The great euro rescue gamble

Hopes that today's emergency summit will solve the EU's debt crisis are fading fast. Yet few doubt that it will culminate with a new rescue package. Can such a plan avert disaster?

Today's emergency summit in Brussels was thrown into confusion last night as it was revealed that a meeting of European finance ministers had been cancelled. The absence of the continent's key economic ministers from the summit, where they were due to meet in advance of the formal EU leaders' meeting, raised doubts about the level of crucial detail that will be unveiled in plans that are supposed to safeguard the future of the single currency.

The euro and stocks on both sides of the Atlantic slid on the news amid fears that Europe would prove unable, after two years, to get a grip on its debt crisis.

In Britain, officials were privately downbeat about the prospect of any final deal being reached at the meeting, although Mr Cameron still intends to travel to Brussels to attend.

"Our sense at the moment is that these issues may not be resolved in time to announce any sort of comprehensive plan tomorrow night," a Government source said yesterday. "It's quite likely that we will be back again in a few days' time."

The German Chancellor, Angela Merkel, also indicated that she is fiercely opposed to the inclusion of any form of words in the plan that would enable the European Central Bank (ECB) to buy sovereign bonds to stabilise European debt markets. Referring to a draft of the summit statement mentioning the ECB's bond purchase scheme, Mrs Merkel told reporters in Berlin: "This sentence was not agreed by us." But many analysts argue that without some involvement from the central bank, it will prove impossible for European leaders to resolve the eurozone debt crisis.

There were signs, however, of progress on the question of what size of write-down should be imposed on the private banks that hold Greek sovereign debt. Jean-Claude Juncker, who leads the group of eurozone finance ministers, said: "The private creditor participation will have to be more substantial, about 50 per cent."

Details of a complex plan to increase the firepower of the European bailout fund, the European Financial Stability Facility, were also leaked last night. This is expected to involve a scheme to insure portions of newly issued sovereign bonds and also to establish a new fund designed to attract money from global investors.

The build-up to the crucial summit was further coloured by anxiety over Italian Prime Minister Silvio Berlusconi's ability to guarantee debt-slashing measures to satisfy the demands of other eurozone governments without causing the collapse of his fractious coalition.

That was a prospect that only receded last night, when Mr Berlusconi's king-making coalition partner, the Northern League, said that an agreement had been reached over planned reforms. While Northern League leader Umberto Bossi said he had reached a settlement with Berlusconi about a key pension reform, he was still pessimistic about the survival of the coalition government.

"In the end we have found a way. Now we will see what the EU says," Mr Bossi told reporters. "I remain pessimistic."

An aide to Mr Bossi told the Wall Street Journal that the party leader had reached a preliminary compromise with the government to change Italy's pension system, but did not elaborate.

The deal appeared to have been reached just hours after the Northern League said it would block a rise in pension age, from 60 in some cases, to 67 – which is to be Italy's contribution to rescuing the euro.

Infrastructure Minister Altero Matteoli admitted the political crisis might sink the government. "We are in the process of negotiating. There is this hypothesis [that the government could fall], but there is a margin for manoeuvre," he said.

Professor Francesco Giavazzi, of Milan's Bocconi University, said: "At this moment a government crisis would be a disaster, because we have a huge quantity of debt that needs to be refinanced."

Lamberto Dini, a former Italian prime minister, said on Sky Italia there was "no alternative to raising the pension age", and without it, Italy would "head down the same road as Greece".

The four key strategies... and their chances of success

Reduction of Greek debt

The Greek state is in a debt trap. A confidential EU/IMF report last week revealed that Athens' pile of borrowing is on course to grow to €444bn, despite the austerity that the government of George Papandreou is imposing on the nation in the face of considerable public resistance. €444bn would represent a debt burden of more than 200 per cent of Greece's annual GDP. Greece plainly needs the bulk of this debt to be written off to have any chance of avoiding a default. Greece's creditors, after much arm-twisting, now seem to have accepted a "voluntary" write-down of some 60 per cent of the face value of their loans. But there are two gambles here. First, there is a risk that the write-down may trigger insurance policies on Greek debt, resulting in crippling losses popping up in unexpected places in the global financial system, as occurred in 2008 when Lehman Brothers went bust. The second gamble is the proportion. A 60 per cent write-down in Greece's debt may not be sufficient to sort out the county's public finances. Even after that level of forgiveness, the country will still have a debt-to-GDP ratio equal to that of the UK.

Probability of success 80 per cent

Recapitalisation of Europe's banks

The capital buffer of European banks is too small and everyone working in financial markets knows it. That is why so many banks are finding it increasingly hard to borrow in the capital markets. No one wants to lend money to a bank they fear could be insolvent. European regulators have finally accepted that their stress tests of the sector in July convinced no one. European leaders will now tell their banks to raise their capital ratios up to 9 per cent of the value of their assets over the next six months. There are two gambles here. The first is that the mandated capital raising – estimated to be €108bn in total across all banks – will be enough. Some analysts say that the size of the capital hole is significantly greater than €108bn. The second gamble lies in allowing the banks to try to raise the cash themselves, rather than forcing them to take it from the coffers of national governments. The banks have strongly hinted that they will try to meet their new capital ratios by shrinking their assets, rather than raising new money. Given that bank's assets tend to be loans to individuals and businesses, such sales could have a disastrous effect on an already fragile European economy.

Probability of success 60 per cent

Boosting the eurozone bailout fund

The key nation in the eurozone crisis is not Greece, but Italy. If Italy, the third largest economy in the eurozone, crashes out of the single currency, the whole edifice could collapse. And Italy is so interlinked with the European and global economy that the consequences of this would be truly catastrophic. The existing European €400bn bailout fund, known as the European Financial Stability Facility, is big enough to bail out Greece, Portugal and Ireland. But it is not big enough to protect Spain. And it is certainly not large enough to backstop Italy. Therefore European policymakers are working on plans to extend the firepower of the bailout fund by turning it into a kind of insurance scheme for newly issued Italian debt. The gamble here is twofold: will the scheme – which is likely to offer to guarantee 20 per cent of the face value of newly issued bonds – convince investors that it is safe to invest in Italian debt? And are there enough funds left in the bailout pot to cover all the debt that will be issued by Italy over the coming few years? If the markets think not, the panic will continue.

Probability of success 20 per cent

Sorting out Italy

This is, to some extent, a crisis of confidence in the soundness of eurozone sovereign bonds. One way of convincing investors that sovereign bonds are sound – and that they will get their money back if they buy them – is to put pressure on governments to reduce their budget deficits and to reform their economies in order to generate growth. Italy is one of the biggest single borrowers in the world, with a national debt of some €1,843bn. And investors are wary of Italian bonds. That is why in recent days Angela Merkel of Germany and Nicolas Sarkozy of France have been making stern and public demands to Silvio Berlusconi to sort out Italy's economy. But this is a gamble. The consequences of pressuring national governments from the outside are unpredictable. In Italy it seems to have precipitated a political crisis that could bring down Mr Berlusconi's coalition. That risks making the situation still worse.

Probability of success 50 per cent

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