How Emu Break-up Can Be Avoided

7/30/2019 How Emu Break-up Can Be Avoided

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November 2012 0

Mark CliffeChief Economist ING Group

Presentation to the Peterson Institute for International Economics

Washington D.C.

13th November 2012

Roads to Survival

How EMU Break-up can be avoided


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November 2012 1

Outline

1. Unfinished business Double dip driven by fiscal squeeze and weak credit growth

Core vs. periphery divergence is politically and economically unsustainable

2. Sovereign and bank solvency intertwined

Tougher capitalisation requirements are also hurting growth Banks remain reliant on ECB funding, exposed to government debt

3. There areRoads to Survival

It is not just about fiscal discipline, or even external indebtedness

growth(especially in the periphery) is crucial too for now, its up to the ECB More resources will have to be transferred to the periphery

Banking and funding union involve covert transfersbut fiscal union is thedestination

Will politicians secure popular support to trade sovereignty for solidarity?


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November 2012 2

Italy

Spain

Eurozone debt crisis unfinished business

Greece

Ireland

Germany

Portugal

NL

10Y government bond yield (%)

0

5

10

15

20

25

30

35

40

07 08 09 10 11 12

0

5

10

15

20

25

30

35

40


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November 2012 3

d e b t =

Pr i m a r y d e f ici t + ( I n t e r e st r a t e GD P- g r o w t h ) x Ex i st i n g d e b t

Four ways to bring down debt-to-GDP ratio

Austerity / higher taxes

1

Lower interest rates Faster real growth orhigher inflation

Sell-off assets orrestructure/default

2 3 4


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November 2012 4

Diverging fiscal policy

Fiscal tightening*

Source: OECD, ING

* % of potential GDP; annual change in underlying primary balance

-1

0

1

2

3

4

5

6

SP PT GR IT IR FR NL EA17 UK US DE

2012 2013

Periphery led by Spain is tightening more than the core

Domestic Demand

86

88

90

92

94

96

98

100

102

104

08 09 10 11 12

86

88

90

92

94

96

98

100

102

104

GermanyUS

NetherlandsItaly

UK

Spain

1Q08 = 100 1Q08 = 100


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November 2012 5

1

2

3

4

5

6

7

07 08 09 10 11 12

Greece Portugal Spain Italy NL

(%)

Diverging interest rates

Corporate lending rates*

* Loans over 1m at floating rate and up to 1 year initial rate fixation

Source: ECB

Markets are penalising, not rewarding, the peripherals for their fiscal austerity


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Bank regulation strongly pro-cyclical

Policy-makers are keen make the financialsector more robust.

A key idea is for banks to increase capital,including counter-cyclical buffers

But the effect is strongly pro-cyclical, addingto the weakness of growth

1.Higher bank funding costs banks seen asuninvestable, with regulatory uncertainty

2.Pressure to increase holdings of governmentdebt for liquidity buffers

3.Volume of lending is being squeezed

4. Capital markets are filling the gap but doesthis make the systemsafer? Asset pricevolatility the source of crises - could evenbe greater

Bank funding costs rise (Asset Swap Spreads)

0

50

100

150

200

250

300

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

ASW (bp)

0

50

100

150

200

250

300

Covered Senior


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Draghis pledge the euro is irreversible

There is no going

back to the Lira or the

Drachma or any other

precursor currency

ECB OMT:

To repair the effective working of monetary policy

the ECB may undertake outright open market

operations

of unlimited size

focused on the short end of the yield curve (


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NL

Portugal

Spain

Italy

Germany

Greece

Ireland

France

Real gross domestic product (GDP level)

Eurozone: widening economic divergences

UK

82

84

86

88

90

92

94

96

98

100

102

2008 2009 2010 2011 2012

1Q 2008 = 100

Greek experience is ominous


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-15%

-10%

-5%

0%

5%

'00 '02 '04 '06 '08 '10

ES DE IE

Crisis not solely caused by fiscal indisciplineSpain and Ireland ran budget surpluses on the eve of the crisis

Budget balance as % GDP

Ireland

Spain

Germany


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Source:IMF, Eurostat

Debt/deficit Eurozone lower than in US & JP

Netgovernment debt (% GDP)

Budgetdeficit

(% GDP)

U S

D E

F R

GR

ES

I E

PT

U K

JP

N L

A T

BE

I TEZ

-11

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170


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Sovereign and bank debt solvency intertwined

The sovereign debt crisis is more a symptomthana cause: it stemmed from the financial crisis.

