European officials are working on a grand plan to restore confidence in the single currency area that would involve a massive bank recapitalisation, giving the bailout fund several trillion euros of firepower, and a possible Greek default.
German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone's sovereign debt crisis is spiralling out of control.
Their aim is to build a "firebreak" around Greece, Portugal, and Ireland to prevent the crisis spreading to Italy and Spain, countries considered "too big to bail."
According to sources, progress has been made at the G20 meeting in Washington, where global leaders piled pressure on the eurozone to fix its problems before plunging the world back into recession. In a G20 communique issued on Friday, the world's leading economies set themselves a six-week deadline to resolve the crisis -- to unveil a solution by the G20 summit in Cannes on November 4.
Sources said the plan would have to be released as a whole, as the elements would not work in isolation.
First, Europe's banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the E2.5 billion (L2.2 billion) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.
Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) -- the eurozone's E440 billion bailout scheme.
The second leg of the plan is to bolster the EFSF. Economists have estimated it would need about E2 trillion of firepower to meet Italy and Spain's financing needs in the event that the two countries were shut out of the markets. Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.
The complex deal would see the EFSF provide a loss-bearing "equity" tranche of any bailout fund and the ECB the rest in protected "debt." If the EFSF bore the first 20 percent of any loss, the fund's warchest would effectively be bolstered to E2 trillion. If the EFSF bore the first 40 percent of any loss, the fund would be able to deploy E1 trillion.
Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic.
The arrangement is similar to the proposal made by US Treasury Secretary Tim Geithner to the eurozone at the September 16 EcoFin meeting in Poland. Gathering turmoil in financial markets has convinced Germany to begin work of some kind of variant of the US plan, despite having initially rejected the notion as unworkable as threatening to compromise ECB independence.
The proposal would be hugely sensitive in Germany as its parliament has yet to ratify the July 21 agreement to allow the EFSF to inject capital into banks and buy the sovereign debt of countries not under a European Union and International Monetary Fund restructuring programme. The vote is due on September 29.
As quid pro quo for an enhanced bailout, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private-sector creditors would bear a loss of as much as 50 percent -- more than double the 21 percent proposal currently on the table. A new bailout programme would then be devised for Greece.
Officials would hope the plan would stem the panic in the markets and stop bond vigilantes targeting Italy and Spain, which European and IMF figures believe should not be in any immediate distress but are in need of longer-term structural reform.
Delegates at the IMF meeting in Washington claimed that there had been "a visible shift in pace and mood" to address sovereign debt problems, particularly in the eurozone.
But George Osborne, the Chancellor, said today: "No one here has put forward a plan for that. Greece has got a programme and needs to implement it."