The 'solution' to Europe's debt crisis

by David Taylor

It was a big week. It was a week that saw European leaders come together to work through a plan they hope will solve the debt crisis plaguing the region.

They came up with a plan of attack that looked at three broad issues.

Firstly, and perhaps most importantly, they're suring up the banks - raising the tier one capital ratios, and providing enough liquidity to support them in the event of some kind of financial trauma - in an effort to avoid a run on banks or contagion if we see a sovereign default.

The second aspect of the plan was to increase the size of the European Financial Stability Facility (EFSF) to over a trillion euros. Leaders have decided to leverage the fund, or use its capital to borrow more money, and offer it as an asset choice to offshore investors - in an effort to boost its fire power and share the risk burden it inherently has.

The final aspect is the development of an insurance policy for the EFSF. That is, insurance will be provided on debt issued that is backed by the EFSF. This is designed to encourage demand in EFSF debt, lower the yield and make repayments easier.

So will it work? The short answer is we don't know. If you think about it though, there are two major developments with this proposal. The first is disappointing - Europe has simply decided to increase the fund through debt (leverage), which is what got us into this mess in the first place. The second is more encouraging but unrealistic. Opening the fund to foreign investment is essentially asking the whole world to help Europe dig its way out of debt. Global debt markets though are not charities. If it's not a sound investment, the demand simply won't be there.

No body wants to see this plan put to the test (through a sovereign debt default for eaxmple), but that may be the only way to see if the plan is water-tight.

David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.