disagreements over new financial aid to Greece threatened to derail efforts to devise a comprehensive solution to the two-year-old euro zone debt crisis.

The head of an influential group representing private sector creditors released a statement saying that negotiations were stalled over the size of the loss, or “haircut,” investors will be asked to absorb on Greek debt, which economists agree is beyond the country’s ability to repay. Most plans under consideration called for write downs in the range of 50 percent, a leap from the 21 percent previously agreed upon.

“There has been no agreement on any Greek deal or a specific ‘haircut,’ said Charles Dallara, the lead negotiator for the Institute for International Finance. “We remain open to a dialogue in search of a voluntary agreement. There is no agreement on any element of a deal.”

The leaders did manage to agree on a plan to require banks to raise about $140 billion by the end of June — enough to increase their holdings of safe assets to 9 percent of their total capital. The percentage is regarded as crucial to assure investors of the banks’ financial health.

Earlier on Wednesday German lawmakers overwhelmingly approved a measure to expand an emergency bailout fund to $1.4 trillion, more than double its current size of about $610 billion. The vote followed Chancellor Angela Merkel’s plea to lawmakers to overcome their aversion to risk and put the might of Germany, Europe’s strongest economy, firmly behind efforts to combat the crisis, which has unnerved financial markets far beyond Europe’s borders.

“The world is looking at Germany, whether we are strong enough to accept responsibility for the biggest crisis since World War II,” Mrs. Merkel said in an address to the Parliament in Berlin. “It would be irresponsible not to assume the risk.”

The $1.4 trillion figure is generally accepted as the likely target for negotiators here, but many questions remained about how the enlarged fund would be financed.

Europe does not face any hard deadline to forge a deal, as it did last month when it had to head off a Greek default. But its leaders would like to agree on a definitive plan to address the systemic aspects of the euro crisis rather than issuing vague proclamations as they have so often in the past.

The fear is that at some point, uncertainty surrounding the solvency of struggling countries like Greece and Portugal might infect larger economies like those of Spain and, especially, Italy, in turn raising questions about the solvency of the European banks that lent to them in large quantities. That, in turn, could ignite a panic like the one following the failure of Lehman Brothers, when financial institutions refuse to extend credit to one another for fear their counterparts might be insolvent.

The overall euro deal under discussion is complicated, weaving together the interrelated efforts to restructure Greek debt, inject new capital into Europe’s banks and expand the bailout fund so that it can ward off a financial panic in Italy — the euro zone’s third-largest economy — as well as in the relatively small economies of Greece and Portugal. Attention has focused on Italy because its moribund government seems incapable of responding to the crisis, which has undermined the markets’ faith in Europe’s capacity to solve its problems.

Mrs. Merkel and President Nicolas Sarkozy upbraided Italy’s prime minister, Silvio Berlusconi, on Sunday for failing to following through on his promises of budget cuts and various economic changes, But Mr. Berlusconi, hobbled by an internal power struggle, managed to bring only a “letter of intent” to Brussels outlining plans to implement the kind of economic changes that his counterparts want.

The Europeans also want Mr. Berlusconi to live up to his promises to do more to reduce Italy’s huge accumulated debt — about $2.65 trillion, or 120 percent of gross domestic product, among the highest in the developed world — and to promote economic growth in a largely stagnant economy. While Italy’s annual deficit is modest, the debt overhang means that speculation is driving up the cost of financing that debt, which if unchecked, could tear holes in the budget.

The current crisis has placed Mr. Berlusconi between two irreconcilable forces: his fellow European Union leaders and Umberto Bossi, the leader of the powerful Northern League, who holds the fate of the Berlusconi government in his hands and is bound to Mr. Berlusconi like an inoperable Siamese twin.

For months, Mr. Bossi had refused to back a plan to raise the retirement age to 67, relenting only on Tuesday for everything except seniority pensions, still leaving the government at risk of collapse on the issue. That change had been demanded by the European Union in return for its support.

The European Central Bank demanded various changes as the price for buying up Italian debt at a reasonable, nonmarket price. But as soon as the bank stepped in, Mr. Berlusconi failed to propose a convincing package of measures, let alone put them into effect, infuriating his European counterparts and the bank.

Given reasonable progress made by Ireland, Portugal and Spain to fix their fiscal problems, the vulnerability of the far larger economy of Italy is the main reason the Europeans are trying to enlarge, or leverage, their bailout fund, the European Financial Stability Facility, which at around $600 billion is considered less than half as large as needed to cover Italy’s debts. At least $200 billion of this fund is already committed to Greece, Ireland and Portugal, and European leaders have not yet agreed on at least two options they are considering for enlarging the fund.

One idea is to try to attract outside investors, possibly with the help of the International Monetary Fund, but it is unclear what guarantees outsiders would demand.

A parallel idea, which could run simultaneously, is to use the fund to limit losses bondholders might suffer in the future.

Details of the proposed growth measures Mr. Berlusconi presented to Brussels have not been made public, but Italian news media reported that they would include privatizations, a liberalization of Italy’s professions and a simplifying of bureaucratic red tape.

Italy’s fundamentals, other than its enormous debt, are relatively strong, but its fragile political leadership adds to market uncertainty, said Marco Fortis, an economist at Milan’s Cattolica University. “The only thing that’s missing is a government that can make decisions and gives signals to the markets that the country is not at risk,” he said.

Reporting was contributed by Jack Ewing from Frankfurt and Rachel Donadio and Elisabetta Povoledo from Rome.


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