Euro zone: Hopes are waning that euro zone leaders will agree on serious long-term reforms to solve the debt crisis in March. The odds are still that they will agree on some pain relief for Greece and Ireland, and they may convince Portugal to accept a bail-out. Markets have already lost some of this year's early euphoria, but there is room for further fallout if the euro zone disappoints, potentially dragging Spain back into the mire.
At the very least, finance ministers are expected to increase the European Financial Stability Facility’s lending capacity to the full ¤440 billion originally planned, rather than the ¤255 billion imposed by rating agency rules. That shouldn’t be too much of a problem.
The next issue is cost. Current lending rates from the EU’s aid mechanisms are high, generate political controversy and tend to worsen recipient countries’ solvency problems. Further, making bailouts less painful will be needed to persuade Portugal to accept one. Finally, the new Irish government will want to renegotiate the terms of last December’s package, and the euro zone may want to show some goodwill. But to make a difference, rates will have to be much lower than currently, or loans extended over a much longer time period. All this could lead to legal challenges in Germany.
Other, more radical, measures are looking less likely by the day. It has been suggested that the EFSF be allowed to buy bonds to help orchestrate debt restructurings. But as they’re facing defeat in Germany’s regional elections, Chancellor Angela Merkel’s coalition partners and her own party are proposing laws preventing such schemes for the euro zone’s future as a permanent bailout mechanism. This should harden Berlin’s stance at the summit. More exotic ideas, such as allowing the EFSF to recapitalise banks directly, look even less probable.
Investors hoping for a solution to the euro zone's fundamental problems of peripheral insolvency and bank capitalisation will probably have to wait, perhaps for another round of talks. Spanish credit default swaps are 56 basis points wider than their tightest level in February, but are still 86 basis points inside their widest point in January, suggesting they could widen further if the final package is disappointing. Spain could suffer if renewed market tensions make it harder for its banks to refinance debts and for the government to fund recapitalisations. Madrid isn't out of the contagion vortex yet.