EU Summit Looms on Debt Deadlock

As crisis intensifies, leaders debate role of bondholders in Greek bailout.

European leaders will this week seek to revamp their debt crisis-fighting strategy and snap a deadlock that is spooking investors and prompting warnings of contagion from the International Monetary Fund.

With European Central Bank President Jean-Claude Trichet reiterating opposition to any Greek debt restructuring, government chiefs convene July 21 in Brussels to discuss “the financial stability of the euro area as a whole and the future financing of the Greek program,” European Union President Herman van Rompuy said in a July 15 statement. Among topics for the talks is a potential overhaul of the 440-billion euro ($618 billion) rescue fund to enable Greece to better pay its bills.

The second summit in a month follows an intensification of the debt crisis that thrust Italy to the attention of investors and pushed bond yields to euro-area records across Europe’s most debt-laden nations. Delay in finding a solution combined with discord among policy makers on whether bondholders should share the burden if Greece defaults has unnerved financial markets.

“This crisis has clearly taken on more systemic risk,” said Laurent Bilke, head of interest rates strategy for Europe at Nomura International Plc in London and a former European Central Bank economist. “It’s crucial at the current juncture for policy makers to get the right things done.”


Italian Yields Surge
Italian and Spanish bonds fell today, widening the gap in yields versus German bunds as the crisis spurred investor demand for the euro area’s safest assets. The cost of insuring against default on European sovereign debt, including bonds sold by Greece, Ireland, Italy, Portugal and France, rose to records. Last week, Italian two-year note yields surged the most in over a year and yields on notes from Ireland, Portugal and Greece soared to euro-era records.

A summit was originally mulled for last week before being postponed amid German fears it would backfire without a pact on how the private sector can bear some of Greece’s euro debt burden. This week’s meeting takes place just over a year since leaders organized a 110-billion euro lifeline for Greece.

German Chancellor Angela Merkel will attend the July 21 EU summit, her chief spokesman Steffen Seibert told reporters today in Berlin.

“I’ll only travel there if there is an outcome,” Merkel said in an ARD television interview yesterday. “I do think it’s urgently necessary. We have to send a signal of stability and I believe we could make a lot of progress on the Greek program.”

Separately, German Finance Ministry spokesman Martin Kotthaus said EU finance ministers won’t convene ahead of the summit.


Lower Interest Rates
EU leaders are taking control after European finance ministers last week said they would “shortly” deliver fresh measures to cut Greece’s debt burden with bond buybacks or a temporary default among the steps being debated. They indicated Greece might be granted lower interest rates and longer repayment times for official loans, though maybe requiring collateral.

The tension lies in how to include investors in any second bailout, which may total as much as 115 billion euros over three years. Bankers and officials held talks in Rome last week after proposals for a “voluntary” rollover of Greek debt met with warnings from credit-rating companies that they would declare a default. That would be a bridge too far for the ECB.

“If a country defaults, we can no longer accept as normal eligible collateral defaulted bonds issued by the government of that country,” Trichet said in an interview with the Financial Times Deutschland released yesterday by the ECB. “This would impair our ability to be an anchor of confidence and stability.”


ECB’s Wrath
Germany’s government says no extra aid is possible without bondholders being forced to stay exposed to Greek debt. It has incurred the ECB’s wrath by pushing for a debt swap.

"The more we get private investors voluntarily involved now, the less likely we will have to take further steps,” Merkel said in her ARD television interview. “Of course we have to be prepared, but the most important thing is that Greece has to do its homework and private creditors are brought into the fold.”

Yields on 10-year Italian bonds increased 11 basis points today to 5.87 percent as of 10:24 a.m. in London, widening the spread, or yield gap, over benchmark German bunds to 326 basis points. Spanish 10-year yields rose 15 basis points to 6.22 percent, taking the spread over bunds to 363 basis points.

The Institute of International Finance, a trade association representing more than 400 banks and insurers, said in a statement yesterday that “progress has been made and the discussions are continuing” after last week’s talks in Rome.


Bond Purchases
Also overshadowing the summit is the question of how far governments will increase the scope of the European Financial Stability Facility given some steps may require the support of local legislatures, which would take time and political capital. It may be allowed to buy bonds in the secondary market or enable Greece to retire its debt at a discount of as much as 50 percent. Germany has resisted such steps in the past.

ECB Executive Board member Lorenzo Bini Smaghi said in an interview with Greece’s To Vima newspaper that it would be “useful” to allow the EFSF to buy bonds on the open market, according to a transcript from the ECB published yesterday.

“This would allow the private sector to sell bonds at their market value, which is currently lower than the nominal value,” Bini Smaghi said. “This would allow the private sector to sell while the public sector would save money.”


IMF’s Share
Officials are concerned the IMF may curb its share of a second rescue unless the plan includes deep cuts in Greece’s debt, two people with knowledge of the talks said last week.

The IMF, which has provided one-third of the three previous euro bailouts, last week called for a “greater sense of urgency” in fixing Greece given that the 21-month crisis threatens “market disorder that would affect funding rates for other vulnerable sovereigns and could have severe implications for financial institutions.”

Markets found some calm at the end of last week as Italian Prime Minister Silvio Berlusconi survived confidence votes on a 40-billion euro austerity package that aims to balance the budget by 2014.

The euro area’s banks may also be in focus this week, after eight lenders failed the European Banking Authority’s stress tests released on July 15, showing a combined shortfall of 2.5 billion euros. As many as 16 more will need to bolster capital after their core Tier 1 ratio dropped below 6 percent, little more than the assessment’s 5 percent pass-mark, the EBA said.


Bloomberg News


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