Toward a Greek default

The economist

Jul 21st 2011, 14:38 by R.A. | WASHINGTON

AS EUROPEAN leaders gather in Brussels to settle on a new plan to address Greece's debts and—they hope—the broader issue of market confidence in the euro zone, details of a potential deal are emerging. It appears that German Chancellor Angela Merkel and French President Nicolas Sarkozy met last night with European Central Bank head Jean-Claude Trichet in an attempt to iron out their differences. A framework for an agreement was reportedly reached and will be presented at today's summit. No specifics are available, but a few key issues appear to have been settled.

First, it looks as though a haircut for Greek creditors is now likely.

Ms Merkel has repeatedly asked that bondholders share the costs of the Greek bail-out, insisting that this was a necessary precondition for German citizens to accept an increased fiscal commitment to the periphery. The ECB had, until now, been adamently opposed to anything smacking of default, but Mr Trichet is seemingly now on board. The ratings agencies would likely place Greece in "selective default" in that event. It isn't clear whether the ECB would continue to make good on its threat not to accept defaulted debt as loan collateral. European leaders may find themselves needing to guarantee defaulted Greek bonds and/or find alternative quality collateral.

Next, it looks like the European Financial Stability Facility (EFSF), the €440 billion bail-out fund, will be given greater flexibility to operate. It may have the authority to lend to countries that have not yet received official bail-outs and to recapitalise banks. The EFSF might also be used to fund a large-scale buy back of Greek debt. It does not appear, however, that an increase in the EFSF's size is on the table. The idea of a bank tax, which had previously been suggested as a means to help finance a Greek rescue, now seems dead.

European markets have continued the rally that began on Tuesday. Yields on peripheral debt continue to tumble, and the euro rose sharply. So, is all well?

It's too early to say, but for the moment the bigger picture remains bleak. The rumoured policy changes still need to be agreed at today's summit. The European public will ultimately weigh in on whatever decision is reached, and it seems like German voters, at least, continue to grow more sceptical of the currency union. And then there is the broader question: will the plan actually help? Even if Greece's obligations are meaningfully reduced, it faces a wrenching period of fiscal adjustment and a shrinking economy. The more ambitious the plan, the greater the need for a bigger fiscal commitment, which will test national governments.

Euro-zone leaders will hope that their agreement moves Spain and Italy back outside of the crisis perimeter. But an auction of long-term Spanish debt today doesn't bode well; Spain sold €1.8 billion in 10-year debt at an average yield of nearly 6%. If yields creep much higher than that, Spain's debts will become unmanageable without euro-zone assistance. Meanwhile, evidence of a euro-zone economic slowdown grows. Given the austerity environment within the euro zone, foreign demand will be crucial in supporting its economy. But as we've seen today, good news on the debt crisis leads to a sharply rising euro (thanks in no small part to the ECB's rush to increase interest rates). A dearer euro will hurt euro-zone exports at just the moment export growth is most needed.

The euro zone appears to have achieved a welcome calming of distressed markets. But there will be more trouble ahead.