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The Euro Zone Crisis

Joining the euro zone has been a strategic goal for Poland. But that won’t be happening anytime soon. The euro zone is “still struggling with very deeply-rooted structural problems”, according to Poland’s finance minister. And the country will not enter the currency bloc until they are sure the euro zone is “well-constructed and safe to join.” Poland is not marking its calendar.

Last week euro zone leaders met for a summit to address the euro area crisis …the 14th meeting in less than two years. And as dawn broke last Thursday, they agreed on a plan to quell the crisis….the third plan so far this year.

The “comprehensive package” will do a few things. The capacity of the financial rescue fund will be increased to $1.4 trillion (the fund has already served as a lifeline for Greece, Ireland and Portugal…not yet Spain or Italy). Private bondholders will accept a 50% reduction in the face value of Greek bonds…this is a “voluntary” write-down of the debt (and will halve the value of $224 billion in bonds). And to reduce the risk of collapse, European banks will be recapitalized; they will have until June 30, 2012 to reach core capital reserves of 9%. The European Banking Authority estimates capital needs at €106 billion… Spain and Italy’s banks (the larger troubled economies) will need €26.2 billion and €14.8 billion, respectively. And if they fail to raise the necessary capital, they will tap national governments…then the rescue fund.

The plan is not entirely convincing. The Greek bond write-down is not going to make the country’s debt burden sustainable. That’s because 35% of the country’s debt is held by public institutions, and therefore not subject to the 50% reduction. That means that the plan will reportedly bring Greece’s debt down to 120% of growth…the same level as 2009.

And the write-down is “voluntary”, meaning bondholders are “invited” (yes, the EU actually said invited) to take the reduction in the value of the debt. If the plan is ‘voluntary’, it will not trigger credit default swap payouts (these are insurance contracts against sovereign default). But realistically, a 50% haircut is not inviting or voluntary…and its going to be forced on bondholders. And if losing half of the value of a bond isn’t a default, what is? But more to the point, even if a “credit event” does not occur, the write-down stands to undermine the value of the credit default swap market. Investors will be left to wonder how much protection that insurance really buys when they are ‘invited’ to take a ‘voluntary’ 50% hit.

But the good news is that the euro zone has woken up from the dream that Greece would somehow actually be able to meet its debt obligations. And the new plan is an official admission that it can’t.

While this plan is being referred to as ‘comprehensive package’, it is not a cure-all by any means. It is a financially engineered fix that puts a band-aid over the symptoms, and buys more time, but it doesn’t get to the root causes of the euro zone’s problems.

And at this point, this is no longer a Greek crisis. Or a crisis of other peripheral economies. This is a euro zone crisis. And while the new package may be enough to ignite a year-end market rally, it isn’t a lasting solution, and it isn’t going to put a stop to the crisis in the euro zone.

The plan will fall short. As a senior portfolio manager at Pimco put it, “this piecemeal strategy by the euro zone’s leaders, one reactive policy slice at a time, is backfiring”. This new ‘comprehensive plan’ just shows that euro zone leaders are still scrambling behind the evolution of the crisis.


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