It is not the first time that a high-level summit of Europe's leaders has claimed a breakthrough in providing solutions to the Continent's festering debt crisis. The emergency deal struck on Thursday at Brussels after a marathon session is comprehensive and can mitigate the rigour of the debt crisis which has threatened the financial stability of not just Europe but virtually the entire global economy. The deal has three elements. One, with a renewed focus on Greece, political leaders persuaded reluctant private banks holding Greek debt to accept a write-off of 50 per cent of their returns. This is much more than the 40 per cent “hair-cut” that banks were willing to offer. The move, which holds the key to the success of the overall strategy, is expected to cut Greece's debt burden to 120 per cent of its GDP in 2020. Without it, the debt would have risen to 180 per cent. Secondly, the corpus of the main euro bailout fund, the European Financial Stability Facility (EFSF), is being increased substantially from €440 billion to €1 trillion. This is meant to prevent market panic from spreading to other countries, notably Italy. The fund will be leveraged four to five times to enhance its fire power.
Thirdly, European banks are asked to raise about €106 billion in new capital by June 2012. Such a massive recapitalisation, it is hoped, will shield not only the banks against losses resulting from government defaults, but will also protect the larger economies such as Spain and Italy from slipping into default. The financial markets around the world have responded favourably to the news of the package. The euro has risen. While the leaders can justifiably claim to have engineered the breakthrough, it is clear that the success of the package is contingent on whether, and to what extent, Greece and the eurozone are able to convince the markets that the worst will be over soon. However, even the reduced debt burden Greece will carry till 2020 is hard to service by an economy that will be subjected to harsh austerity measures. Investors need to be convinced that the money promised for the bailout fund will in fact be available, preferably through simpler structures than what has been proposed. Finally, infusion of public money into big European banks might have boosted bank stocks, but the larger, fundamental question of whether taxpayers should bailout banks that have been reckless in their operations remains unanswered.
