Politicians are hardly likely to persuade electorates to embrace steps like job cuts

The eurozone crisis, centred around Greece, has occupied the centrestage at the Cannes G-20 summit in France. With so much of fluidity in Greek politics, questions have been asked as to whether the crisis can be solved by deal, however meticulously crafted. Nevertheless, at the end of the summit, there has been all round disappointment. Hopes that the rest of the world would use the summit to offer additional backing to eurozone efforts have been dashed.

On October 27, after marathon negotiations in Brussels, leaders in Europe announced a deal that, on the face of it, promises to ‘fix' the crisis. This is not the first time that political leaders claimed to have clinched a settlement to the vexatious problem. But in every case, the deal unravelled quickly, pushing the eurozone economies further into the danger zone. In fact, European policymakers had hoped that the sovereign debt crisis could be contained within the Continent's periphery. After all it first impacted Greece, Portugal and Ireland whose relative economies, it was hoped, could be mended through a combination of domestic sacrifices and external support.

Both remain crucial to the success of any eurozone rescue package. But as the details of the latest deal emerge, it is becoming clear that the extent of outside help, no matter how large, may not be enough even to create the necessary psychology to calm the markets. And domestic sacrifices — almost all of them through severe austerity measures imposed from outside — will be hugely unpopular. Politicians, even if they are convinced, are hardly likely to persuade their electorate to embrace measures such as job cuts, pay freeze and so on that are projected as being in their long-term interests. Many political leaders will lose their jobs as they try to push unacceptable austerity measures.

‘Three-pronged' deal

Against such a backdrop, it is worth examining whether the emergency ‘three-pronged' deal will go farther than its predecessors and justify the initial optimism days after its conclusion. The key elements of the deal are:

(1) Restructuring of Greek debt: Private banks holding Greek debt will accept a write-off of 50 per cent of their returns. The move is expected to cut the nation's external debt burden to 120 per cent of its GDP in 2020. Without the reduction, it would have increased to 180 per cent. It goes without saying that financial institutions needed plenty of persuasion to agree to such a steep ‘hair-cut'. Reluctant banks had initially agreed to 40 per cent but the deal for the higher amount was struck after German Chancellor Angela Merkel and French President Nicolas Sarkozy intervened during the last days of the meeting.

(2) Increase the fire-power of the bailout fund: The corpus of the main bailout fund, the European Financial Stability Facility (EFSF) will be boosted from euro 440 billion to euro 1 trillion. It is also proposed to leverage its balance (estimated at euro 250 billion) by 4-5 times. This will be done in two ways — by offering insurance to purchasers of the eurozone's debt. This will make the bonds more attractive and lower the borrowing costs of governments. Special purpose investment vehicles will be set up which big investors (both private and public, including China) would like to contribute.

(3) Finally, bank recapitalisation: European banks will be required to raise about euro 106 billion in new capital by June, 2012. The expectation is that with this additional capital they would be better equipped to deal with possible losses arising out of government defaults and protect larger economies like Italy and Spain from the turmoil.

Credible response

The French President claimed that the deal gives a credible and ambitious and overall response to the Greek crisis. Yet, even as the markets reacted with enthusiasm, there are a number of critics. Many of them have criticised it for being short on details and for creating complicated, new structures such as in deploying the bailout fund. Besides, when the larger European economies, notably Germany, have been reluctant to support the bailout fund to the hilt, it is too much to hope that China and other large emerging economies will step in.

While the agreement to pare down Greek debt in private hands by 50 per cent has been hailed as a significant achievement, it has been pointed out that an essential ingredient for its success is to build a strong credible firewall around heavily indebted, but solvent borrowers such as Italy. Unfortunately, this is one of the weakest parts of the deal. The main bailout fund, the EFSF is not big enough to withstand a run on Spain and Italy. Critics are unanimous that the only enduring source of support will have to come from the European Central Bank. Unfortunately, the central bank has ruled itself out. Also worth noting is that Germany and other richer countries are unwilling to contribute more.