* Summer break first, then crisis looms large again
* Euro zone faces critical hurdles including Greece, Spain
* Dutch elections may complicate Greek talks
* Negotiations likely on further Greek debt write off
* Continued pressure for banking licence for bailout fund
By Jan Strupczewski
BRUSSELS, July 29 Over the past couple of years,
Europe has muddled through a long series of crunch moments in
its debt crisis, but this September is shaping up as a
"make-or-break" month as policymakers run desperately short of
options to save the common currency.
Crisis or no crisis, many European policymakers will take
their summer holidays in August. When they return, a number of
crucial events, decisions and deadlines will be waiting.
"September will undoubtedly be the crunch time," one senior
euro zone policymaker said.
In that month a German court makes a ruling that could
neuter the new euro zone rescue fund, the anti-bailout Dutch
vote in elections just as Greece tries to renegotiate its
financial lifeline, and decisions need to be made on whether
taxpayers suffer huge losses on state loans to Athens.
On top of that, the euro zone has to figure out how to help
its next wobbling dominoes, Spain and Italy - or what do if one
or both were to topple.
"In nearly 20 years of dealing with EU issues, I've never
known a state of affairs like we are in now," one euro zone
diplomat said this week. "It really is a very, very difficult
fix and it's far from certain that we'll be able to find the
right way out of it."
Since the crisis erupted in January 2010, the euro zone has
had to rescue relative minnows in Greece, Ireland and Portugal
as they lost the ability to fund their budget deficits and debt
obligations by borrowing commercially at affordable rates.
Now two much larger economies are in the firing line and
policymakers must consider ever more radical solutions.
If Spain, the euro zone's fourth biggest economy and the
world's 12th, loses affordable market financing the next domino
at risk of falling is Italy - the euro zone's third biggest
economy and a member of the G7 group of big wealthy nations.
A bailout of Spain would probably be double those of Greece,
Ireland and Portugal combined, while Italy's economy is twice as
large as Spain's again.
The European Union has already agreed to lend up to 100
billion euros to rescue Spanish banks. One euro zone official
said Madrid has now conceded that it might need a full bailout
worth 300 billion euros from the EU and IMF if its borrowing
costs remain unaffordable.
European officials have spent the past few days issuing a
series of statements declaring they will act to halt the crisis.
In the latest, issued on Sunday, Chancellor Angela Merkel
and Prime Minister Mario Monti "agreed that Germany and Italy
would do everything to protect the euro zone".
The wording was similar to remarks by European Central Bank
chief Mario Draghi last week prompted buying in financial
markets on the expectation that the bank would take steps to
lower the cost of borrowing of Spain and Italy.
DEFLATING LIFE RAFT
The euro zone does not seem to have enough cash in the
current setup to deal with a scenario of Spain and Italy needing
a rescue, and a sense of doom is growing among some
policymakers. Fighting the crisis, said the euro zone diplomat,
is like trying to keep a life raft above water.
"For two years we've been pumping up the life raft, taking
decisions that fill it with just enough air to keep it afloat
even though it has a leak," the diplomat said. "But now the leak
has got so big that we can't pump air into the raft quickly
enough to keep it afloat."
Compounding the problems, Greece is far behind with reforms
to improve its finances and economy so it may need more time,
more money and a debt reduction from euro zone governments.
If Greek debt cannot be made sustainable, the country may
have to leave the euro zone, sending a shockwave across
financial markets and the European economy.
Sept. 12 is a crucial date in the European diary. On that
day the German Constitutional Court is scheduled to rule on
whether a treaty establishing the euro zone's permanent bailout
fund, the 500 billion euro European Stability Mechanism (ESM),
is compatible with the German constitution.
A positive ruling is vital, because Germany is the biggest
funder of the ESM, and the euro zone would be powerless to
protect Spain or Italy without the ESM.
On the same day, parliamentary elections are held in the
Netherlands where popular opposition to spending any more money
on bailing out spendthrift euro zone governments is strong. The
Dutch vote may complicate talks on a revised second bailout for
Greece, which also has to be agreed in September.
Athens wants two more years than originally planned to cut
its budget deficit to below 3 percent of GDP, so as not to
impose yet more spending cuts on a country which is already in a
This would mean Greece's 130 billion euro second bailout
package may need to be increased by 20-50 billion euros,
according to estimates by some euro zone officials and
economists, and there is no appetite in the euro zone to give
Greece yet more extra money.
