Love It or Leave It: The Future of the Euro in the Balance

International markets will turn their full attention to the outcome of the Thursday (July 21) emergency summit of European heads of state and government of the 17 eurozone countries. At stake is whether these leaders will be able to agree on how best to organize a second bailout package for Greece. And the stakes—for Greece, for Europe, and for the global economy—are very high. If anything, the sovereign debt crisis has moved beyond saving Greece from insolvency and has now enveloped Europe’s largest economies. Investors have grown weary of the “trifecta” of slow economic growth, dysfunctional political systems, and soaring levels of debt—the combination that is now present in Italy. Yet Italy is not a peripheral economy; it is Europe’s fourth-largest economy and the third-largest bond market in the world. The exposure of European banks and nations to Italian debt is far greater than their exposure to that of the other troubled countries. Put bluntly, an Italian debt crisis would be cataclysmic. The recent surge in Italian bond yields (the cost of borrowing) has added new and urgent pressure on European leaders to stem and contain its debt crisis. As Italian bond yields surge and stock prices plummet, the euro is entering a new and more ominous phase in the economic crisis. This week the euro fell to its lowest level against the dollar in four months, against growing market anxiety and uncertainty that Europe cannot find a solution to its most existential crisis since the end of World War II.

Q1: What are the different proposals for Greece’s second bailout?

A1: One needs a scorecard to keep up with the various proposals that are currently being discussed among European leaders. So far, three major proposals have emerged. The first, as originally proposed by Germany’s Finance Ministry, is a restructuring of Greece’s debt maturities that would extend Greek bonds set to expire in 2014 to now expire in 2021. Two important stakeholders do not support this proposal: the credit rating agencies (e.g., Moody’s and Standard and Poor’s) and the European Central Bank (ECB). The rating agencies have stated that this proposal would trigger a selective default rating for Greece. The ECB has emphatically stated that if Greek bonds go into default, even if it is selective default, they will not be accepted as collateral at the Central Bank. As Greek banks are major holders of their own nation’s debt, being unable to use their bonds as collateral in liquidity transactions with the ECB would likely cause a run on Greek banks. Greek bank deposits have already fallen by 15 percent in the last year; a run on the banks would bring about the collapse of the Greek banking system.

The ECB’s tough stance on the default of Greek bonds is motivated by the fact that the Central Bank itself holds vast quantities of bonds from the peripheral EU nations, including Greece. The ECB’s primary responsibility is to ensure that Europe’s banks remain solvent. Any devaluation of Greek bonds affects the capitalization of the ECB. If a bank were to collapse, as Lehman brothers did in the United States, at a time when the ECB itself was undercapitalized, disaster would be inevitable.

The second proposal, which has received favorable reviews by economists, is to allow the European Financial Stability Fund (EFSF)—Europe’s bailout fund—either to “buy back” Greek bonds from the banks and insurance companies that want to unload them in the secondary market, or swap European bonds (create so-called eurobonds) for Greek bonds. For this to work, the rules of the EFSF would have to be amended and agreed to by all 17 eurozone members. Again, there are objections to this proposal by the credit rating agencies, which contend that any losses incurred by the private sector would result in a selective default rating as the banks and insurance companies would unload their bonds at a discounted rate. While this proposal would meet Germany’s criteria of involving the bondholders together with European taxpayers to “share the burden” of resolving the crisis, a eurobond would increase borrowing costs for Germany and other AAA-rated eurozone countries, constituting a “transfer” of creditworthiness as well as credit. This idea is not popular with any of the AAA countries, particularly Germany, the Netherlands, and Finland.

The third proposal would be to increase the Greek bailout package to allow Greece to buy back its own bonds at a discounted rate, thereby allowing Greece for the first time to be able to decrease its public debt by €20 billion, which begins to address the problem. However, this plan also exposes Greek bonds to a selective default rating.

A fourth proposal, which has emerged over the past few days, is to levy a tax on European banking institutions (regardless of whether they hold Greek debt or not) to go toward Greece’s second bailout package. This would allow the private sector to participate without invoking default. European banks, many already struggling with meeting Tier 1 capital requirements, are not enthusiastic about this latest idea.

Despite a proliferation of proposals, the bottom line is that there is no easy choice for the European leaders on Thursday. It is clear that the longer Europe goes without decisively solving this crisis (recent statements by Chancellor Angela Merkel of Germany suggest it may not be resolved quickly), the more European states will be consumed by the crisis. Unless European leaders quickly restore unity and faith in the euro, the continent is headed for more pain.

Q2: Can European banks handle a Greek default?

A2: On July 15, European banks underwent a series of stress tests to measure their ability to withstand various market shocks. The stress tests found only 8 of 90 European banks to be failing, with a combined capital shortfall of €2.5 billion. This should have been good news, but the markets were not buoyed. This is primarily because the tests also revealed just how exposed to sovereign debt European banks are. According to the New York Times, Belgium, Greece, and Italy are sitting on European government bond holdings that range from 60 to 90 percent of their total bank capital. If the peripheral countries were in fact to default, most European banks, not just Greek banks, would be susceptible to a massive run, with depositors and institutions withdrawing their money to avoid further losses. The European financial system is anchored by its banks. A run as described above would constrict credit flows, a recession in the euro zone would follow, and a global financial crisis would not be far behind—further proving that a crisis for Greece is a crisis for the globe.

Q3: How does this crisis affect the United States?

A3: Predicting how this crisis will impact the United States is complicated. First, no one is certain of how exposed the nation is to European debt and related financial instruments. The Bank for International Settlements (the bank of central banks) estimates that the combined actual and potential exposure of U.S. banks to Portugal, Ireland, Italy, Greece, and Spain is about $640.8 billion. The challenge is determining the difference between actual and potential exposure. Actual exposure would come in the form of owning European bonds; potential exposure could come in the form of complicated financial instruments, including credit default swaps and hedges. Needless to say, tracking the investments of U.S. banks in these instruments is difficult, and knowing how they will be impacted by a default is even harder.

What we do know from the global financial crisis in 2008 is that the international banking system is extremely interdependent. A selective default of Greek debt will put great stress on European banks, which in turn will impact U.S. banks and global markets. Overall, credit flows could be restricted, asset prices could decline, and investors could become more risk averse—all having the combined effect of another global recession.

Heather A. Conley is a senior fellow and director of the Europe Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Uttara Dukkipati is a research assistant with the CSIS Europe Program.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2011 by the Center for Strategic and International Studies. All rights reserved.