Lots of important stories coming out this weekend, and its going to be a week dominated by headlines regarding the European sovereign debt crisis. We had important meetings galore, highlighted by discussions at the IMF and the G-20.

IMF Meetings - Geithner Urges Europe to Boost the Size and/or Leverage of the EFSF

width=356Geithner again made the case for European leaders to increase the firepower of hte ESF, the temporary bailout fund being used by Europe to fund current bailouts. Failure to act carries the threat of cascading default, bank runs and catastrophic risk Geithner said in a statement. He has been lobbying the Europeans to use policy tools the US used after 2008, including leveraging the EFSF so it can lend out more even without increasing its size.

The message was loud and clear that Europeans have to pass the changes to the EFSF agreed upon on July 21st, including the ability of it to buy bonds in the secondary market, as well as give lines of credit to troubled countries, and also to inject funds directly and help recapitalize banks. The extra responsibilities for the fund will tax its current 440 billion-euro size ($595 billion), and why even German Finance Minister Wolfgang Schaeuble said leverging up the rescue fund is a possibility.

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Look for talk of that to help the Euro.

G-20 - Agreement to Let Greece Default, Create Firebreak for Contagion, Recapitalize Bank?

A UK Treasury deputy spilled the beans about discussions behind closed doors at the G-20.

It seems as part of the discussions Greece would be allowed to default on part of its staggering $475 billion of government debt, with a write-down closer to the 50% range and not the 21% currently agreed upon from the July 21st Summit. Greece would get some addition aid to help pay its bills for another few months, but by cutting its debt load the country could return to debt sustainability.

As part of this deal, Europe's banks would get funds for recapitalization via the EFSF or states in the form of a European TARP. The 3rd, and most important step, would be for the European to put together the firepower needed to defend other euro-zone countries and stop contagion from spreading from Greece to Ireland, Portugal, Spain and Italy.

It was reported, but not confirmed, that Merkel and Sarkozy were working on a $2 trillion plan to create a firebreak that would help stop the spread of the crisis. In exchange, Germany would extract the 50% haircut from Greek bond holders. Bank of Canada Governor Carney said 1 trillion euros would have to be deployed.

A Greek default can help put an end to an open festering wound in financial markets, bringing some stability to an uncertain situation. However it also brings forth those losses to bondholders and can still have damaging effects for banks with large exposure to periphery countries' sovereign debt.

However, done this way, combining an orderly default with support measures that are strong enough to cope with contagion, then it may be the best choice out of a bad lot. An un-orderly default in Greece would be a huge shock to the financial system. Still, it make take time to put the pieces in place, and it will be about 6 weeks until the G-20 meets again.

Pressure Builds on European Leaders, Will it Mean Action?

The UK Chancellor of the Echequer George Obsorne said a solution is needed by that time, when time G-20 leaders meet in Cannes, France on Nov3-4. The euro zone has six weeks to figure this out he said.

The main thing needed by Parliaments in Europe would be to pass the EFSF changes of July 21st. Germany is set to do so on September 29th, which will be watched closely as a proxy for how much support Merkel has to push forward more support measures.

For all the talk of the EFSF, its still a temporary fund that was set up while the another permanent fund the European Stability Mechanism, or ESM, was being rolled out in 2013. This fund would bring more clarity and stability, and would allow for an orderly default of a sovereign.

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The discussion coming out of the weekend is that the ESM could be set up to run by next July instead of in 2013, something that while is a step towards calming markets, is again something the markets will have to have patience for.

The ECB has also signaled a bigger willingness to help by offering banks unlimited liquidity for up to a year as soon as next week, and there has been lots of talk of the ECB reversing course and cutting interest rates back down to 1% when the ECB meets next on October 6th.

Impact on the EUR

Some of these steps - leveraging up the EFSF, moving forward implementation of the ESM, and talk of recapitalization banks - should help provide some relief to the market. But the waiting and uncertainty involved in all of this will continue to exert pressure on the EUR. The market has priced in a Greek default, and its just how the European leaders want to to respond to this situation that may make or break how financial markets react in these next 6 weeks...

That should catch you up on many of the developments, and make sure to keep checking back to FXTimes.com throughout the week as we discuss the impacts of these fundamentals on the Euro.

Nick Nasad
Chief Market Analyst
FXTimes