Germany and France Reach Greece Deal, but Problems Remain

One down, one to go. A robust rescue package for Greece suddenly seemed a reality on Friday after Germany caved in to France and the European Central Bank by abandoning their demand to roll over Greek debt maturities. Details remain to be finalized on the Franco-Germany deal, but even as the Euro zone's two biggest economies reached agreement, a major obstacle remains — whether the Greek government can survive a vote of confidence next week following this week's cabinet reshuffle.

The collapse of the Greek government would cast doubt on the country's ability to implement the deep market and budget reforms required by the E.U. and the International Monetary Fund in exchange for aid, threaten to derail any bailout and indeed potentially derail other euro zone economies.

On Friday, however, German and French officials insisted on focusing on the success of a compromise agreement. German Chancellor Angela Merkel, reeling from five consecutive losses in state polls, has in the past few weeks been reluctant to reach a deal with France given the populist anger in Germany over the massive taxpayer-financed bailouts for Greece, Ireland and Portugal over the past years. But with the global financial markets once again in turmoil over the last few days over fears that Europe's sovereign debt crisis could threaten the entire Euro zone, Merkel decided it was time to do a deal.

The compromise agreement works essentially like this: instead of forcing investors to extend the maturities on Greek debt— as suggested by German Finance Minister Wolfgang Schäuble — Merkel and Sarkozy now support a bailout plan for Greece that is based on the 2009 deal for Eastern European countries facing similar threats of default. Using the so-called "Vienna Initiative" as a template, Merkel and Sarkozy want European banks to maintain their exposure to Greece but to voluntarily roll over their bonds as they come due. This would buy Greece sufficient time to allow its fiscal austerity measures, economic reform and privatization of state holdings to kick in. In the meantime, an estimated 80 billion to 100 billion euros in fresh aid from the E.U. and the International Monetary Fund would provide sufficient funding until 2013 to keep the government running.

"We would like to have a participation of private creditors on a voluntary basis," Merkel told reporters in Berlin Friday at a press conference as Sarkozy stood by smiling. And pressing the point that financial markets were eager to hear — that Merkel would heed European Central Bank (ECB) warnings about forcing investors to roll over Greek debt — Merkel added that any deal regarding a debt rollover "should be worked out jointly with the ECB and there shouldn't be any dispute with the ECB on this."

The details of the Franco-German plan have yet to be made public. But it is fair to wonder just how the scheme is supposed to work. In a rollover, bondholders would reinvest the proceeds of bonds as they mature, putting their money into new securities with long maturity — but with a coupon that is significantly lower than going market yields. "It is hard to see why anyone in the private sector would do that voluntarily," David Mackie, an economist with JP Morgan Chase Bank in London wrote in a note to investors.

The drama could hardly have been more intense ahead of the Franco-German negotiations on Friday. About a month ago, Germany all but derailed talks over a new bailout for Greece by demanding that any deal force bondholders to agree to roll over maturities for Greek debt. Extending debt maturities, effectively restructuring Greek debt, would have forced banks, insurance companies and other investors holding Greek bonds to take losses. Independent economists, Germany's European partners, and the European Central Bank warned that such a forced measure would cause a further downgrade of Greek debt. It was feared that Greece's likely default as a consequence could trigger another global financial crisis.

That scenario, at least, seems to have been averted. "I'm fairly confident that there will be a rescue deal for Greece now," said Nicola Mai, an economist at JP Morgan Chase Bank in London. "Merkel and Sarkozy are sending a strong signal that European policy makers are becoming aligned now that Germany has backed down."

Now all eyes will turn back to Athens, where Greek citizens have been camped out by the thousands in front of the country's parliament for weeks. Angry protests over the government's austerity measures — a massive plan to privatize state holdings from the telephone company, to hotel chains and a state-owned casino — reached a peak this week and forced socialist Prime Minister George Papandreou to replace his embattled finance minister, George Papaconstantinou, in a broader cabinet reshuffle aimed at salvaging a weakened government.

The new finance chief is Evangelos Venizelos, a veteran politician and law professor who had been Defense Minister. Widely considered an astute and tough strategist with keen political instincts, Venizelos had challenged Papandreou in 2007 for leadership of the center-left PASOK party, which Papandreou leads and his father founded. Though Venizelos lost that race, he became a key powerbroker for Papandreou after PASOK won national elections in 2009.

Some analysts say Venizelos and the rest of the new cabinet are political insiders who won't sit well with many restless Greeks who distrust politicians, blaming them for Greece's economic woes. Others, like University of Piraeus economics professor Theodore Pelagidis, say the new cabinet is more unified than the previous one — and that Venizelos has the skills to convince both the Greeks and the Europeans that the austerity program will produce results.

"Venizelos is in a position to tell the Europeans that Greece will make the reforms to get out of debt, but we also need time and some breathing space, not just new loans," Pelagidis says. "He is politically capable of saying to Brussels, look, we need to set up a new agenda to actually solve this problem, not put it off." Now, finally, Greece is getting concerted action from the major European powers. But the question remains — can it keep its own house in order long enough for that to make any difference?

With reporting by Joanna Kakissis / Athens