Europe made another attempt at solving its debt crisis with its most comprehensive plan to date. The initial reaction of financial markets was quite positive (for example, the German stock market was up over 6% on Thursday). What is the plan and is the problem "solved"? The basic elements include private investors in Greek debt taking a voluntary 50% haircut. A 50% haircut means that those that purchased a 10,000 euro bond will receive only 5000 euros back (50% loss). Private investors may be willing to accept this because it's better than receiving even less. Greece likes it because it reduces thier debt load. Why make it "voluntary"? Since it's voluntary, Greece won't officially default on the debt so, among other things, credit default swaps won't be triggered (they can be seen as insurance against default, so without an official default, there's no need to pay the insurance.
In addition, Europe will modify and expand the European Financial Stability Facility (EFSF); a fund established in a previous solution to the crisis. Under the new plan, the EFSF will be used to insure against the initial losses of future haircuts (reducing the risk of bonds somewhat since losses to investors will be reduced somewhat). The hope is that this will keep interest rates relatively low by limiting the risk of bonds (normally need higher interest rates to compensate for higher perceived risk; so less risk results in lower interest rates). The second change in the EFSF involves introducing new investment vehicles (i.e., bonds) that will be purchased by sovereign wealth funds (i.e., China, Brazil, etc.) that will provide more funds for future bailouts. Ideally, if investors knew that there were funds available to bailout Greece, Portugal, and others, they will feel more secure about their investment and thus be more willing to buy bonds at a relatively low interest rate.
The haircut is a good thing. Private investors know that there's a risk of buying bonds and are compensated in the form of higher interest rates. Greece cannot sustain their bond payments, so holders of Greek bonds should suffer a loss (they knew the risk when they bought the bonds). For now, I'll side step the issue of whether the market determine the amount of the loss. Regarding the new investment vehicles, will it raise enough funds to be successful? Many think that China (and Brazil) will be willing to help finance it in exchange for more influence in multilateral organizations.(IMF, etc.). In addition, will it raise enough funds to convince investors that there's enough funds in case of other countries needed haircuts (Portugal? Italy?).
Finally, European banks are given to June to increase capital ratios to 9%. Among the ways they can do it are be issuing equity (investors buy new stock which provides the banks with more funds) or by tightening lending and holding onto more deposits. Most analysts expect banks to primarily follow the latter approach, which will mean credit will become harder to come by in Europe, contributing to the likelihood of a recession in Europe.
Did it solve the problem? Probably not. It gives Europe more time, but much more work needs to be done to get the debt problems under control.
