Europe: Many challenges ahead

european union

European leaders will gather in Brussels later this month to nail down a “comprehensive plan” for solving the eurozone debt and banking crisis.

NEW YORK (CNNMoney) — Europe appears to be gaining momentum in its long, slow march toward a lasting solution to the sovereign debt and banking problems threatening the future of the euro.

But analysts warn that there are still significant political and logistical challenges to overcome before the 12-year old currency union can move past its debt woes for good.

The leaders of France and Germany, along with top officials from the European Commission, have devised a “comprehensive plan” that European Union heads of state will discuss at a summit later this month.

The plan calls for a “decisive” response to the debt crisis in Greece; enhanced financial “backstops” for other troubled euro area nations; recapitalization of European banks; fast tracking policies to boost economic growth; and more robust governance measures.

While the details remain sketchy, European leaders have pledged to present a more definitive version of the plan at a meeting of the Group of 20 world economic powers in November.

The promise of a coordinated and multifaceted approach to the nearly two-year-old crisis has boosted morale in global financial markets, where investors have been clamoring for EU leaders to get ahead of the curve.

“Assuming all goes according to plan, this may mark the end of the beginning of the sovereign debt crisis,” said Alastair Newton, fixed-income strategist at Nomura Securities in London.

“However, major challenges will still need to be addressed — often through unpopular measures — for some time to come if the eurozone is definitively stabilized,” he added.

In particular, many analysts point to a rift between France and Germany over how to recapitalize European banks.

G20 finance chiefs to discuss Europe’s ‘comprehensive plan’

Germany has stressed that individual European states should inject capital into domestic banks that lack sufficient buffers. But analysts say France is opposed to this idea because it could jeopardize the nation’s top-tier credit rating.

Given the competing interests of different countries, the “comprehensive plan” may not be the break through that investors are hoping for, according to Mujtaba Rahman, an analyst at research firm Eurasia Group.

“After almost one and a half years, crisis resolution in the eurozone remains decisively in muddle-through,” said Rahman.

After a messy three-month political process that resulted in the resignation of the Slovakian Prime Minister, all 17 euro area nations have approved a plan to increase the powers of a bailout fund for banks and struggling euro area nations.

The European Financial Stability Facility now has the authority to intervene in sovereign debt markets and help fund bank recapitalizations by lending money to governments.

The new powers are billed as a crucial first step to address the immediate crisis and restore confidence in global financial markets. But the fund is widely seen as needing additional leverage to maximize the impact of its relatively limited resources.

The €440 billion EFSF has already committed funds to Ireland and Portugal. It is also expected to back a second €109 billion bailout for Greece.

Greece, Ireland and Portugal stand behind €30 billion of the fund’s resources. Those guarantees are probably worthless and cannot be counted as part of the €440 billion, notes High Frequency Economics chief economist Carl Weinberg.

Weinberg reckons the EFSF has €250 billion in uncommitted resources to work with. “While this is better than nothing, it is insufficient by all measures,” he said.

The IMF has estimated that European banks have an overall credit risk of at least €200 billion stemming from government bonds issued by Greece, Portugal, Ireland, Italy, Spain and Belgium.

Banks in Europe have been struggling to raise capital in an environment where investors are hunkering down and avoiding anything risky. The concern is that a string of government defaults could cause the European banking system to collapse.

European leaders have acknowledged the problem, saying banks should first take steps to raise capital from the private sector. If that doesn’t work, the plan is for individual European states to inject capital into banks before tapping loans from the EFSF.

Analysts expect more details on the bank recapitalization plan to emerge after the European Council meets on Oct. 23.

“As always, the devil will be in the details and policy makers may not be afforded further opportunities to ‘get it right,'” wrote Michael Gapen, an economist at Barclays Capital, in a note to clients.

In addition to helping strengthen the banking system, the newly empowered EFSF is viewed as a potential buyer of last resort in the sovereign debt market.

The European Central Bank has been reluctantly buying billions of euros worth of bonds issued by Italy and Spain, among others, in an effort to ensure that governments have access to affordable funding.

But many economists warn that, given all its other commitments, the EFSF would run out of money in a matter of months if it were to buy bonds at the same rate the ECB has over the last few months.

EU policymakers have been discussing ways to “leverage” the fund, including using it to partially guarantee newly issued government bonds in an effort to lure buyers. But officials have ruled out increasing the amount of money the fund controls.

Meanwhile, EU officials have proposed accelerating approval of the European Stability Mechanism as a permanent replacement to the EFSF, which expires in June 2013.

After obsessing for months about a default by Greece, investors and economists are convinced that the nation’s debt load will eventually need to be restructured.

This has sparked widespread speculation that banks and investors will ultimately be forced to write down the value of Greek bonds by much more than the previously agreed to 21%.

Even so, Greece appears likely to receive a much-needed €8 billion installment of bailout money next month. The debate over a second €109 billion rescue for Greece is expected to pick up in December, when the next review of the nation’s finances will be due.

In any event, the talk of a so-called controlled default in Greece has raised fears that Italy may suffer a similar fate.

Moody’s downgrades Italy

Italy is struggling to pay down an unsustainable amount of debt of about €1.9 trillion. That would be a heavy burden to bear in the best of times, but Italy’s anemic economic growth makes it even more difficult to repay.

But unlike Greece, Italy has a relatively small budget deficit and its citizens are good savers. That could make it easier for the nation to get out of debt if the often dysfunctional Italian government can engineer an economic recovery.

Still, some experts say allowing Greece to default will scare investors away from the Italian bond market, which would drive up the nation’s borrowing costs and raise the risk of a default.

“If a Greek situation caused so many problems, what on Earth would happen if Italy defaulted?” asked Gary Jenkins, head of fixed-income at Evolution Securities in London. “I have no idea how you would work out the ability of the rest of Europe to pay in a scenario where the world’s third-largest bond issuer has just defaulted.” To top of page

Article source: http://rss.cnn.com/~r/rss/money_topstories/~3/EXmj6b1VKTY/index.htm

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