Under intense market pressure, the European Union has unveiled details of a permanent system for resolving future debt crises, breaking a taboo on eurozone sovereign states ever needing to restructure their debts.
A combination of Franco-German political will — essential to any EU accord — detailed input from the European Commission and the private sector, and guidance from the European Central Bank's president helped clinch a deal at a critical moment.
But despite the angst and sweat that has gone into drawing up the European Stability Mechanism (ESM), financial markets appear unconvinced that it will clear up Europe's debt hole.
Since Germany and France agreed in Deauville, France, on Oct. 18 that they wanted a permanent system for handling debt crises, there has been mass uncertainty in financial markets about what impact it would have on private holders of sovereign bonds, an uncertainty that aggravated the current crisis.
On Sunday, France and Germany came together again, this time in closer coordination with others, to put flesh on the bones of the ESM — a radical system for handling eurozone sovereign defaults or restructurings from mid-2013 on.
The IMF-backed mechanism would hardly have been thinkable a year ago. But the debt crisis has overhauled thinking. The very idea of a European sovereign defaulting, like some 1980s Latin American or 1990s Asian emerging economy, is no longer taboo.
The 16 countries that share the euro single currency — some of the world's largest and most stable economies — will now have a fixed system for handling default, with private bondholders sharing the cost with taxpayers.
"If you had asked me a year ago, I would have said such an idea was impossible," said Andre Sapir, a senior fellow at Bruegel, a leading Brussels think-tank, and the co-author of a paper this month whose ideas were incorporated in the ESM.
"One is now accepting an idea which itself is an incredible leap — that a euro area country's debt may be restructured. That was unthinkable, it was something just for emerging countries. In that sense, this is a real revolution."
Without Germany and France, the two largest European economies and the traditional drivers of the European Union, working closely together, a deal acceptable to the other 14 eurozone member states would probably not have been possible.
According to French officials, they were responsible for convincing Germany that the original idea of private bondholders facing automatic writedowns — also dubbed haircuts — in a restructuring had to be softened to keep financial markets onside and support the euro.
"Yesterday, we achieved something almost as important as the aid to Ireland," said Economy Minister Christine Lagarde.
"That is we managed, thanks to the determination of the president, to convince Mrs. Merkel to put in place (softer) rules regarding the private sector."
But it is also clear that other eurozone countries had input. Finland, for example, was the first to say collective action clauses, which compel minority bondholders to accept majority holders' position, should be part of all new eurozone debt issuance. Such clauses will be necessary from June 2013.
Eurozone sources say there was also critical input from the European Commission, the EU executive, which led conference calls with the ECB President Jean-Claude Trichet and the chair of the Eurogroup, Jean-Claude Juncker, on Sunday morning.
In all the discussions, Trichet, who has perhaps the most experience of speaking to the financial markets and charting a course through crisis, was an indispensible voice.
"He is a man with huge experience in a crisis, and he has a job that gives him huge credibility. Given the combination of the two, I would say, yes, he is playing a very important role," said Sapir. "And the Commission too," he added.
MARKETS REMAIN UNCERTAIN
But the question remains whether it will calm the storm.
More details of how the European Stability Mechanism will work will be discussed by EU finance ministers at a meeting on Dec. 6-7, and EU leaders are expected to sign off on the final elements of the mechanism at a summit in Brussels on Dec. 16-17.
The mechanism does not come into force until mid-2013, and will be reviewed by the Commission and ECB in 2016.
In the meantime, there is plenty of time for pressure to be piled on periphery eurozone debt, particularly Portuguese and Spanish bonds, as was the case on Monday.
Some financial market analysts expressed optimism on Monday about the ESM and how it would work. "Overall, there is a lot of positive news for the market in the statement" on the ESM, said Jens Larsen, chief European economist at RBC Capital Markets.
But Mark Grant, managing director of corporate syndicate and structured debt products at Southwest Securities in Florida, remains skeptical the ESM can clear up the debt mess.
"What is going on is Germany and France doing everything they know how to shift responsibility from taxpayers to debt owners without upsetting bondholders so much that yields across the eurozone rise to unsustainable levels," he said.
"If you think their proposal through, it will now be the EU in conjunction with the IMF who will decide when bond owners, even senior bond debt owners, get a haircut or not.
"Do you honestly think that professional money managers will stand for that great unknown? No, many will exit the European sovereign debt sector," he said.
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