Private holders of Greek debt may need to accept losses of up to 60 percent on their investments if Greece's debt mountain is to be made more sustainable in the long-term, a downbeat analysis by the EU and IMF showed on Friday.
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Euro zone finance ministers threw Greece a lifeline on Friday by agreeing to approve an 8 billion euro loan tranche that Athens needs next month to pay its bills.
But the European Commission, European Central Bank and International Monetary Fund -- the so-called troika -- issued a gloomy report on Greece's ability to pay its debts.
Among three scenarios it examined, the only one that would reduce Greece's debt pile to 110 percent of GDP -- a level still regarded as high -- was one in which private bond holders agreed to a 60 percent haircut.
"To reduce debt below 110 percent of GDP by 2020 would require a face value reduction of at least 60 percent and/or more concessional official sector financing terms," the debt sustainability report, obtained by Reuters, showed.
A footnote explained that the ECB disagreed with including the scenarios in the report, concerned that private sector lenders would refuse to agree to such a steep writedown voluntarily, effectively leading to a fullscale Greek default.
The report also said Greece's debt pile could peak at 186 percent of GDP, from around 160 percent currently.
The euro zone finance ministers said the 8 billion euro tranche, the sixth installment of 110 billion euros of EU/IMF loans agreed last year, would be paid in the first half of November, pending the IMF's sign-off. That should allow Greece to avoid defaulting on its debt this year.
Meeting ahead of a summit of EU leaders on Sunday, finance ministers also indicated that deep divisions between France and Germany over how best to scale up the euro zone's bailout facility to give it more firepower may have been overcome.
France believes the most efficient leverage method would be to turn the European Financial Stability Facility (EFSF) into a bank, allowing it to access ECB liquidity. Germany and others opposed this, and France's finance minister said he was not going to be unnecessarily confrontational over the issue.
"We will not make it a point for definitive confrontation," he told reporters as he left the meeting late on Friday. "What matters is what will work. And what will work is something that is dissuasive and an effective firewall."
Austria's finance minister, Maria Fekter, who arrived at the meeting saying there were seven options on the table for leveraging the EFSF, left the meeting saying there were now two, indicating that some progress had been made.
If France does ultimately drop its insistence on the EFSF being turned into a bank, then the most likely method for scaling up the EFSF is expected to be some form of insurance programme aimed at restoring confidence in euro zone debt.
A group of 10 major financial companies, including banks, insurers and global bond fund giant PIMCO, wrote to EFSF chief Klaus Regling on Friday saying partial insurance of sovereign bonds could be a viable means to secure private funding for euro zone states "if implemented in size".
"The ability of the EFSF to potentially write significant amounts of such 'insurance' without any further increase to the existing commitments should be an important element in any comprehensive plan by the European government to address the crisis," the letter, seen by Reuters, said.
By guaranteeing only a portion, perhaps a third or a fifth, of each debt issue, the available EFSF funds could stretch 3-5 times further, increasing it to around 1 trillion euros.
However, analysts are concerned that such a plan could create a two-tier bond market, with bonds that have guarantees trading at a premium to the secondary market -- an outcome that could exacerbate market turmoil. Some analysts believe chosing such an option would be the worst outcome of the summit.
BLIZZARD OF MEETINGS
In a related set of discussions, EU finance ministers will on Saturday meet to discuss the requirements for recapitalising the European banking system, with the aim of making it more resilient to the possibility of a default in Greece and any wider contagion across the continent.
EU leaders will then meet on Sunday to see if they can agree a comprehensive plan to resolve the two-year-old debt crisis, with another summit scheduled for Wednesday, Oct. 26, because no breakthrough is expected on Sunday.
German Chancellor Angela Merkel, French President Nicolas Sarkozy and Europe's top two officials, European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso, will also meet late on Saturday to try to break the deadlock before Sunday's summit.
Sarkozy appeared isolated after an acrimonious meeting in Frankfurt on Wednesday, when he pushed the idea of turning the EFSF, a 440-billion-euro ($600 billion) fund, into a bank.
Germany, the ECB and the European Commission all argued that the move would violate an EU treaty prohibition on monetary financing of governments.
"The path is closed for using the ECB to ease liquidity problems," Merkel told conservative lawmakers in Berlin, according to participants at the private meeting.
The outcome of the Sunday and Wednesday summits will determine whether investor confidence in the euro area can be restored. It will also influence whether an expected Greek debt write-down triggers a chain reaction of financial turmoil across Europe, hitting French, German and other banks -- and potentially pushing Italy and Spain deeper into the mire.
EU officials say the total amount required to shore up the region's banking system is just short of 100 billion euros. Those banks that cannot raise money on the markets will have to turn to national governments, and finally to the EFSF.
European banks will be required to increase their core tier one capital ratio to 9 percent to help them withstand losses on sovereign debt, banking sources said.
FRENCH RATING IN SPOTLIGHT
An EU source said France, which has presidential and parliamentary elections from April to June and is desperate to keep its top-notch AAA credit rating, was pressing for banks to be given at least nine months to meet the target.
France fears its credit rating could come under threat if the wrong method is chosen to scale up the bailout fund to prevent contagion spreading to Italy and Spain, the euro zone's third and fourth largest economies.
Ratings agency Standard & Poor's said on Friday it was likely to downgrade France and four other states if Europe slips into recession. It was the second agency this week to cast doubt on France's rating after Moody's on Tuesday.
Underlining the threat the euro zone crisis poses to the global economy, U.S. President Barack Obama held a video conference with Merkel and Sarkozy on Thursday, reiterating that he hopes a solution will be in place in time for a summit of G20 leaders in Cannes, France on Nov. 3-4.