Europe is paving the way for Greek bailout

While the euro zone officials are in favour of a bailout, doubts remain how much Greece will deliver on its austerity promises .

After months of brinkmanship, leaders of the euro zone finally paved the way for the approval of a fresh 130 billion euro bailout for Greece at a meeting of European finance ministers.

At the same time, the European Central Bank began to swap its holdings of Greek bonds for new debt to shield it from losses being absorbed by private creditors. The bailout is needed to avert a potentially devastating Greek default; Greece must redeem 14.5 billion euros ($19 billion) in bonds by March 20. After a recent conference call, the German chancellor, Angela Merkel; Greek Prime Minister, Lucas D Papademos; and the Italian Prime Minister, Mario Monti, issued a statement saying they were confident a bailout deal could be reached.

In doing so, euro zone leaders appeared to have put the fraught negotiations over the bailout and bitter exchanges between Greek and German officials, which occurred earlier this week, behind them.

 Euro zone officials will meet to try to tackle technical issues blocking the loan package. Chief among these is the extent to which the latest bailout will succeed in cutting Greece’s stifling debt.

Recent calculations suggest that, instead of reducing Greece’s debt to 120 percent of gross domestic product by 2020, the efforts – which include losses imposed on private creditors holding Greek bonds plus the austerity measures – would bring the level down to around 129 percent, said an official briefed on the discussions, who did not want to be identified. It remains unclear how that gap would be closed.

The euro zone ministers are also looking for tough oversight measures to ensure that Greece sticks to any bailout conditions negotiated. One idea discussed during a teleconference among euro zone ministers of splitting the bailout package and delaying part of it until after the Greek elections, has foundered, said officials.

The ECB’s decision to exchange its holdings of Greek bonds for new debt also foreshadows a possible deal. A person with direct knowledge of the decision, who confirmed the ECB’s plans to exchange the debt, said it was part of a maneuver to avoid having to share in losses absorbed by private investors.

The plan to trade bonds with an estimated face value of 50 billion euros is being carried out over the objections of the German Bundesbank, the person said, which fears that giving the ECB preferential treatment could further undermine investors’ willingness to buy the debt of other weakened euro zone countries, like Portugal.

Investors would worry that their losses would be greater if Portugal or another country also restructured its debt.

The ECB swap comes as Greece nears agreement with its creditors to reduce its debt load by about 100 billion euros, resulting in losses of nearly 70 per cent to bondholders. The plan is designed to be voluntary, but the Greek Parliament is expected to pass a law to prevent a minority of investors from holding up the deal.

There is also concern that any move to give the ECB preference over other bondholders could draw legal challenges, especially from hedge funds that bought Greek bonds at steep discounts. Some funds have gambled that the final agreement with creditors will still allow them to make a profit on the bonds.

It is unclear if the swap would protect national central banks, like those in Greece, Cyprus or France, that own Greek bonds separately from the ECB.

By issuing new bonds to the ECB, Greece would exempt the central bank from the law being discussed and from sharing in the losses, meeting the demands of Mario Draghi, the ECB president, who has insisted that the central bank not be included.

The president of the Bundesbank, Jens Weidmann, has also ruled out any ECB participation in the debt write-down, saying that would amount to the financing of governments by the ECB and would violate the bank’s charter. The Bundesbank does not own any Greek bonds.

Draghi has said the ECB will pass on any future profit from its bond holdings to countries in the euro zone. But the Bundesbank, the largest and most powerful central bank in the euro zone, opposes passing on any profits before they are realised, which would take place over the next several years. The ECB started buying bonds from Greece, Portugal and other troubled countries in May 2010 to help stop a slide in prices.

But the intervention, totaling almost 220 billion euros so far, did not prevent effective interest rates on Greek bonds from soaring, and the ECB has recently dialed back the program.

During the past week, the ECB spent 59 million euros in bond markets, a relatively small amount compared with other weeks.

The plan for the ECB to swap bonds is likely to come as a disappointment to the private holders of Greek bonds, who hoped the ECB would contribute. It also raises the question of whether, without help from the ECB, Greece’s debt can be reduced to a level that the country has a realistic chance of repaying.