More importantly Greece needs to bring its debt, which is
equal to 160 percent of its annual economic output, under
control. This means euro zone governments, which own roughly two
thirds of it, may need to write part of it off.
Private creditors have already suffered a huge writedown in
the value of their Greek debt holdings but so far euro zone
taxpayers have not lost a cent on any of the bailouts.
LAST CHANCE OPTIONS
Policymakers are working on "last chance" options to bring
Greece's debts down and keep it in the euro zone, with the ECB
and national central banks looking at also taking significant
losses on the value of their bond holdings, officials said.
If governments swallowed the bitter pill by also accepting a
cut in the value of their contributions to loans already made to
Greece, this would break a taboo and could provoke demands for
similar treatment from Ireland or Portugal.
Peter Vanden Houte, chief economist at ING bank, said euro
governments might be forced to accept a halving of the value of
their Greek debt - known in the business as haircut.
"If Greece is to be saved, we must see some debt forgiveness
from euro zone governments in the coming years because otherwise
Greece is never going to come out of the situation it is in
now," he said. "We are talking about potentially a 50 percent
haircut, which would still mean the Greek debt would be
(proportionately) around the euro zone average."
The euro zone would want concessions from Athens. "Most
probably in exchange, euro zone partners will be more strict on
Greek compliance with structural reforms and may ask Greece to
give up some sovereignty," said Vanden Houte.
While no official discussions are underway on another Greek
debt restructuring, euro zone officials say privately it may be
necessary if Greece is to have a fighting chance.
"The Greeks might say they are in such a mess that to
survive they we need to ease up the austerity a bit, and to
still regain debt sustainability they will have to default on
30-40 percent of the loans," one euro zone official said.
"There would be a lot of people saying this is
understandable, so maybe this makes sense and maybe we could
have a reasonable discussion among the member states on how
Greece can move forward," the official said.
The official speculated that euro zone debt forgiveness for
Greece could be made dependent on progress in structural reforms
or that it could be reviewed once Athens has to start paying
back the capital of the loans in 10 years.
"Maybe we could agree to give debt relief of, say, 25
percent to make possible some changes in the programme. Then we
implement that for six months or a year and maybe we find out
that we need to give them another 25 percent and at the end of
the day we might get to a stable situation," the official said.
The situation will become clearer once international lenders
produce a new debt sustainability analysis for Greece at the end
THE BATTLE OF SPAIN
Preventing Spain and Italy from losing debt market access
may require the crossing of another red line - ECB help in
keeping down governments' borrowing costs.
Draghi signalled last Thursday the bank was ready to act,
indicating it may revive its programme of buying bonds of
troubled governments on the secondary market.
"Within our mandate, the ECB is ready to do whatever it
takes to preserve the euro. And believe me, it will be enough,"
Draghi said. "To the extent that the size of the sovereign
premia (borrowing costs) hamper the functioning of the monetary
policy transmission channels, they come within our mandate."
However, Germany has always been hostile to the idea and the
Bundesbank said on Friday that it continued to view it "in a
German Finance Minister Wolfgang Schaeuble dismissed
suggestions Spain will ask the bailout fund to try to lower its
borrowing costs by purchasing its bonds.
Spain faces high borrowing costs because investors fear they
will not get their money back. The Spanish economy is shrinking,
many of its autonomous regions need bailouts from Madrid and
banks need the recapitalisation of up to 100 billion euros.
Madrid still has to raise about 50 billion euros on the
market by the end of the year. This may be impossible if its
funding costs stay well above 7 percent for 10-year bonds.
Draghi's remarks knocked yields down by more than 40 basis
points to below 7 percent on Thursday, but they could quickly
climb back if the market does not see firm ECB buying soon.
The ECB also seems to be softening its stance on another
taboo - giving the ESM a banking licence so the fund can borrow
from the ECB against euro zone government bonds.
If Spain or Italy applied for euro zone help in bringing
down their borrowing costs, the temporary European Financial
Stability Facility (EFSF) bailout fund or the ESM could help.
But with their combined firepower, under current agreements,
of 459.5 billion euros until July 2013 and at 500 billion from
July 2014, the funds do not have enough to impress markets.
If the ESM could refinance itself at the ECB, however, it
would have virtually unlimited firepower for bond market
intervention without causing inflationary pressure.
Discussions on the banking licence for the ESM have been
going on in the background for many months, officials said, with
France openly calling for such a solution, but Germany, Finland
and the Netherlands strongly against.