BRUSSELS First the good news: European leaders are nearing a strategy to counter the euro zone's sovereign debt crisis. Now, the less good news: it has some apparent flaws and may fall apart.
Under an emerging deal likely to be struck on Wednesday, Greece's debt will be reduced, European banks will be recapitalised, the euro zone's rescue fund will scaled up to provide partial insurance in sovereign bond markets, and Italy will be pressured into getting serious about economic reform.
Each of those planks may fall short of expectations.
The euro and stocks rose after Sunday's first part of a two-leg summit on hopes that Europe is finally close to adopting a comprehensive response to the two-year-old crisis, which has sent shudders through the global economy.
Yet it remains unclear whether the likely agreement will be enough to stop the rot and restore investor confidence, not least because it relies on some untested financial engineering.
Unable or unwilling to use the European Central Bank to provide the firepower to fight contagion in bond markets, the 17-nation single currency area is contemplating turning to China and other emerging economies for funds.
One idea on the table is to create a special purpose investment vehicle (SPIV), backed by the euro zone rescue fund, to attract foreign investors to buy sovereign bonds in the primary and secondary markets.
"It's incredible to think that we may give the Chinese a say in the euro zone because the Germans won't let us use our own central bank like a central bank," one EU official said.
Berlin and the ECB rejected a French proposal to turn the 440-billion-euro European Financial Stability Facility into a bank, giving it access to central bank funds, arguing it would breach a prohibition on monetary funding of governments.
French President Nicolas Sarkozy has backed down for now, but diplomats said Paris had put down a marker and the idea would return if the alternatives proved inadequate.
The two options still on the table involve using the EFSF to guarantee buyers of new Italian and Spanish bonds against the first slice of potential losses, and the special purpose vehicle to draw in outside sovereign and private wealth.
Creating the SPIV would require weeks of talks with investors and credit ratings agencies.
Analysts say the insurance scheme could create a two-tier bond market with old bonds worth less than new ones, and said the overall plan was still insufficient to tackle the crisis.
It may also fail to create sufficient demand for the more than 600 billion euros which Italy alone needs to issue in the next three years to refinance its maturing debt.
"Will guarantees of 20-25 per cent be sufficient to entice investors to buy the sovereign bonds of the countries concerned, given that the Greek example already shows that a much higher 'haircut' is possible in the event of a sovereign default?" asked Janis Emanouilidis, senior policy analyst at the European Policy Centre think-tank.
Governments are trying to convince banks and insurers this week to accept a "voluntary" write-down of 50-60 percent on their Greek bond holdings, while insisting that Greece is a unique case, not a precedent.
"Will the leverage effect be large enough to persuade markets that the EFSF is able to offer a liquidity net to all eurozone countries in danger?" Emanouilidis said.
Officials estimate the bond insurance option could scale up the available funds to about 1 trillion euros. But the whole edifice would crumble if France, the second largest EFSF guarantor after Germany, were to lose its AAA credit rating.
Two ratings agencies, Moody's and Standard & Poor's, said last week they might downgrade France due to the prospect of weak economic growth and rising contingent liabilities for banks and euro zone crisis management.
"This latest so-called solution is going to flop very, very quickly and when it does, France is going to be downgraded and then we'll really see a mess," said one EU adviser involved in drawing up possible solutions to the debt problems.
CHINESE GOODWILL, ITALIAN COMPLIANCE
Even if France keeps its top rating, the strategy seems heavily reliant on Chinese goodwill and Italian compliance.
It is not clear whether the SPIV scheme will entice China to increase its estimated 600 billion euro exposure to euro zone debt, courtesy of the 25 percent or so of its $3.2 trillion foreign exchange reserves that analysts believe is invested in euro-denominated assets.
Some EU officials say it is aimed primarily at attracting foreign banks rather than sovereign funds, but U.S. investors have cut back their exposure to the euro zone and seem unlikely to reverse that move in a hurry.
Chinese officials have argued that stabilising the euro zone is in Beijing's interest since Europe is China's biggest export market, but Internet bloggers and academics are urging caution in pouring more money into a Western crisis zone.
The head of China's sovereign wealth fund, Jin Liqun, who manages assets of over $230 billion, said last month that Beijing could not help heavily indebted euro zone countries without seeing a solution to the debt problem.
"China cannot be expected to buy high risk euro zone (instruments) without a clear picture of debt workout programmes," he told a conference in London on Sept. 29.
Jin also said Europe should recognise China's market economy status, which would give Beijing better protection from EU anti-dumping duties. Brussels says China must meet a series of criteria before it can receive the designation.
As for Italy, EU officials acknowledge they have scant faith in Prime Minister Silvio Berlusconi's will and ability to push through unpopular pension and labour market reforms and business deregulation to boost Rome's anaemic economic growth.
Sarkozy and German Chancellor Angela Merkel applied public pressure on Berlusconi on Sunday to speed up the reforms, but diplomats recall that after promising deficit-cutting measures earlier this year, the premier laughed them off within days.
It took another bond market frenzy to force the government to enact tougher austerity.
With Berlusconi fighting for political survival while facing three court cases for alleged fraud, tax evasion and frequenting an under-age prostitute, his capacity for imposing radical reforms on a fractious coalition and a divided parliament looks slim.
(Additional reporting by Natsuko Waki in London, Jan Strupczewski, Luke Baker and Julien Toyer in Brussels; Writing by Paul Taylor; editing by Janet McBride)
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