Crunch time for Eurozone leaders

In an information light announcement at a bilateral summit in Berlin, President Sarkozy and Chancellor Merkel set October as a deadline to reach agreement on a package of measures to stabilise the Eurozone. This will include a recapitalisation of European banks if required. After months of dithering over the politics and ignoring the economics, their hand is clearly being forced by growing international pressure for action as the announcement will come just before November’s G20 summit.

Whilst detail is thin on the ground it does seem that recapitalisation of banks will be at the forefront of any announcement. For weeks there has been talk of a boost to the European Financial Stability Fund (EFSF) with figures as high as €2tn being discussed in order to offer liquidity to member states. But after the break up of the Belgian bank Dexia and downgrade in credit rating of 12 UK financial firms, attention has moved to avoiding a repeat of 2008’s banking crisis.

The international pressure for Europe to find a resolution is enormous. Today in an interview with the Financial Times Mr Cameron urged the euro membership to accept collective responsibility and backed an increase in the eurozone’s €440bn (£378bn) bailout fund. The hope is that decisive action will bring an end to the uncertainty that is currently destroying confidence in the markets.

But how will the cards fall for Greece? Whilst the current Prime Minister has refused to speculate on a Greek default, former PM John Major made it clear yesterday in an interview with the BBC that Greece would have to default.

“In the short term the banks need to be recapitalised and Greece needs to default, the sooner that happens… the sooner you remove something from the overhang in the markets.”

In this scenario banks would take a big haircut and if they weren’t sufficiently capitalised it would spark another banking collapse. But it seems increasingly likely that this will be the course of action as the German news agency DPA has reported a discussion between Eurogroup senior officials about a potential haircut of up to 60 per cent on Greek bonds’.

Reassurances by Sarkozy and Merkel that recapitalisation is on the table and banks would be given all the support they needed add weight to this likelihood.

A default would badly damage banks that are exposed to the Greek debt and would set a dangerous precedent to other heavily indebted economies. At the moment Italy and Spain are not insolvent but have liquidity problems that would not be helped by the drying up of lending likely to occur if banks take a haircut over Greece. But banks may be prepared to accept this so long as they are sufficiently recapitalised. The time for leadership and the use of EFSF funds has come and perhaps an acceptance of a default will end the uncertainty.

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