Excessive privateborrowing (leverage)

exacerbated the downturn

BUT its not just about debt, since asset prices

1.fuelled debt, just as debt fuelled asset prices

2.precipitated the bust

3.may drive a deleveraging doom loop if they fall further

Bank and fiscal solvency are intertwined: banks

still depend on ECB/state support, weak bank

lending may hurt economic growth and publicfinances, banks are big buyers of public debt

Financial stability, fiscal and monetary policy are all

intertwined

Central banks are now targeting asset prices

BANK

SOLVENCY

FI SCAL

SOLVENCY

ECONOMI C

GROWTH

ASSET

PRI CES

The Deleveraging Doom Loop

Solvency is threatened by falling asset prices and growth


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CurrentAccount(% GDP)

Net external debt (% GDP)

Peripheral countries are large net debtors

BE

DE

IE

GR

ESFR

IT

NL

AT

PT

FI

US

UK

JP

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%-100% -50% 0% 50% 100%

Source: Eurostat; external debt 2010; current account 2011


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And its not just about external balance

In principle, external balance can be

achieved through squeezing domestic

demand fiscal restraint can deliver this...

BUT if this is at the expense of growth

and employment, it will ultimately beeconomically and politically unsustainable

As Jan Tinbergen pointed out, each

policy objective needs a policy

instrument

Without the exchange rate, regaining

competitiveness is tough

Tightpolicy

Highersaving

Uncompetitive currency

Foreign slump Externaldeficit

Externalsurplus

Competitivecurrency

Foreign boom

Recession Growth

Loose policylower saving


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Eurozone debt crisis reality check

Politics will decide how losses are divided between bond holders and tax payers

1. Debt restructuringcore country creditors have

already taken losses: there could be more to come...

2. Transfer Union much bigger fiscal transfers from

the rich to the poor

ECB funding (covert)

Common bond issuance (covert) European taxes/transfers

The Paradox of Merkelism attempts to limit the costs

to the core countries have served to increase them!


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Capital flight financed by the ECB

Peripheral* Eurozone Balance of Payments: Private Capital Takes Flight

* Sum of Greece, Portugal, Ireland, Spain and Italy ** Calculated as residual *** Non-annualised

Source: National central banks, IMF, European Commission, ING estimates

-500-400

-300

-200

-100

0

100200

300

400

500

-500-400

-300

-200

-100

0

100200

300

400

500

2006 2007 2008 2009 2010 2011 1H2012***

Target 2 financing Program financingNet private inf lows** C/A deficit

EUR bn

25% of theperipherys

GDP

Markets are penalising, not rewarding, the peripherals for their fiscal austerity


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EMU Roads to Survival

Fiscal austerity alone will not ensure the

survival of EMU. So what to do?

Reform structural, or supply-sidereform

could stimulate economic growth. this is theroad favoured by Germany and NL.

Reflation loosen macro policy to boost

demand.

Redistribution boost the periphery with

resource transfers from the core, either covert

or contingent (e.g. ECB funding or bail-out

loans) or explicit fiscal transfers .



