Think twice

European finance ministers had a busy weekend. First, they agreed to an 85-billion-euro ($111 billion) aid package for cash-strapped Ireland. Then they threw their support behind a Franco-German compromise for resolving debt crises in the eurozone from mid-2013 onward.

Financial markets displayed a largely negative reaction on Monday to the multibillion-euro rescue package for Ireland and the announcement of new rules for dealing with future debt crises. The weeks ahead will tell whether the measures are enough to quell market fears of contagion spreading to other heavily indebted euro countries, like Portugal and Spain.

Diluted compromise

Under the agreement announced Sunday, the current European Financial Stability Facility – established as an ad hoc measure to support eurozone countries with sovereign debt problems after the Greek crisis – will be replaced by the European Stabilization Mechanism (ESM), based on a proposal by Germany and France.

The compromise dilutes an earlier demand by Chancellor Angela Merkel for investors to "automatically" assume losses and share bailout costs with taxpayers. Wording in the ESM agreement now speaks of having private bondholders share the cost of restructuring a eurozone country's debt on a "case-by-case basis."

"The Sunday agreement aligns Europe with the International Monetary Fund practice that (involving) private-sector creditors should be done on a case-by-case basis," Philip Lane, a macroeconomics professor at Trinity College Dublin, told Deutsche Welle. "This is sensible since every crisis is different and the appropriate policy response should be calibrated to the details of the crisis."

Although the agreement makes no mention of an "automatic" mechanism for bondholders, experts argue that such an instrument is implied nevertheless. "In the cases that are likely to appear in the euro area, a high degree of automaticity, which Germany sought in the area of sanctions for fiscal transgressions, seems overwhelmingly likely," said Niels Christoffer Thygesen, a retired economics professor at Copenhagen University.

The lack of detail in an earlier Franco-German deal on a crisis mechanism, agreed in October, and talk of private investors having to take losses, or "haircuts," on the value of sovereign bonds, helped drive Ireland over the cliff, critics claim.

Tough fiscal adjustment program

For weeks, European officials have been scrambling to play down possible links between Ireland and Portugal, which is seen as the next eurozone country at risk – and the possibility that troubles in Portugal could quickly spread to Spain because of their close economic ties.

Under the new two-step plan, a eurozone country with liquidity problems would be able to apply for emergency funding from the ESM subject to a tough fiscal adjustment program, without having to restructure its debt or agree to a standstill. Countries whose debt positions are judged by the IMF, the European Central Bank and the European Commission as unsustainable would have to enter into negotiations with creditors to restructure its debt as a condition for further bailout funding.

International Monetary Fund procedures would apply in the ESM.

The plan has won some praise from the investment community but also raised some concern. "I think the idea of differentiating between a liquidity and a solvency crisis is a good one in theory, but it will be difficult to distinguish in practice, and the decision will always inevitably be partly political," said Marco Annunziata, chief economist of the Unicredit Group. "Just think how often in the last three years we have been unsure whether banks and governments were illiquid or insolvent."

Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels, agrees the highly complex ESM could be challenging to implement. "There are no rules for proceeding on a step-by-step basis," he told Deutsche Welle. "This will be extremely difficult and will vary from country to country."

The permanent crisis resolution mechanism, to be finalized in the weeks ahead, promises a break with several longstanding taboos in the Europe Union. For instance, it effectively drops the "no bailout" clause in the EU treaty, accepts for the first time the possibility of a sovereign default in the eurozone and allows for the possibility of making private bondholders share the cost with taxpayers.

"Overall, this sends a clear message to private investors to be very careful before lending to governments," said Unicredit's Annunziata.

Author: John Blau
Editor: Sam Edmonds