Euro stability fund is a mirage

@CNNMoney September 30, 2011: 9:50 AM ET
European Commission president Jose Barroso said the euro area bailout fund needs to be stronger and more flexible, but he stopped short of backing an increase in the amount of money it can lend.

European Commission president Jose Barroso said the euro area bailout fund needs to be stronger and more flexible, but he stopped short of backing an increase in the amount of money it can lend.

NEW YORK (CNNMoney) -- As a proposed overhaul of the European bailout fund inches its way toward approval, investors and economists are already calling for more aggressive measures to contain the eurozone debt crisis.

European leaders agreed in July to expand the powers of the European Financial Stability Facility, which was set up in the wake of the 2008 financial crisis.

The goal is to give the fund more flexibility to stabilize shaky government finances and provide money for banks that need to raise capital.

So far, the plan has been ratified by 13 of the 17 nations that use the euro. On Thursday, the German Parliament approved the measure, which is politically unpopular in many northern European nations.

Euro area officials said last week that they plan to implement the proposed changes by mid-October, assuming the overhaul is approved by the remaining eurozone nations.

Europe's bailout fund: Where countries stand

But there is now widespread agreement among economists and investors that the €440 billion fund is not big enough to be effective if some of the larger euro area economies fail.

Some economists have estimated that the fund would need up to €2 trillion to bail out Spain or Italy. Both nations are struggling with unsustainable levels of debt and dim economic prospects.

"Even an enhanced EFSF will have barely €100 billion to throw at the bond market...minus, of course, any new commitments made to Greece" said Carl Weinberg, chief economist at High Frequency Economics, in a note to clients.

More recently, European officials have been discussing ways to increase the fund's ability to absorb bad sovereign debt by leveraging its assets in some way. However, experts say the fund is unlikely to see an increase in the amount of money it is able to deploy.

Europe's debt crisis: 5 things you need to know

José Manual Barroso, president of the European Commission, said Wednesday that the stability fund "must immediately be made both stronger and more flexible." After the overhaul of the fund is official, he added, "we should make the most efficient use of its financial envelope."

There is no shortage of theories on how the fund could be used more effectively.

Under one of many scenarios, the EFSF could buy €440 billion worth of bonds issued by distressed euro area governments and use those securities as collateral to borrow from banks in the private sector. The proceeds could then be used to buy even more government bonds.

Another scheme being debated involves using the fund's €440 billion to guarantee the first 20% of any losses the private sector may suffer on bonds issued by troubled sovereigns. The goal is to encourage investors to buy newly issued bonds and lower borrowing costs for governments struggling with massive debts.

There has also been talk about using EFSF funds to guarantee purchases of government debt by the European Central Bank, which has been buying up billions of euros worth of bonds issued by Spain and Italy, among others.

The euro will survive (That's not a typo)

However, the emergency bond buying program has already caused a major rift within the ECB's management and many analysts say the bank may be reluctant to take on more bad debt.

Overall, many experts say increasing the stability fund's price tag to €2 trillion is highly unlikely given the political headwinds.

"Emerging details about the recent proposal to supersize the eurozone's bail-out fund suggest that, at best, the plan is simply to use existing funds more imaginatively," said Jennifer McKeown, senior European economist at Capital Economics.

In addition, she noted that the proposals seem to have more support outside the eurozone than within it, "suggesting that the region's policymakers are still a million miles away from resolving the crisis."

What's at stake

The immediate risk is a potential default by the Greek government, which is struggling to pay down a mountain of debt in the midst of a painful recession.

Greece has been kept afloat for well over a year by billions of euros in bailout money from the European Union and the International Monetary Fund.

In exchange, the Greek government has imposed harsh austerity measures in an effort to bring down its budget deficits. The unpopular reforms have sparked a pubic backlash and dragged on economic growth, but have done little to improve the situation. In fact, some economists argue that more austerity will do more harm than good.

Wanted: A radical idea to fix the eurozone

For the past few weeks, Greece has been in talks with officials from the IMF and other European nations over the latest €8 billion installment of last year's €110 billion bailout.

Without those funds, Greece is expected to run out of the money it needs to pay its bills by next month.

Monitors from the so called troika of IMF, EC and ECB returned to Athens Thursday after abruptly leaving the country earlier this month.

German finance minister Wolfgang Schauble told lawmakers Thursday that a decision on the much-needed funds will be made Oct. 13.

European leaders agreed in July to provide another €109 billion bailout for Greece, which officials said would cover all of the nation's financing needs.

But many economists and investors say a so-called structured default will eventually be necessary for Greece to get out of debt.

"As far as Greece is concerned the market's discussion has long since turned to when rather than if it will default," said Gary Jenkins, head of fixed-income at Evolution Securities.

A default by Greece, which experts say would likely be telegraphed and tightly managed by the governments, could involve significant write downs for banks.

Under the proposed second bailout for Greece, many banks had agreed in principle to accept a 20% reduction in the value of the Greek bonds on their books.

Yet some economists say banks will need to accept much larger losses, with some calling for 50% haircuts, if Greece is ever to recover. To top of page

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