Europe is taking a deep breath Friday, which is good because there is still a lot of heavy lifting to do on its debt crisis.
Markets rallied after Germany backed off its demand that the next Greek bailout include mandatory concessions from the private sector lenders who financed Greece’s descent into the sovereign debt swamp.
The deal means that European policymakers are now counting on bankers to voluntarily roll over their loans to Greece, in a replay of a 2009 pact known as the Vienna initiative that forestalled a crisis in Eastern Europe.
Friday’s development, together with the International Monetary Fund’s decision to fund another installment of bailout payments to Greece, suggests the crisis may not be at a critical stage, as appeared likelier earlier this week.
European finance ministers are due to meet Sunday, and markets have set their hopes that a deal for further financing of Greece can be reached there.
Even so, investors remain nervous because the end game in Greece isn’t clear – and the same could be said of two other bailout recipients, Ireland and Portugal.
The anxiety is reflected in the high level of government bond yields and the still rising costs of insuring against defaults. Greek 10-year bond yields fell to 17%, but Portuguese and Irish yields remained near 11%, suggesting Friday’s reprieve is only temporary.
The spread on credit default swaps referencing Greek debt surged above 2,000 basis points, meaning it costs more than $2 million annually to insure $10 million of bonds for five years.
The European Central Bank, which has been propping up the weaker countries’ banking system by freely lending against collateral including government bonds, has been adamant about not forcing creditors to accept reduced repayment terms. Officials believe a haircut or even a debt maturity extension could send money out of Greece at an alarming rate, leading to a market collapse.
Germany now appears to have accepted this point, but whether the banks will actually step forward to make the deal work is far from settled.
“The main sticking point has been that the ECB would like the involvement of private creditors to be on a purely voluntary basis – but it is questionable how forthcoming investors would be,” says Jeavon Lolay of Lloyd’s Bank.
If the Europeans extend more financing and the banks decide not to play along, the political strife that has been wracking Greece could get even worse. The observation that rich bankers are being exempted from the intense belt-tightening being felt everywhere won’t make austerity measures any easier for policymakers to sell.
At the same time, it is clear that Greece and the other peripheral countries are not going to grow their way out of their troubles -- which means that every day Europe postpones its date with debt restructuring, the tab due taxpayers grows.
But that's later. For now, the ECB’s concern for now is avoiding a replay of Lehman Brothers, whatever the cost.
"Trying to eliminate moral hazard in the middle of a systemic crisis is like shooting yourself in the foot," ECB member Lorenzo Bini Smaghi said Friday. Not the most appealing idea -- assuming the alternative isn't shooting yourself somewhere else.