7 reasons why the eurozone is still in crisis

The muted market reaction to the second bailout of Greece shows that, while eurozone leaders took a big step forward yesterday, the euro is not out of danger yet.

Summit didn't fail

The European Union emergency summit has bucked the trend of previous high level meetings on the continent by actually achieving something.

A prior agreement between Chancellor Merkel of Germany and President Sarkozy of France paved the way for partial success. Encouragingly, the eurozone leaders' statement (PDF link) showed big decisions were taken that could solve the sovereign debt crisis that has spread financial contagion from Greece to Ireland and Portugal, and threatens Spain and Italy. 

However, the devil is always in the detail and analysts say crucial information was lacking from some of the key commitments in the €160 billion (£141 billion) package.

The main measures were:

• An extra €109 billion (£96 billion) for Greece (on top of last year’s €110 billion rescue) – with €36 billion from the International Monetary Fund (IMF) and €73 billion from the European Financial Stability Facility (EFSF) bailout fund.
• The bailout fund to extend future loans from 7.5 years to 15-30 years with a grace period of 10 years on interest.
• Its interest rate on loans cut to around 3.5% from 5.5%.
• Private sector contribution of up to €50 billion in 2011-14 (rising to €106 billion by 2019) - a big win for chancellor Merkel.
• This will be achieved by privately held Greek bonds being extended from six years to 11 years.
• Greek sovereign bonds will also be bought back at a discount – ie, for less than they are worth, crystallising losses for banks and other institutions, an event of historic importance.
• The EFSF will be empowered to provide loans to government to re-capitalise troubled banks – this could be a big help for Spain.
• The bailout fund can also in ‘exceptional circumstances’ intervene in bond markets to buy bonds in order to reduce bond yields and the implied interest rates they present struggling countries.
• It can also for the first time give states precautionary credit lines before they are shut out of bond markets.
• Lending rates to Ireland and Portugal to be reduced to the Greek level with their loans extended to 15 years on average.

Kathleen Brooks of Forex.com was pleased saying the agreement was ‘more of a plaster cast than a band-aid’. Nevertheless, problems remain.

1. Greece is still in a hole

The latest bailout will still leave Greece with debts equivalent to 140% of GDP (gross domestic product) next year, according to Royal Bank of Scotland. The hard work of reforming its public sector and cutting its budget deficit remains to be done with the IMF breathing down its neck with quarterly reviews. RBS says: ‘We doubt that Greece can manage this politically and socially and so the risk of a harder default remains in 2011/early 2012.’

2. Restructuring is a default

The willingness of banks to take a hit on the Greek bonds they hold is a highly significant development, even if it is unclear exactly what the EU has proposed.

David Simner, portfolio manager of Euro Bonds at Fidelity International, said ‘this is the big one and effectively means banks are taking a write-down on Greek debt and the European Central Bank has compromised by continuing to accept bonds as collateral in financing operations.’

Because the agreement is deemed to be voluntary the ‘haircut’ on the Greek bonds will not trigger credit default swap insurance payments – much to the relief of banks that sell this cover.

However, Fitch, one of the leading credit rating agencies, today confirmed that the agreement will prompt it to downgrade Greek bonds to a ‘selective default’ rating as it means the original contractual terms of the bonds are not being met. Even though this is not a ‘disorderly default’ there is still a risk that it could still spark a panic and a sell-off in bond and equity markets.

3. Contagion risk remains

EU leaders insist that banks will not be asked to take losses on the bonds of other indebted countries, such as Ireland or Portugal, which have also received bailouts. However, there is scepticism about whether the EU can hold this line. For example, the cut in interest rates does not reduce Ireland’s debt mountain by much, making it likely that private sector involvement will be placed on the table again in future.

As RBS analysts say: ‘It provides the template for the type of resolution that will likely be applied also to Ireland and Portugal should they need a second bailout in the future.’