Snap Analysis: Euro zone rescue may only work in short term

Steps announced by European Union finance ministers and the European Central Bank on Monday are by far their best effort to avert a regional debt crisis, and look likely to succeed in calming markets in the short term.

But doubts remain about policymakers' will to implement the steps aggressively, and root causes of instability in the euro zone -- including big divergences among economies -- have not been resolved.

So markets will probably remain worried about the long-term prospects for the zone, and it seems unlikely that euro assets will stage an extended rally back to their levels of early this year.

Massive Firepower

By pledging 500 billion euros ($670 billion) of loans and loan guarantees to any euro zone countries needing funds, plus about 250 billion euros from the International Monetary Fund, European policymakers have thrown a huge amount of money at the problem.

This "massive firepower" strategy was used successfully during the global financial crisis of 2007-2009, particularly by the United States with its $700 billion Troubled Asset Relief Program (TARP).

Private economists have calculated that if Portugal, Ireland and Spain -- the three states widely seen as the next potential "dominoes" after Greece -- were to lose access to the sovereign debt market, it might cost about 444 billion euros to fund them through to the end of 2012.

The financial safety net created on Monday therefore looks ample. After any rescue of Portugal, Ireland and Spain, there would be enough money left to give Greece more support if its 110 billion euro aid plan, set last week, runs out in about two years and Athens remains unable to return to the market.

By creating a wide safety net, European policymakers seem to be drawing on a lesson from the Asian crisis of 1997-98, when markets stabilized after the IMF had dealt with all major weak spots in the region: Thailand, Indonesia and South Korea.

In the cases of the TARP and other bailout packages during the global financial crisis, the announcement of the plans stabilized markets enough for governments to disburse much less money than they had allocated. The U.S. Treasury has said it does not expect to deploy more than $550 billion of TARP funds.

The same could happen in Europe. At current bond yields, analysts calculate Portugal and Spain could continue borrowing from the market for a year or more without irretrievably damaging their finances; the existence of the safety net might eventually push yields down far enough so that the countries never had to seek aid.

Even if all the funds are spent, the 500 billion euros allocated by euro zone governments will be equivalent to about 6 percent of the zone's gross domestic product, spread over several years -- not beyond the zone's economic capacity.

Political Will

But doubts will remain about the willingness of some major contributors in the rescue package to continue contributing over several years.

In Germany, Chancellor Angela Merkel's center-right coalition lost an election in the important state of North Rhine-Westphalia on Sunday, depriving Merkel of a majority in parliament's upper house. One reason for the loss appeared to be public anger at the idea of aiding Greece.

Merkel may also lose the services of Finance Minister Wolfgang Schaeuble, who has been a major proponent of aiding Greece. Schaeuble, who has been in and out of hospital several times this year, missed Sunday's rescue talks because he was admitted to hospital.

So sometime in the coming years, Germany might become reluctant to support a string of indebted euro zone states, especially if those states proved unwilling or unable to meet tough austerity conditions attached to bailout loans.

There are also doubts about the willingness of the ECB to provide aggressive support to any multi-country bailout.

The ECB took an unprecedented step on Monday in saying it would buy government and private debt in the euro zone, effectively shouldering countries' debt; this is the "nuclear option" which some analysts consider vital to calm the markets.

But ECB policymakers have in the past been extremely reluctant to take that step, believing it would compromise their conservative monetary principles; last Thursday the ECB said it had not even considered the measure.

So the central bank may choose to exercise it only very sparingly -- certainly more sparingly than the U.S. Federal Reserve, which bought assets actively during the global crisis.

The ECB also said it would conduct operations to "sterilize" its purchases of bonds, absorbing back liquidity released by its buying. This could reduce the positive impact on the bond market of the policy.

Buying Time

Using the safety net would not solve countries' fundamental problems; it would merely buy them three years to try to repair their finances and reform their uncompetitive economies enough to survive the euro zone's monetary straightjacket.

Some analysts think Greece, and perhaps Portugal, will be unable to meet this challenge, making restructuring of their debt inevitable.

If restructurings come to seem unavoidable, governments may choose to do them sooner rather than later to reduce the pain of austerity measures on their citizens.

A Reuters poll of 54 economists late last month found them estimating a 20 percent chance of a Greek debt restructuring over the next 12 months and 30 percent over the next five years, despite the bailout plan for Athens. They saw a 9 percent chance of Greece leaving the euro zone in five years.

Konrad Hummler, chairman of the Swiss Private Bankers Association, estimated on Friday that banks would need to write down the value of their Greek bonds by 30 to 50 percent. Greece has about 300 billion euros of sovereign debt.

Any Greek restructuring could quickly cause markets to worry about restructurings in other weak euro zone states, forcing them to use the safety net.

[Source: By Andrew Torchia, Reuters, London, 10May10]

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