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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.

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 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.’

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11 comments so far. Why not have your say?

George Irvin

Jul 22, 2011 at 20:51

I'm an academic eonomist and an EU specialist---I agree with all the above. But I'm optimistic that the crisis has been contained for some months.

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colin wilson

Jul 22, 2011 at 21:55

George. What happens after "some months" though?

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William Bishop

Jul 22, 2011 at 23:01

Maybe market expectations were so low given past political havering and delays that they were actually exceeded modestly in the short term, hence the market bounce. But it seems likely that this represents no more than another round of "kicking the can down the road", and that some sort of crisis situation will again occur within months. A much enlarged bail-out fund would have had a greater impact, but no doubt Germany remained obstinately against anteing up.

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stuart parrott

Jul 22, 2011 at 23:23

Academic economists are part of the problem. Remember that (even the great) John Maynard Keynes regarded gold as a superstious and barbaric throwback to the Dark Ages. Try telling that to one billion Indians and another billion Chinese! I

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Jul 23, 2011 at 08:43

I am a complete idiot, and agree with all of the above!

I am also more than a little bit curious as to what happens next?

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Robin McEvoy

Jul 24, 2011 at 00:03

The more they delay tackling the root of the problem the bigger it will be when it comes to ruin us all. Everything that has been done so far, esp QE, has only made the total debt bigger.

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Chris Kenney

Jul 24, 2011 at 09:44

I would also like to know what happens next, As The EU have sent out a signal that debts will not always be honoured in full who is going to risk buying their bonds in future?

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Paul 2

Jul 24, 2011 at 10:44

Stu, I didn't realise you were a Citiwire reader. It makes a change from writing books.

Chris, Unfortunately once politicians have made up their mind on a course of action then can be remarkably stubborn. With the Euro, this could mean going to the brink and beyond, with the tail wagging the dog. Thus, in the UK and some other countries we could end up poor and with a type of Europe that most of us didn't want. Following from this the so-called EU democratic deficit will increase.

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Jul 25, 2011 at 08:26

Is anyone out there getting annoyed like me at Germany's attitude? They have benefitted greatly from being shackled to a currency that is dragged down by other members of the Eurozone. What would the Dmark rate have been for the last few years had it still existed independently - my guess is at least 30% higher and that might have made quite a big dent in Germany's recent export-led boom.

It seems to me that Germany benefits but is unwilling to pay the price of such good fortune (or even acknowledge that such benefit exists). And that lack of political direction has made the risks, and costs of resolving them escallate as the inaction persists.

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Graham Barlow

Jul 28, 2011 at 09:53

Whatever gloss you put on the agreement, it is a default on bonds held in the Banking and Assurance companies portfolio. It can only be written off on the bottom line,and the value of profit participation policies. Merkel and Sarkosy have damaged the supply side of the Sovereign debt market. Nobody is openely saying so, but we all know it is a fact.If you are not going to get back what you put in ,then it is a loss. Academic Economists even must understand this simple arithmetic?

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Sep 13, 2011 at 11:12

If the Euro is a basket case as most of the financial press would have us believe & the market commentators allege , why does it remain so high in comparison with sterling

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