EU Leaders Offer $229 Billion in New Greek Aid

“We doubt that this package alone will bring an end to recent contagion effects…”

Jonathan Loynes, chief European economist at Capital Economics Ltd

By Simon Kennedy and Jonathan Stearns - Jul 22, 2011 7:53 AM GMT+0300

Euro-area leaders redoubled efforts to end the 21-month sovereign bond crisis as they erected a firewall around Spain and Italy and risked temporary default to lighten Greece’s debt burden.

After eight hours of talks in Brussels, leaders announced 159 billion euro ($229 billion) in new aid for Greece late yesterday and cajoled bondholders into footing part of the bill. They also empowered their 440-billion euro rescue fund to buy debt across stressed euro nations after a market rout last week sparked concern the crisis was spreading. The fund can also aid troubled banks and offer credit-lines to repel speculators.

The euro strengthened as officials drew concessions from Germany, the European Central Bank and investors for a twin- track strategy to support Greece and ensure its woes don’t spread. The summit is the latest in a running-battle to resolve the crisis amid calls this week for tougher action from U.S. President Barack Obama and the International Monetary Fund.

“These measures are welcome because they create the best possible conditions for Greece and other peripheral countries to put their houses in order and hence limit the risk of contagion,” said Marco Valli, chief euro-area economist at UniCredit SpA in Milan. “Still, the market will continue to price some probability that troubled countries will not be up to the challenge.”

Regaining Initiative

The euro jumped as much as 1.6 percent to $1.4435 yesterday as details of the plan emerged. It traded at $1.4384 at 1:37 p.m. in Tokyo. Greek, Italian and Spanish bonds rose, with the yield on Greece’s two-year security plunging more than 400 basis points to 33.81 percent.

The Greek financing package will consist of 109 billion euros from the euro region and the IMF. Financial institutions will contribute 50 billion euros after agreeing to a series of bond exchanges and buybacks that will also cut Greece’s debt load, the leaders’ communiqué said.

The European Commission plans to brief reporters on the package’s technical details at 1 p.m. in Brussels.

The leaders sought to regain the initiative after market turmoil intensified amid a spat between ECB President Jean- Claude Trichet and German Chancellor Angela Merkel over how to manage the crisis. The outlook was worsened by signs that Greece was backsliding on axing its budget deficit as it struggles to cut a debt of 143 percent of gross domestic product. A Bank of America Merrill Lynch poll this week showed investors trimming their European stock holdings to the lowest in more than a year.

European Monetary Fund

French President Nicolas Sarkozy compared the transformation of the bailout fund to the creation of a “European Monetary Fund.”

“This meeting came at a difficult time,” Merkel told reporters. “I’m satisfied with the outcome because the euro countries showed today that we are up to the challenge, we can take action.”

The risk is that the drive will fall prey to the same internal European Union wrangling that blunted previous drives to stop the crisis. EFSF bond purchases will need the “mutual agreement” of member states and the fund may not be large enough should markets turn on Italy and Spain at the same time. Sarkozy and other leaders also stressed that the Greek package won’t be replicated for other countries.

Crisis Management

European officials tried to draw a line under the crisis in May 2010 when they set up the bailout fund and the ECB agreed to buy government bonds of debt-laden nations. That didn’t stop Ireland and Portugal needing bailouts when splits over how to make investors participate in financial rescues prompted a new wave of bond market selling later in the year.

The pact still doesn’t “make a significant dent” in Greece’s debt and may disappoint investors by failing to boost the size of the rescue fund, said Jonathan Loynes, chief European economist at Capital Economics Ltd. in London. “We doubt that this package alone will bring an end to recent contagion effects and prevent the broader debt crisis from continuing to deepen over the coming months.”

For now, Merkel and her allies have succeeded in their drive to make investors co-finance bailouts after voters balked at the cost of saving spendthrift nations.

Bond Exchange

Banks will reduce Greece’s debt by 13.5 billion euros by exchanging bonds and “potentially much more” through a buyback program still to be outlined by governments, said the Institute of International Finance, a Washington-based group representing banks.

Investors will have the option to exchange existing Greek debt into four instruments. Three will be fully collateralized by AAA-rated zero-coupon securities and have a 30-year maturity, and the fourth will be for 15 years and partially collateralized by funds held in an escrow account.

Crisis managers are aiming for a 90 percent participation rate from Greek bondholders.

“With this offer, the global investor community is stepping forward in recognition of the unique challenges facing Greece,” said IIF Managing Director Charles Dallara. The gathering was also attended by Deutsche Bank AG Chief Executive Officer Josef Ackermann and BNP Paribas SA counterpart Baudouin Prot.

Sovereign Default

The ECB removed an obstacle to a new bailout after Trichet softened his opposition to a default which may be declared by credit rating companies if the debt swap occurs. The ECB had until now said the euro region’s first sovereign default could spark a bout of financial turmoil, clashing with Merkel’s position that a default could be inevitable.

Trichet signaled governments will guarantee any defaulted Greek debt offered as collateral during money market operations. That may enable Greek banks to keep tapping the ECB for emergency funds. Officials said the aim would be limit any credit event to a few days.

“The ECB pushed the argument as far as it could,” said Laurent Bilke, an economist at Nomura International Plc in London who used to work at the ECB. “It is Europe, everything is a compromise.”

Under the plan, Greece and fellow bailout recipients Portugal and Ireland will also have the interest rate on emergency loans pared. Maturities will be lengthened to as long as three decades with a 10-year grace period.

Financial Stability Facility

Trichet may gain solace from the bailout fund’s wider remit which he repeatedly sought since the ECB suspended its own bond buying program in April amid concern it was doing the work of governments. Germany previously rejected broadening the European Financial Stability Facility, whose size was beefed up to its original lending target as recently as last month.

The facility will be able to buy debt directly from investors so long as creditors agree and the ECB declares “exceptional financial market circumstances.” EU President Herman Van Rompuy said the purchases could be used to stabilize markets as the ECB was doing or to help countries retire debt at a discount.

The fund may also start passing money to countries to support banks a week after stress tests on 90 financial institutions put as many as 24 under pressure to show they can raise capital. Precautionary credit lines would allow it to lend to nations before markets freeze, mimicking a system introduced by the IMF for states that start losing investor faith even though they have relatively sound economies.

Domestic Critics

Governments will have to ratify the facility’s new powers, posing a potential obstacle given domestic critics in Germany, Finland and the Netherlands.

Leaders dumped a suggestion to finance Greek aid through a tax on banks with a French official noting the threat had nudged banks into agreeing to help in other ways. While they signaled no shift toward issuing joint bonds, Germany’s Deputy Foreign Minister Werner Hoyer said in an interview on July 20 that it may eventually back the concept “if we further develop the European Union towards a political union.”

To contact the reporters on this story: Simon Kennedy in Brussels atskennedy4@bloomberg.net Jonathan Stearns in Brussels at jstearns2@bloomberg.net