Euro zone shifts to accepting possible Greek default

The euro zone acknowledged for the first time some form of Greek default may be needed to cut Athens' debts, but markets seized on the lack of a deadline for action and a lukewarm response from the IMF to heap pressure on Italy and Spain.

Dutch Finance Minister Jan Kees de Jager said on Tuesday euro zone finance ministers had effectively accepted that if they wanted to have the private sector involved in a second bailout of Greece, a selective debt default was likely, despite the European Central Bank's vehement opposition to such a move.

"We have managed to break the knot, a very difficult knot," he told reporters as he arrived for a second day of talks.

Asked about whether a selective default was now likely, he replied: "It is not excluded any more. Obviously the European Central Bank has stated in the statement that it did stick to its position, but the 17 (euro zone) ministers did not exclude it any more so we have more options, a broader scope."

Participants said both a buy-back of Greek debt on the secondary market and a German proposal for a bond swap for longer maturities were under consideration after a complex French plan to roll over bonds made no headway.

Both would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for financial markets.

The lack of immediate action and the increased likelihood of some form of default sent European bank stocks and debt markets into a spin and propelled the euro sharply lower against the dollar.

The cost of insuring against a default in Spain, Portugal and Greece hit a record high and 10-year bond yields in Italy, the euro zone's third-largest economy, shot above six percent for the first time since 1997, well above the level which bankers say will put heavy pressure on finances.

There is now acute concern about contagion to Italy, where political tensions between Prime Minister Silvio Berlusconi and Finance Minister Giulio Tremonti have exacerbated concerns, and to Spain, the euro zone's fourth largest economy.

"Euro area politicians and especially Germany have inadvertently transformed a modest periphery crisis into a euro-wide crisis as conflicting views and slow-footedness foster a lack of confidence," Lloyds Bank strategists said in a report.

The euro fell to a four-month low against the dollar in part because IMF Managing Director Christine Lagarde said the lender and its EU partners were not yet ready to discuss terms for a second Greek bailout.

"Nothing should be taken for granted," she told reporters in Washington.

While the finance ministers were not explicit about how they planned to tackle Greece's debt, saying only that proposals would be discussed "shortly," they acknowledged that the debt pile -- which stands at around 160 percent of GDP and is unsustainable at that level -- had to be reduced.

"We stress the need to make Greek debt more sustainable," Jean-Claude Juncker, the chairman of the Eurogroup, told reporters after more than eight hours of talks on Monday.

Economists regarded Juncker's words and the comments from other finance ministers as a fundamental shift, although it remains unclear what specific steps will be taken.

"The euro area now seems to be moving more explicitly toward debt relief via EFSF-funded purchases of secondary market debt," JP Morgan economist David Mackie wrote in a research note, referring to the euro zone's 440 billion euro emergency loan fund, which as it stands would not have enough resources to bail out Italy.

"Greece will need debt relief at some point, but it is not clear it is much of a help now. More likely the shift toward debt relief is intended as an attempt to limit contagion."

Quick Markets, Slow Decisions

As markets reacted quickly and negatively, the policymakers themselves suggested there was no need to hurry.

"We have time on Greece. The next tranche is due in September," German Finance Minister Wolfgang Schaeuble told Deutschlandfunk radio.

That lack of haste prompted stern criticism from Greece's prime minister but the finance ministers did hint at the prospect of more fundamental steps to come.

"Ministers stand ready to adopt further measures that will improve the euro area's systemic capacity to resist contagion risk, including enhancing the flexibility and the scope of the EFSF, lengthening the maturities of the loans and lowering the interest rates, including through a collateral arrangement where appropriate," they said in a statement.

Despite reiterating the need to have the private sector involved in a second package for Greece, how to do it remains unresolved. The ministers gave no indication that they had broken a stalemate over how to make banks, insurers and other funds share the cost of additional funding for Athens.

Germany, the Netherlands, Finland and others want the private sector to provide at least 30 billion euros in a new package for Greece that could total 110 billion euros.

Ministers tasked a working group to propose ways to finance a new multi-year program for Greece, reduce the cost of servicing its 340 billion euro debt -- nearly 160 percent of annual output -- and improving its sustainability.

Euro group sources said ministers were likely to meet again before the end of July to try to clinch an agreement.

In a withering open letter to Juncker, Greek Prime Minister George Papandreou said European partners had acted too slowly to stem the crisis while creating a "cacophony" that had ultimately put domestic politics before the common currency.

"Crunch time has arrived and there is no room for indecisiveness and errors such as taking decisions that in the end prove 'too little, too late' to convince the markets we are serious; (and) making compromises that satisfy our internal political 'red lines' that in the end substitute tactical politics for sound management of the crisis," he wrote.

[Source: By Luke Baker and John O'Donnell, Reuters, Brussels, 12Jul11]

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