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News : EU Economy Last Updated: Feb 7, 2011 - 5:43 AM

EU Summit and cutting Eurozone debt without default
By Finfacts Team
Feb 4, 2011 - 8:18 AM

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Spain's Prime Minister José Luis Rodríguez Zapatero and German Chancellor Angela Merkel, at Zarzuela Palace, Madrid, Feb 03, 2011, with King Juan Carlos (l).

A summit of the leaders of 27 European Union countries will be held in Brussels today and the expansion of the role of the Eurozone’s €440bn bailout fund will be the main issue of discussion. Meanwhile, a paper published by a Brussels-based think-tank, proposes a market-based approach to debt reduction, without involving default.

Both the Angela Merkel, the German chancellor and Nicholas Sarkozy, the French president, have agreed in principle to expand the powers of the European Financial Stability Facility (EFSF) and Merkel is reported to be pressing for coordination on such issues as retirement ages across countries, scrapping any links between wages and inflation and bringing corporate tax systems closer together.

The Financial Times says that according to the draft conclusions sent to governments on Thursday by Herman Van Rompuy, the EU’s president, EU leaders will agree “concrete proposals” by next month so that the fund will have “the flexibility and financial capacity to provide adequate support” for the euro.

The FT says the draft is vague on Merkel's “pact for competitiveness” for the 17 Eurozone members.

The European Central Bank has suspended its bond buying  program and it's eager that the EFSF would assume that role.

Since last May, the ECB has purchased the bonds of peripheral countries including Ireland, with a value of €76.5bn.

Debt Reduction without Default

Daniel Gros, director of the Brussels-based Centre for European Policy Studies and Thomas Mayer, chief economist of Deutsche Bank, Germany's biggest, propose in a paper Debt reduction without default (pdf),  a two-step, market-based approach to debt reduction:

  • Step 1. The European Financial Stability Facility (EFSF) would offer holders of debt of the countries with an EFSF programme (probably Greece, Ireland and Portugal = GIP) an exchange into EFSF paper at the market price prior to their entry into an EFSF-funded programme. The offer would be valid for 90 days. Banks would be forced in the context of the ongoing stress tests to write down even their banking book and thus would have an incentive to accept the offer.

  • Step 2. Once the EFSF had acquired most of the GIP debt, it would assess debt sustainability country by country.

If the market price discount at which it acquired the bonds is enough to ensure sustainability, the EFSF would write down the nominal value of its claims to this amount, provided the country agrees to additional adjustment efforts (and, in some cases, asset sales).

If under a central scenario this discount is not enough to ensure sustainability, the EFSF might agree on a lower interest rate, but with GDP warrants to participate in the upside.

A key condition for this approach to succeed in restoring access to private capital markets is that the EFSF claims are not made senior to the remaining claims and the new private bondholders. EFSF support must be comparable to an injection of equity into the country.

The paper says while the EFSF concentrates on the exchange of the stock of bonds, the IMF could fund the remaining deficits in the usual way with bridge financing, until the fiscal adjustment is completed. The ECB would of course immediately stop its ‘Securities Market Programme’, which would have lost its raison d’être.

David Milleker, chief economist at Union Investment joined CNBC after the ECB kept rates on hold and said inflation is likely to climb further and could exceed the Bank's target for most of the year:

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