European leaders finally took a small step in their long journey ahead in resolving their debt crisis. However, many say that the details of the new plan are unclear and are also raising questions about the effectiveness of this plan.
By Ben Rooney
October 27, 2011: 4:05 PM ET
NEW YORK (CNNMoney) -- At long last, European leaders took a significant step forward on the long road toward resolving the eurozone's debt crisis.
But many details remain unclear and economists are already raising questions about the effectiveness of the latest plan.
"We certainly have moved a step in the right direction," said Guntram Wolff, deputy director of Brussels-based think tank Bruegel. "But this is definitely not the end of the story."
The plan includes a 50% reduction in the face value of Greek government bonds, steps to boost bank capital buffers and schemes to leverage an already stretched rescue fund.
The aim is to safeguard the stability of the euro currency by preventing the debt crisis in Greece from engulfing larger economies, such as Italy.
Investors welcomed the agreement, but analysts said the initial "sugar rush" response could prove short lived.
"This only increases the risks of disappointment, once the reality of the deal sinks in," said Natascha Gewaltig, chief of European economics at Action Economics in London.
Is Greece out of the woods?
Greece is currently being crushed by a debt burden equal to about 160% of its overall economy.
Under a hard-fought deal with bondholders, the Greek government will have that debt load cut to 120% of economic output over the next decade.
"Even if investors fully sign up to the plan, this would still be an unsustainably high level of debt," said Jonathan Loynes, chief European economist at Capital Economics. "Accordingly, further Greek restructurings or defaults seem very likely in the future."
The Institute of International Finance, which represents the private sector banks and investors that hold Greek bonds, signed off on the deal after EU leaders agreed to provide a €30 billion 'sweetener.'
Despite the overall agreement, certain technical aspects of the writedowns are still pending.
Charles Dallara said the institute looks forward to finalizing a "concrete agreement" on the Greek debt discount.
In addition, the rescue package also calls for €100 billion of bailout funds for Greece that will be backed by EU nations and the International Monetary Fund. Including the €30 billion contribution to the deal with bondholders, the total bailout tab for Greece comes to €130 billion.
This program is expected to cover the nation's financing needs through the end of 2014.
The latest bailout would be in addition to a €110 billion rescue package Greece received last year. The terms of the second package are expected to be negotiated by the end of this year.
Does the bank plan go far enough?
European banks will be required to hold more high-quality assets on their books as a shield against potential losses on sovereign debt.
The leaders agreed that banks should raise "core tier one" capital levels to 9%, after accounting for declines in the value of government bonds.
That means that European banks would need to raise €106 billion to meet the new targets, according to the European Banking Authority.
The plan is for banks to get government support only if they cannot raise money by selling assets or converting debt into equity.
In addition, the EU agreement says "guarantees on bank liabilities" may be required to help banks that are struggling to secure financing in the wholesale funding market.
But economists say it remains unclear how EU governments will pay for all of these measures.
"European bank recapitalization remains an aspiration rather than a reality," said Ian Gordon, a banking analyst at Evolution Securities in London.
Will the rescue fund live up to its mandate?
The leaders outlined two ways the €440 billion European Financial Stability Facility could be leveraged up to about €1 trillion.
Under one method, the fund would partially insure new issues of government bonds to ease the market for Italian and Spanish debt.
"The full details are still hazy and will only be agreed in the coming months," said Gewaltig. "But the idea is that instead of handing out the money, the EFSF will issue guarantees to attract four times the amount in investment in eurozone bonds."
The leaders also agreed to create one or more special investment vehicles to combine the fund's resources with investment from the private sector. The proceeds could be used to fund bank recapitalization and additional bond purchases.
The goal is to attract capital from cash-rich sovereign wealth funds in China, Russia and other developing nations. However, analysts say the structure of the special investment vehicles remains unknown.
French president Nicolas Sarkozy briefed Chinese President Hu Jintao on the latest EU rescue plan Thursday. Hu acknowledged European leaders' efforts but made no mention of whether China would be interested in participating.
"It is not in China's interest to fund this scheme," said Carl Weinberg, chief economist at High Frequency Economics. "It is better advised to sit this out and buy assets at liquidation than to invest in a sinking ship."
What about Italy?
The EU outlined plans to set stricter budget rules and increase economic competitiveness across the euro area.
The leaders praised recent efforts by Italy and Spain to cut public spending and reduce unsustainable levels of debt.
But economists say political instability in Italy remains a major obstacle for the nation to successfully implement promised reforms.
Italy has committed to raising the retirement age to 67 by 2026, according to a "letter of intent" from prime minister Silvio Berlusconi.
The debate over this issue in the Italian Parliament nearly broke the Berlusconi government, with lawmakers literally coming to blows earlier this week.
The ability of the Italian government to enact broad structural reforms "is absolutely key to the success of the whole endeavor," said Bruegel's Wolff.
"If Italy doesn't mange to make the reforms that are necessary, we will face extremely difficult decisions in the euro zone," he said.
How does the ECB fit in?
The role the European Central Bank will play in ongoing rescue efforts is also a major unknown.
The ECB has been buying billions of euros worth of government bonds under a controversial emergency program. The bond buying has already led to the resignation of two key German central bankers who objected to the ECB taking on risky sovereign debt.
Under its single mandate to "maintain price stability," the ECB is required to control inflation by managing interest rates. But the bank has argued that buying bonds is necessary to ensure that it can fulfill its mandate amid dysfunctional markets.
"We fully support the ECB in its action to maintain price stability in the euro area," the EU leaders said, according to the conclusions from the most recent summit.
But economists warn that the euro area needs a credible buyer of last resort for stressed government bonds.
"In our view, the role which the ECB will or will not play remains crucial," said Holger Schmieding, chief economist at Berenberg Bank.
-- CNN's Jaime FlorCruz contributed from Beijing
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