EU officials scramble to solve the crisis

@CNNMoney October 21, 2011: 4:53 PM ET
Eurogroup president Jean-Claude Junker and Herman Van Rompuy, head of the European Council, are among officials taking part in a flurry of meetings this weekend to finalize a broad plan to stabilize the euro.

Eurogroup president Jean-Claude Junker and Herman Van Rompuy, head of the European Council, are among officials taking part in a flurry of meetings this weekend to finalize a broad plan to stabilize the euro.

NEW YORK (CNNMoney) -- European leaders will be in talks pretty much non stop over the next few days as they hammer out a plan to fix the eurozone debt crisis.

The flurry of "consultations" comes ahead of a highly-anticipated summit of European Union government leaders on Sunday in Brussels. This was supposed to be the defining moment with a clear solution.

But as political wrangling heated up, officials scheduled a second meeting, saying the plan would be finalized next Wednesday.

Analysts said a delay is not surprising given the difficult choices that must be made and what's at stake.

While the outcome of these meetings is impossible to predict, expectations for bold action have come down dramatically this week.

French President Nicolas Sarkozy and German Chancellor Angela Merkel appear to be at odds over the best way to enhance a government-backed fund for banks and troubled euro area economies.

The two leaders are also not on the same page over how to restructure Greek government debt, according to the latest chatter in financial markets.

Still, many investors remain optimistic about an effort to strengthen European banks, which is expected to involve a reassessment of capital needs and total about €100 billion.

But the relatively calm tone in financial markets could change in a heartbeat if the talks fail to translate into concrete action.

"The markets seem remarkably sanguine about the ability of policymakers to save the day," said Jonathan Loynes, economist at Capital Economics in London. "We doubt that will remain the case."

EFSF: The least worst option

The European Financial Stability Facility is at the center of the current impasse between Germany and France.

The €440 billion fund is widely seen as needing additional "firepower." But increasing its resources has been effectively ruled out by European leaders who cannot back additional "bailouts" for financial or political reasons.

That could be a problem, since the EFSF is expected to play a role in the recapitalization of European banks, a second bailout for Greece, and some type of mechanism for supporting euro area governments that are struggling to pay down debt.

France has called for the EFSF to be converted into a bank. This way, it would be able to borrow money from the European Central Bank or another EU institution to fund additional purchases of government bonds.

Analysts say France is pushing for this option because it would help the nation maintain its top-tier credit rating. If the French government is forced to back additional EFSF loan guarantees, as opposed to the ECB, the nation's creditworthiness could be in jeopardy.

Moody's to France: We're watching you

But the ECB and Germany have staunchly opposed the French proposal because it would further expand the ECB's balance sheet and violate the bank's mandate to stay out of government finances.

The ECB has already been reluctantly buying billions of euros worth of bonds issued by Italy and Spain, among others, as part of an emergency program to ensure that governments have access to affordable funding.

Given the impasse, analysts say using the EFSF to partially insure losses on newly issued government bonds is the most likely outcome. The strategy could be implemented without too much political rigmarole and does not involve the ECB.

But the insurance plan, which aims to boost demand for stressed sovereign debt, has already been deemed insufficient by many market analysts.

According to research from Citigroup (C, Fortune 500), the EFSF would be able to plausibly insure the first 20% of losses on about €200 billion of newly issued government bonds, given all its other commitments. That would translate to a "total envelope of maybe one trillion euro."

That's far short of the €2 trillion that many analysts have been calling for and compares with combined funding needs of about €900 billion for Italy and Spain over the next year or so.

In addition, the insurance plan may run afoul of certain EU laws.

As a work around, officials are reportedly considering a plan to use EFSF funds to provide loans that governments can use to partially insure new issues of domestic debt. But this would effectively add to already unsustainable levels of public debt.

"All of this is stupidity," said Columbia Business School professor David Beim. "All they can think to do is get an ever larger fund and throw it into ever worse assets."

Beim, like many economists, argues that the first step toward stabilizing the eurozone is to restructure the Greek government's debt load. All else merely delays the inevitable and perpetuates the crisis.

Haircuts for everyone?

Greece has struggled to make the changes necessary to reduce its deficit, let alone make a dent in its massive debt load.

The government has forced through unpopular reforms, which have sparked violent riots in Athens. But there is widespread agreement that austerity alone cannot solve the nation's financial problems.

Under a hard-fought agreement announced in July, bondholders had agreed in principle to write down the value of Greek bonds by 21%. But given the lack of progress Greece has made on fiscal reforms and its worsening recession, many economists say writedowns of up to 50% will be necessary.

Germany and France said Thursday that negotiations should start immediately with the private sector to ensure the "debt sustainability" of Greece.

But analysts say talks with the private sector on larger so-called haircuts have been unconstructive.

"Given all of the uncertainty and moving variables, our best guess at this time remains for a deal that would build on key elements of the July 21 agreement -- possibly ranging between 30-50 percent," wrote Mujtaba Rahman, an analyst at Eurasia Group, in a note to clients.

Europe default risk signal flashing red

Sarkozy is said to be particularly concerned about larger haircuts because French banks are among the most exposed to debt issued by Greece and other stressed nations. The worry is that the government may need to pump money into big French banks.

The broader fear is that allowing Greece to restructure its debt load will encourage other nations with unsustainable levels of debt to seek a similar deal.

EU leaders have said repeatedly that Greece is a unique case and that no other euro area nation will be allowed to restructure its debts, which is a nicer way to say default. But many market analysts remain concerned that Greece could set off a string of sovereign defaults and spark a disastrous banking crisis.

"Even if officials stress that this would be a one-off, who would believe it after they repeatedly said there wouldn't be Greek default and for a long time pretended the issue will work itself out," asked Natascha Gewaltig, director of European economics for Action Economics in London. To top of page

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