European leaders meet tomorrow, and I am not the only one that believes it is maybe the most important meeting yet. When the crisis was at the periphery, it was easy to postpone, buy time, not a humongous issue, it was just a fiscal problem of small countries. Now that Italy is at risk, the problem is more real. We have said from very early on that this was an institutional problem of the euro itself, that the monetary union without a fiscal union could not work, and the fact that the crisis is now advancing towards the EU core should be making it clear to EU leaders (especially the Germans and the French).

Italy’s sovereign debt market is the biggest in Europe, with $2.6 trillion outstanding, or 120% of GDP. The approach taken with Greece, Ireland and Portugal is clearly not feasible if the situation got to be much worse for Italy, and some even point to France next. The probability of such event is not yet significant, as Italy can only have a solvency problem if its rates were to be much higher for a long period of time. But the fact that rates are now higher should be telling EU leaders that a broader and more comprehensive approach is needed to stop the crisis from spreading from insolvent countries to those still solvent, and clearly differentiate the latter. Who judges who is who? Well, markets to some extent have, and basic analysis is not that difficult. But solvency has a large component of endogeneity (it can or cannot, depending on a few developments, some internal), and politics will clearly play a key role in that determination. Thus, Italy and Spain have to be solvent, and could be solvent.

As we have said many times before, the institutions underlying the euro are flawed, and this is the issue at hand, not Greece, not Portugal. This is a bigger crisis, a much bigger problem. The ideal solution here is to design an efficient and swift debt restructuring for those countries that are clearly not solvent under most realistic scenarios (Greece, and potentially Portugal, not clear if also Ireland), with the example of Uruguay 2003 as the clear best mechanism (see ‘Germany’s Uruguayan steps on Greece‘, June 9, 2011). At the same time, the EU should make a decisive irreversible and large step towards fiscal union, which can be done in the form of what is now called Eurobond. If the EU issues EU debt to fund its members (excluding insolvent ones that have not restructured), then Italy would be able to get funding at a much lower rate (something in between Bunds and its current rate, hopefully closer to Bunds), making its debt dynamics sustainable. One idea here is to make the first 60% of each GDP EU debt, and anything above that each country would issue under its own name in junior notes. Germany and the rest of the core would only be backstopping solvent countries that somehow end up not paying, as opposed to lending money today. This is not a totally new idea, and some EU leaders have already proposed it (i.e. Luxembourg Prime Minister Jean-Claude Juncker, head of the group of euro-area finance ministers, among others).

How does it work for Greece? The example of Uruguay 2003 is the best strategy, as it achieves restructuring with no default, minimal rating impact, and minimizes losses by the markets. The EU+ECB+IMF need to coordinate and offer a debt restructuring swap where bondholders submit Greek bonds and get EU bonds in exchange, in such a way that the principal is cut in say 50% (only if participation is higher than say 95%). The credible threat from EU+ECB+IMF that no restructuring means Greece will have to fend for itself will make the exchange successful. Most likely, the market value of debt once swapped would be closer to where it is today, but Greece gets a much lower debt burden and interest burden. The EU should also establish a mechanism through which debt burdens need to stay within certain limit, otherwise a country can no longer issue under the EU bond scheme.

This scenario has 3 fundamental problems: 1) it would mean a change of the rules of the game (relative to what the EU has stated since early 2010); 2) most importantly, it seems still unrealistic relative to where EU leaders’ mindset seems to be; and, 3) it could still be insufficient to make Greece sustainable. A monetary union is not complete with a fiscal union, it also requires a degree of homogeneity in regulations, education, infrastructure, etc., in order to have roughly similar productivity growth rates. But debt relief would certainly free some political capital to push for structural reforms.

We believe that unless the EU moves towards fiscal integration, hopefully in a way similar to our ideal scenario, there is a serious risk of a euro breakup, disorderly defaults and devaluations (with new currencies). Our base case scenario is that Europe will move in this direction, but in a very inefficient and slow fashion, which could mean that some periphery countries might not make it, but the core does. Thus, tomorrow we should see a meaningful step in this direction. Does this mean that there would be just one euro team at some future Soccer World Cup? Well, that would certainly make the euro more credible…