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We are not out of the woods by a long shot

THE latest eurozone deal is certainly a step in the right direction. Europe has finally realised it must slash the interest rates it initially charged on its bailout loans -- as well as the length of time bailed out countries had to repay those loans.

Ireland will have the interest rate on its bailout loans cut from about six per cent to between 3.5 and four per cent. This will save us between €600m and €800m in interest a year. We also have up to 15 years to repay those loans -- as well as an option to extend the loan term to 30 years.

The €109bn second Greek bailout should stop Greece dragging Europe down with it -- for the moment.

But let's not lose the run of ourselves. Ireland still has a staggering €94.5bn of national debt. Greece's massive €350bn of debt hasn't disappeared. Neither have the problems that got bailed-out countries into their debt mess in the first place -- and which are threatening to put countries such as Italy and Spain under too. Ireland and Spain still have immense banking problems and private debt, for example.

Commenting on the deal, Fitch Ratings said, "until there is a sustained and broad-based economic recovery across the region, allied with continued progress on reducing outsized government budget deficits and structural reforms to enhance long-term potential growth, further episodes of financial-market volatility cannot be discounted and downward pressure on sovereign ratings will persist".

French president Nicolas Sarkozy said the European deal, which was agreed at last Thursday's emergency summit, had pulled the eurozone back from the brink of disaster. True, the decisions have rectified some of the mistakes that have been made by Europe since December 2009, when the Greek crisis first reared its ugly head. But there are other glaring blunders made by our EU leaders over the last 21 months that have not been addressed.


Other conditions of the bailout loans have been hare-brain budget targets set by the EU and IMF.

"The single biggest mistake by Europe was the decision to impose budget targets on Ireland, Greece and Portugal that were impossible to meet," said Simon Tilford, chief economist with London-based think-tank the Centre for European Reform (CER).

"The economics of those budget targets were nonsensical. To meet those targets, all three countries have had to cut public spending by unprecedented amounts -- but this hasn't put those countries back on a sustainable fiscal path. In Ireland's case, it has led to wage and price deflation which has pushed up the cost of the country's debt.

"Those targets have plunged the private sector further into recession and fundamentally undermined the banks."

The EU is still not willing to row back on its budget targets for bailed-out countries. Last Thursday's draft plan to resolve the debt crisis, for example, described the steps taken by Greece to stabilise its public finances as "unprecedented but necessary". Taoiseach Enda Kenny too insisted that despite the new deal, the harsh measures planned for December's Budget must still happen.


In early April 2011, Portugal asked the EU for a bailout -- making it the third country to do so. Yet about a week later, the European Central Bank hiked interest rates for the first time in two years.

"Increasing interest rates at a time like this exacerbated the problems of countries that were already in crisis," says Jim Power, chief economist with Friends First.

The ECB followed up its April 2011 hike with another rate increase earlier this month. "You have to question why the ECB is raising interest rates now," says Alan McQuaid, chief economist with Bloxham Stockbrokers. "The ECB is jeopardising the mortgage market in Spain -- a country that Europe is trying to keep out of the debt crisis."

McQuaid also criticises the ECB's decision to increase its key lending interest rate back in July 2008, "when every country was going into recession".

"It later had to reverse this decision," says McQuaid.



When the previous government negotiated the €67.5bn bailout deal for Ireland, the ECB ruled out any prospect of burning senior bondholders -- essentially, investors who get their money back before other debts and liabilities are paid should the bank (or company) that issued that debt go bust.

This sheltered senior bondholders from the losses in the Irish banks -- and instead pushed the burden of such losses on to the shoulders of Irish taxpayers.

A similar stance was taken to bondholders in Greece and Portugal. Last Thursday, EU leaders agreed to allow private creditors to give more aid to Greece, which effectively means they will allow the country to partially renege on its debt (in other words, to default). The EU has insisted it is only adopting this approach for Greece. It has also been vague about how it will make bondholders contribute to the second Greek bailout, which suggests these bondholders may not be burned.

"The notion that bondholders should be sacrosanct is rubbish -- particularly in the context of capital markets," says Power. "Europe could have lessened the debt crisis from the start if it came out initially and imposed haircuts on bondholders."

Although markets have reacted favourably to the outcome of the EU summit so far, this reaction could be shortlived. "The drive to seek private sector involvement in the latest Greek bailout has raised expectations of similar outcomes for Ireland, Portugal -- and down the line, Italy and Spain," says Chris Scicluna, deputy head of economic research with investment bank Daiwa Capital Markets.

"If private holders of Greek debt lose say 50 per cent of their investments in Greek debt, the expectation is that investors in other countries' bond markets too will be asked to write down their investments too." This expectation could trigger contagion in the markets.


There is currently €440bn in the EU bailout fund, the European Financial Stability Facility (EFSF). That €440bn allows that fund to lend about €225bn.

The EFSF last month guaranteed to beef up the fund to €780bn in the future -- a move that would increase its lending capacity to €440bn. But even a €780bn fund would not be enough to bail out countries such as Italy and Spain should they go under. Italy, for example, has about €1.8 trillion of debt.

Last Thursday, EU leaders agreed to expand the powers of EFSF -- there was no mention, however, of any beefing up of this fund beyond the €780bn already committed and it is not clear if there are any plans to do so.

In a note published earlier this week, Willem Buiter, chief economist at Citigroup, said one of the key risks to the eurozone was "the inability" of the EU bailout funds "to provide adequate liquidity support to the Italian and Spanish sovereigns should they lose market access".

Chris Scicluna agrees: "All can see that there's insufficient money in these funds to provide support for Italy -- and this has raised investor uncertainty," he says.

"Europe should have said (from the start of this crisis) that it was willing to take all necessary measures and, in particular, provide sufficient funds, to guarantee financial stability and prevent contagion spreading.

"More recently in this context, it should have signalled its intention to enhance significantly the lending capacity of the EFSF and subsequently the ESM (the European Stability Mechanism -- another EU bailout fund) to a size that demonstrates that Europe is even able to cope with an Italian loss of market access. It's not too late to expand these funds but it may now be too politically difficult."

Even if Europe beefs up its bailout funds, the CER's Simon Tilford is dubious of Europe's ability to handle the collapse of one of its bigger countries.

"It is one thing to bail out Greece, Ireland and Portugal," says Tilford. "It's a whole different thing to bail out other countries such as Spain and Italy. Greece, Ireland and Portugal represented about six per cent of the eurozone economy. Add Spain and Italy to that list and those five countries represent about 28 per cent of the eurozone economy.

"As you bailout more countries, the number of countries carrying the bailout loans gets smaller and the credit worthiness of those countries is damaged as a result."

Sunday Indo Business