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.