21 July 2011
Paola Subacchi

Dr Paola Subacchi

Senior Research Fellow, Global Economy and Finance


Today's emergency summit in Brussels is unlikely to put an end to Europe's sovereign debt crisis. Despite the divergent views expressed in recent weeks, an agreement is inevitable in order to avoid the implosion of Europe's single currency union. Over the years European leaders have shown they can effectively cooperate when a critical situation is near breaking point. This is where Europe is now.

With Italy joining the club of problematic countries, contagion has spread to the core of the euro area - Italy being one of the founding members and the third largest economy in the eurozone.

From here the crisis can painfully stretch to its logical conclusion: the default of countries unable to raise fresh capital to repay their outstanding debt. Such an outcome, at this stage and after several attempts to contain the crisis, would spell the end of Europe's single currency. This is the worst-case scenario that policy-makers and the ECB are committed to avoid. Its systemic consequences, and its impact on the international financial and banking system, are unpredictable and possibly devastating. The need for concerted action now is tangible and urgent.

There are a number of options on the table, all with their pros and cons. The most plausible, albeit opposed by Germany, is to use the European Financial Stability Fund to allow Greece to buy-back some of its debt. With Greek bonds currently trading at 60% of face value, € 54bn would write off € 90bn worth of debt - almost 1/3 of the total Greek debt. This would only work, however, on the assumption that creditors are prepared to trade in their debt as the scheme can only be voluntary.

As a bargaining chip to Germany, leaders could agree on involving private bond holders - banks - and ask them to accept a delay in repayment on € 25bn debt due in three years. This would be much lower than € 75bn proposed by Germany.

This would be the best case scenario and would avoid a default - even if a selective one. But it would be an imperfect solution and leave open the key question of how Greece will eventually repay its overall debt of approximately 142.8% of GDP. But it would have the advantage of releasing pressure from all other peripheral countries and bring some respite to Italy and Spain. A bail-out of these two countries is technically impossible, prolonged market defensive reaction would lead to serious damage to the fundamentals of the single currency union.

At this juncture, an injection of confidence is critical to re-balance the situation, and this can come from EU leaders showing they have the ability and willingness to work together. If this happens now, there will be time later to seriously rethink the governance of the euro and to put down some new building blocks.