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Wednesday, October 19, 2011

No way out? Short term options for the eurozone

The window of opportunity for stabilising, or even saving, the eurozone is closing quickly. As EU leaders gear up for a series of key meetings this week, Open Europe has published a new briefing looking at the short-term options available to the eurozone for tackling the most immediate crisis.

Open Europe argues that Greece should default on 60% of its debt through a managed restructuring, and that the planned second Greek bailout should be scrapped altogether, replaced by a limited transition fund designed to control the default. This would radically reduce the burden on taxpayers. Portugal should simultaneously take a 25% write-down on its debt.

Alarmingly, however, Open Europe estimates that 65 banks across the EU would fail serious stress tests, falling below an 8% tier one capital ratio, meaning they require a substantial recapitalisation. To withstand a Greek and Portuguese default, combined with marking Irish, Italian and Spanish debt to market prices, the EU banking system would need to be recapitalised by between €260bn and €372bn. The briefing sets out a three-pronged strategy for how this can be achieved, including a role for the eurozone bailout fund, the EFSF, but with strong conditionality attached.

However, using the EFSF to insure a percentage of Spanish and Italian debt against default – a proposal which is currently being discussed – would merely create a new set of unfunded liabilities, which markets are likely to question sooner or later.

The briefing also concludes that EU leaders should rule out forcing the ECB to act as the eurozone’s lender of last resort by buying hundreds of billions of government bonds – an option favoured by many. The ECB is already taking on risky assets at a worrying rate, and now has an exposure of around €590bn to PIIGS, up from €444bn only this summer, in turn undermining its independence and credibility.

See here for full briefing.

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