An emergency Franco-German summit on October 9 failed to iron out all the differences between the two sides regarding both the size of a Greek debt writedown and how to cushion the blow to the ailing European financial sector.

Addressing a joint news conference after their two-hour meeting in Berlin, German Chancellor Angela Merkel and French President Nicolas Sarkozy said they would wait for the report of the troika inspectors about the sustainability of the Greek debt before taking final decisions by the end of the month.

“We are in close contact with the troika and Greece is a part of the eurozone,” said Sarkozy.
“We won’t go into any detail,” Markel said. “We shall present a comprehensive package for the stabilization of the eurozone at the end of the month.”

But both of them emphasised their determination to support EU banks that are most exposed to the eurozone debt crisis.

“We are determined to do whatever is necessary to safeguard the recapitalization of our banks,” Merkel said. “Soon, the EFSF [European Financial Stability Facility] will have the backing of all eurozone members,” she noted.

Stress test

But she didn’t elaborate on the role of the 44bn euro bailout fund in the recapitalisation of banks that will be adversely affected by a substantial haircut on Greek debt.

“Germany and France want to apply the same criteria and these criteria will be acceptable by all sides,” Merkel stressed. “We shall request from all competent authorities to make sure that what we are doing is sustainable,” she added.

The European Central Bank has already issued a circular to its 17 member banks in the eurozone on October 7 to provide information on the exposure of private banks in their respective countries to carry out stress tests on the assumption of a Greek debt haircut ranging between 30 and 60 percent.
With French banks facing a greater risk from a Greek haircut than those of Germany, Paris favours the scenario of a smaller – 30 percent – haircut.

This would be carried out over the next six months, along the lines of the eurozone summit decision on July 21, which called for voluntary participation of private bondholders, thus ruling out a “credit event” of outright default.

Risky endgame

The French side would also prefer the EFSF to carry out the bulk of bank recapitalisations in order not to risk losing its triple-A credit rating, if its budget is overburdened with expensive French private bank bailouts.

By contrast, Berlin has signalled its preference for a drastic solution of 50-60 percent haircut by December, which entails a credit event as well as a process of bank recapitalisations undertaken by national governments rather than eurozone institutions such as the ECB and the EFSF which the German taxpayer would have to finance.

Although both Merkel and Sarkozy reiterated their “wish” for Greece to remain in the eurozone, the risk remains that even the most well thought-out debt-writedown could get out of hand.

Without solid guarantees of ECB support, this could lead to a simultaneous collapse of Greek public finances and the local financial system, making an exit from the euro inevitable.