by Natalie de Vallieres, BBC News and the Economist, for the BBC and the Economist's Biodun Iginla

The EU-led aid package is huge—but more will be needed

Apr 11th 2010 | BRUSSELS | From The Economist online

AFTER two months of bluff and bluster, the European Union finally unveiled the details of a financial rescue mechanism for Greece on April 11th. The package was unveiled in an unusual Sunday press conference in Brussels, following a round of telephone conference calls among the governments of the 16 countries that use the single currency. It would offer Greece up to €30 billion ($40 billion) in bilateral loans in the first year, with more available in 2011 and 2012. Interest rates would be set at around 5% for three-year loans, at least to start with. That is a rate about midway between the punitive rates that markets have been demanding from Greece in recent days, and the interest rates being paid by the next weakest members of the euro-zone club, such as Portugal.

The interest rate reflects the need to offer Greece a breathing space from the markets, while mollifying German-led calls to avoid any hint of a “subsidy” for an errant and profligate member of the euro club. When and if (though it is surely a case of when) Greece seeks to activate the mechanism, the loans from the other 15 euro-zone members would be topped up by substantial funds, perhaps amounting to €15 billion, from the International Monetary Fund. The IMF would set its own interest rates and conditions for its loans, the first of which could be available within hours of a Greek request.

Jean-Claude Juncker, the prime minister of Luxembourg, who also chairs the Eurogroup of euro-zone finance ministers, insisted that the mechanism, if activated, would leave intact the “no bail-out” clause in the EU’s treaties, on the grounds that “the loans are repayable and contain no element of subsidy.”

Germany will contribute most—but its banks have a lot at stake

As the largest EU economy, Germany will contribute more than any other country towards a Greek rescue (though German banks also hold large amounts of Greek government debt, and thus would suffer greatly in the event of a default). In these recessionary times, German public opinion is strongly opposed to anything amounting to a handout for Greece, and Angela Merkel, the German chancellor, has duly taken a tough line in advance of important regional elections her coalition must fight on May 9th.

Backed by Austria and the Netherlands, Mrs Merkel repeatedly demanded that Greece be made to pay market rates for any rescue loans (even though such a rescue would only logically be necessary once market rates reached levels Greece could not afford). The German government has also said that the country’s federal constitution outlaws any help that might undermine the strict rules created to ensure the stability of the single currency.

The Brussels announcement amounted to the third and most detailed attempt by EU bosses to sell a tricky message to financial markets and voters alike: that Greece would not be allowed to fall victim to a sovereign credit crunch, but that the euro zone stands by its founding principle that profligate members cannot be bailed out.

EU leaders first pledged in February they would not allow any member of the euro zone to fall victim to a sovereign credit crunch, but failed to explain how they would carry out this promise—as if hoping that their resolve alone would frighten the markets into submission. In March, tense negotiations led by the two largest euro members, France and Germany, generated a second pledge with more details—such as a substantial lending role for the IMF—while still maintaining the polite fiction that a rescue mechanism might never be needed.

“...just like a gun on the table...”

As so often before, the Greek finance minister, George Papaconstantinou, told reporters that Greece had not sought help, and hoped to continue borrowing on financial markets. However, his boss George Papandreou, the prime minister, displayed striking candour, telling the Sunday edition of To Vima, a newspaper: “The question remains whether this mechanism will convince markets just like a gun on the table. If it does not convince them, it is a mechanism that it is there to be used.”

Whether it does convince the markets may soon be clear: On April 13th Greece was due to try to auction a fresh slice of short-term debt. The government needs to borrow about €11 billion by the end of May to roll over maturing debt and service interest charges. All in all, the country may need to borrow more than €50 billion in 2010 (estimates vary).

Greece's debt had been downgraded to just a notch above “junk”

In recent days market anxiety had pushed Greece’s long-term bond yields to their highest levels since the country joined the single currency nearly a decade ago, partly thanks to uncertainty over the EU’s readiness to provide aid. Amid press reports of wealthy clients withdrawing deposits from local banks and sharp falls on the Greek stockmarket, Fitch, a credit-rating agency, downgraded the country’s debt by two notches to BBB-, the lowest investment grade, just above “junk” status. In its announcement on April 9th, Fitch cast doubt on the Greek government’s vow to cut its public deficit by a third—the equivalent of 4% of GDP—this year, in light of the country’s deepening recession and the rising costs of servicing a €300 billion mountain of public debt.

In theory, the rescue mechanism is equipped with a double lock: once Greece has decided it has reached the end of the road with normal market borrowing, officials from the European Central Bank and European Commission must agree that Greece is out of options. In practice, once Greece signals it has lost the confidence of the markets, things will move fast.

Representatives from the commission, the ECB and the Greek government will meet IMF officials on April 12th to discuss the conditions that would be imposed on Greece and the exact size of the IMF contribution. The combined EU-IMF package is a substantial one but few imagine that it will be a one-off: on Sunday Reuters news agency quoted a Greek official as saying the country is likely to need a total €80 billion of loans over three years. If so it will be the largest multilateral rescue of a debt-ridden country yet seen.