Can the European Union avoid a financial market meltdown? (Part 2)

In a wild week that gripped the world’s finan­cial mar­kets, the prime min­is­ter of Greece threw a mon­key wrench into a frag­ile (and still some­what amor­phous) plan that was sup­posed to bail out the finan­cially strapped Greek econ­omy, sta­bi­lize Euro­pean banks, and recap­i­tal­ize the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF). And how did PM Papan­dreou pull off this stun­ning accom­plish­ment? By sug­gest­ing Greece would hold a ref­er­en­dum on the bailout plan, which — if rejected by Greek vot­ers — might have placed the entire EU econ­omy and their com­mon cur­rency (the euro) at risk. After pres­sure from other EU mem­bers, the ref­er­en­dum was declared unnec­es­sary and the orig­i­nal effort to address the above three issues resumed.

So, what are the major fac­tors in this plan, keep­ing in mind that they are still quite ten­ta­tive and could change in the future? A few ele­ments seem rea­son­ably clear.

With regard to the first major prob­lem — the bailout of the nearly broke Greek econ­omy, which seems on the verge of default­ing upon its debt oblig­a­tions — the plan is to estab­lish a 130 billion-euro bailout. There are two major ele­ments to this effort. First, pri­vate sec­tor inter­ests cur­rently hold­ing Greek debt secu­ri­ties (which pri­mar­ily encom­passes EU finan­cial insti­tu­tions, includ­ing banks) “vol­un­tar­ily” agreed to writ­ing off half the value of what they are due so as to reduce Greek debt from approx­i­mately 200 billion-euros to just 100 billion-euros. The other 30 billion-euros will come from unspec­i­fied cuts in the pub­lic (gov­ern­ment) sec­tor, pre­sum­ably in the form of lower wages/benefits to gov­ern­ment work­ers and/or elim­i­na­tion of other forms of gov­ern­ment spending.

With banks expected to “vol­un­tar­ily” write off a huge por­tion of the value of Greek debt instru­ments, this means that the value of bank assets will be sig­nif­i­cantly reduced and (as described in last week’s col­umn) could cause banks to become severely under­cap­i­tal­ized to the point of insol­vency. To address this not-so-little issue, the next por­tion of the EU-fix will require banks by next June 30th to recap­i­tal­ize to the tune of at least (take a guess at the min­i­mum fig­ure) 100 billion-euros. That’s right — the same amount that banks are “vol­un­tar­ily” agree­ing to pro­vide Greece as a gift, via a write-down in the value of those Greek debt secu­ri­ties. And the final fig­ure could be well north of the 100 billion-euro fig­ure, given a new min­i­mum bank cap­i­tal­iza­tion ratio of 9 percent.

What is unclear (and thus one of those unan­swered ques­tions asso­ci­ated with the EU plan) is exactly who/what will be will­ing to pur­chase new banks stock offer­ings so as to achieve that 9 per­cent cap­i­tal­iza­tion ratio. After a 50 per­cent “vol­un­tary” reduc­tion in the value of exist­ing Greek debt secu­ri­ties, can new bank investors be assured that another “vol­un­tary” write-down might not occur? And if this leaves pri­vate sec­tor investors poten­tially hes­i­tant to invest in new EU bank stocks, will the pub­lic (gov­ern­ment) sec­tor step in to fill in the gap? If this is required, where will gov­ern­ments get the funds? Taxes? More spend­ing cuts? Addi­tional bor­row­ing? And if one or more of these actions is required, how might they impact the under­ly­ing eco­nomic prob­lems of Greece and the other 16 mem­bers of the EU?

Finally, in an effort to extend the capa­bil­i­ties of the EFSF once the Greek bailout funds are sub­tracted out of the 440 billion-euro autho­riza­tion of the EFSF, how will the approx­i­mately two hun­dred bil­lion euros remain­ing suf­fice to keep other at-risk EU mem­bers (Italy, Spain, Por­tu­gal, and Ire­land) from falling vic­tim to the Greek con­ta­gion? For exam­ple, Italy alone has an out­stand­ing debt of about ten times that of Greece; stand­ing at nearly 2 trillion-euros.

To allow the remain­ing funds in the EFSF (and pos­si­bly some added funds in a new Inter­na­tional Mon­e­tary Fund lend­ing facil­ity) to keep other at-risk EU nations afloat, a “lever­ag­ing” process will be used. While the specifics are murky, the idea is the remain­ing EFSF/IMF funds will guar­an­tee pur­chasers of new bonds that they will be insured against ini­tial losses that may occur, amount­ing to some 10-to-25 per­cent of the funds pro­vided by pri­vate sec­tor investors. This would allow each euro in EFSF/IMF funds to be lever­aged (mul­ti­plied) by a fac­tor of between 4 (at a 25 per­cent guar­an­teed loss-insurance back­ing) and 10 (at a lower 10 per­cent backing).

So how might all of this be viewed over time as the plan is imple­mented? That will be next week’s column.

Dr. James New­ton serves as Chief Eco­nomic Advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on Nov 9 2011. You can follow any responses to this entry through the RSS Feed. Comments can be made below.