Emerging bleary-eyed in Brussels in the early hours of Thursday morning, European leaders insisted that their three-pronged deal to end the swirling debt crisis represented the solid response the markets have been asking for. They've said this before. This time, however, it looks like they mean it: after countless such summits, the Presidents, Chancellors and Prime Ministers of the 17 euro-zone members have come up with a more promising plan than at any time over the past 18 tumultuous months.
The agreement includes a deal with Greek debt holders that writes off 50% of the face value of their bonds. Through a complex mechanism, it leverages the existing bailout fund to boost its firepower several-fold to potentially $1.4 trillion. And it recapitalizes vulnerable banks to the tune of some $148 billion. "We have reached an agreement which I believe lets us give a credible and ambitious and overall response to the Greek crisis," French President Nicolas Sarkozy declared at the end of some 11 straight hours of talks. "Because of the complexity of the issues at stake, it took us a full night. But the results will be a source of huge relief worldwide."
The agreement still lacks detail, but it nonetheless takes the euro zone much further than ever before on each of the three key elements:
The Greek write-down effectively a managed default will slash the country's debt by a third to 120% of GDP by 2020 and require bondholders to take a 50% haircut. That figure is a compromise: the IMF demanded a 75% haircut, while banks and bondholders argued that more than 40% would likely trigger costly insurance claims and provoke a run on Italian and Spanish debt markets. It is still far deeper than the 21% cut agreed on by the leaders at their July summit, and came after almost universal recognition that the country's debt pile was simply not shifting despite the current austerity measures. A revealing detail in the package is that a European Commission team will be permanently in Greece to "to advise and offer assistance in order to ensure the timely and full implementation of the reforms." Officially this is aimed at ensuring "Greek ownership" of the reforms, but it could make the country an economic ward of the E.U.
The agreement on bank capitalization which was made by the full 27-member E.U. on Wednesday set a 9% threshold for the "highest quality" capital by June 2012. The new ratio recognizes that the capital buffer for European banks around 6.5% is too small, with many institutions finding it increasingly hard to borrow. This implies raising a mandated capital of around $148 billion in total across all banks: the European Banking Authority says that Greek banks would need $42 billion, Spanish banks $37 billion, Italian banks $21 billion, French banks $12 billion and German banks $7 billion, while British and Irish banks, it seems, need no new capital. The deal includes calls for more control over salaries and bonuses, saying, "Banks should be subject to constraints regarding the distribution of dividends and bonus payments" until recapitalization is complete.
The deal to boost the bailout fund, the European Financial Stability Facility, will leverage it "several-fold" from its current $616 billion, with Sarkozy and German Chancellor Angela Merkel both referring to an increase of "four to five times." But since the fund has about $350 billion left, the final pot is still only expected to be about $1.4 trillion, significantly lower than the $2.8 trillion "big bazooka" that markers seemed to be demanding. Officials said the leverage mechanism which still has to be finalized would be raised in two ways. First, through insurance, expected to be around 20% of face value, that investors can opt for when they buy sovereign bonds in the primary market; and second, with a special vehicle that will be able to fund the bailout operations. Further resources could be available from cooperation with the IMF and sovereign-wealth funds, including China. However, this is the haziest part of the package, with no numbers included in the final agreement.
The triple package was agreed on after apocalyptic warnings that Europe could be plunged into a new era of war and conflict if it fails to tackle the euro crisis. Speaking to the Bundestag on Wednesday, Merkel had eschewed her former reticence about helping Europe's ailing southern brethren, and even raised the specter of future conflict if an agreement proved elusive. "We have a historical obligation to protect by all means Europe's unification process begun by our forefathers after centuries of hatred and blood spill," she said. "None of us can foresee what the consequences would be if we were to fail."
But minds were doubtless concentrated on events in Italy, under attack from markets skeptical about whether its political system could deliver the reforms its sclerotic economy needs. Although much of the talk has been of the Greek debt meltdown, it was risk of contagion to Italy, the E.U.'s third largest economy, that represented the biggest threat to the euro. Italian Prime Minister Silvio Berlusconi arrived in Brussels with a list of promises and a swirl of rumors that he had made a secret pact with his coalition partners to resign at the end of the year. But back in Rome there was still a sense of chaos when a parliamentary session descended into a brawl, underscoring the country's legislative paralysis.
Yet the drama in Rome makes it easier for Brussels to build a case for new powers to rein in errant governments through budgetary and fiscal discipline. European Commission President José Manuel Barroso said the summit's "exceptional measures" would necessarily lead to closer fiscal union, with new coordination and surveillance, and he promised new proposals over the next few months to further harmonize economic policy. "Europe must never again find itself in this situation," he said. "That is why we must further improve our economic governance."
So what does it all add up to? While short on numbers, the agreement nonetheless represents the strongest signal of intent from euro-zone governments who have, until now, attempted to muddle through while wishing away the single currency's woes. That in itself might prove more significant for markets than the absence of specifics in the package. "Even if it probably was not the final word on the crisis, it is again another important step in the right direction," says Carsten Brzeski, senior economist at ING banking group. "The euro zone could be on its way toward a happy ending. But it won't be a Hollywood happy ending: easy to understand with a big punch line. It rather looks like a French movie: highly complex with a lot of drama but still ending happily."
With reporting by Stephan Faris / Rome