17/10/2011 11:46 BST | Updated 17/12/2011 05:12 GMT

Eurozone Crisis: Policymakers Given One Week To Find Solutions

European policymakers leave the weekend’s G20 summit with a warning that their “comprehensive” plan for resolving the euro zone’s sovereign debt issues may not be as comprehensive as they thought. They now have one week to shore up their response package before a crucial meeting of EU leaders.

The European Commission had proposed a multi-step plan that it hoped would, in one sweep, end the ongoing doubts over Greece’s unsustainable debt mountain and vaccinate the euro zone against the fallout from its inevitable default.

The EC’s plan involved paying Greece an outstanding €8 billion tranche of its 2009 bailout and agreeing a new structural adjustment programme to try to restart its stricken economy.

Following that, the process of ratifying reforms to the European Financial Stability Facility (EFSF), a temporary bailout mechanism for sovereigns, should be completed, giving the fund the power to recapitalise banks. The EFSF’s long term successor, the European Stability Mechanism (ESM) should be brought forward to 2012, according to the EC.

Many in the markets believe that policymakers are preparing for a selective technical default in Greece, where bondholders take larger “haircuts” on their holdings of Greek debt than the 21 per cent originally envisioned in the deal made between the Troika – the EU, European Central Bank and the International Monetary Fund – and private sector owners of the country’s bonds.

This would crystallise losses in the European banking sector, ending the uncertainty but risking a rolling banking crisis, as banks suddenly see their balance sheets reduced.

“If Europe moves towards more radical haircuts on Greece, the second round effects need to be controlled, and this probably explains why the Europeans want to move relatively fast on a bank recapitalisation framework,” Deutsche Bank economist Gilles Moec wrote in a note to clients on Monday.

European banking stress tests proposed that banks should have a tier one capital ratio of at least 5 per cent. This means that the ratio of its core capital – the equity held by its shareholders and disclosed reserves – and its risk weighted assets, should be at least that level for the regulators to consider them capable of absorbing losses from external events, such as a sovereign default. There are now suggestions circulating that this will be increased to 9 per cent.

Moec said that several large questions remain over the programme. Firstly, there is a gap in timing between reform of the EFSF and its ability to deploy resources. “A solution would be a continuation of the ECB’s bond buying program, but given the central bank’s reluctance to commit, this could fail to reassure the markets,” Moec said.

The EC hopes that the combined response mechanism would reassure investors enough to lower their demands when buying debt issuance from other sovereigns, particularly that of the large, systemic nations. Whether, in absence of market confidence over Italy’s ability to reform its public finances, that would come to pass is a major doubt, according to Moec.

Finally – and perhaps most significantly – forcing a recapitalisation of the banks would reduce their ability to lend, as they would need to store up cash.

“Could this trigger a dearth in credit origination?” Moec said. “We think that credit origination has already started to decline abruptly in the Euro area anyway. We think that it is too late for the Euro area to avoid a shallow recession.”

Arresting the sovereign crisis would, at least, restrict this mild recession from becoming “anything more sinister,’ he added.