Six Survival Scenarios the policy mixes

The scenarios involve different combinations of policies:

Scenarios

Policy measuresReform - Product/labour market

- Finance/ funding

Reflation - monetary policy: QE

- monetary policy: rate cuts

- depreciation

- fiscal loosening

Austeria Draghia Bondia Europhilia Inflationia Krugmania

=not applicable =applicable =partly applicable =applicable in reverse

Redistribution - fiscal transfer



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EMU Survival: Reflation vs. Redistribution

Krugmania

America

Austeria

Europhilia

HighLow

High

Low

Reflation

Redistribution

Switzerland

Inflationia

Draghia

Bondia


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Scenario impact scoreboard

Scenario Output Yields Spreads

Core Periphery

Greek exit

Austeria

Draghia (banking union)

Bondia (funding union)

Europhilia (from transfer union to fiscal union)

Inflationia (akaOuter Draghia)

Krugmania

Note: Arrows show direction of impact in years 1-2->years 3-5 (= no change)


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Growth benefits, except in Austeria

The Austeriascenariodepresses activity in the short

term. The others boost GDP,with the biggest gains inKrugmaniaand Inflationia

Reflation and euro depreciationlift activity generally, whiletransfers benefit the periphery

Sustained stimulus is requiredto maintain the growth advantage

of the more reflationary

scenarios in the long term

The initially adverse effects oflabour and product market

reform are turned in sustained

gains to output growth in thelonger term

nevertheless, the Austeriascenario fails to make up for lostground relative to other

scenarios

Core

-4.5

-3.5

-2.5

-1.5

-0.5

0.5

1.5

2.5

3.5

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

YoY%

Base Austeria Draghia

Bondia Europhilia Inflationia

Krugmania

Peripheral

-5

-4

-3

-2

-1

0

1

2

3

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

YoY%


Bondia Europhilia Inflationia

Krugmania


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Public Debt-to-GDP Draghiawins

Core

60

65

70

75

80

85

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016


Bondia Europhilia InflationiaKrugmania

Periphery

75

80

85

90

95

100

105

110

115

120

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Base Austeria DraghiaBondia Europhilia InflationiaKrugmania

Bondiaand Draghias result in thelargest falls in debt to GDP profiles, to

c.75% after 5 years: for the core

countries, the ratio falls close to 60%

Fiscal transfers in Europhilia-,

Inflationiaand Krugmaniaresult in

relative deterioration in the debt profiles

for the core, with ratios staying above

80%, while the periphery sees falls

below 100%

Debt the periphery in Austeria

scenario shows no significant decline as

weak nominal GDP growth offsets

budget cuts, implying that debt

relief/default would be likely


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Banking Union breaking the sovereign link

Share of Eurozone deposit base

Rest, 13.5%

BE, 4.7%

NL, 6.3 %

ES, 12%

IT, 14.4%

DE, 29.6%

FR, 19.5%

Mutualising risk via Eurozone-wide

Regulation and Supervision

Deposit Guarantee

Recapitalisation

Resolution funds

lower bank risk = lower spreads

more, and cheaper, credit

lower sovereign risk = lower spreads

bank funded? Core government back-stop?


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Common Bonds = massive yield convergence

The German government does not rule out

common bonds on principle, but sees them as

a long term option, once fiscal union is agreed.

Crucially, the SPD is supportive

The implied mutualisation of risk is a massive

contingent transfer, and there is an implicit

transfer arising from yield convergence

peripheral yields would plunge, while the

core yields would rise

BUT this would be a positive sum game as

weighted average yields would likely fall

so long as moral hazard fiscal ill-discipline

is addressed with binding commitments1

2

3

4

5

6

7

08 09 10 11 12 13 14

1

2

3

4

5

6

7

non AAA ex GR,PT,IEEZAAA ex GermanGerman

%

Common

Eurobond

Eurozone 10year Government Bond yields


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November 2012 24

Political resistanceLow High

Low

High

Larger bailoutfund

Banking union Euro bonds

Euro bills/EuropeanRedemption Fund

ECB /ESMbond buying

Slowerausterity

Investment

support

ECB Quantitative Easing

ECB rate cut

Economicimpact

A possible route? Discipline before Solidarity

Transfer union


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Summary

1. Macro-policy is tight = pro-cyclical

Fiscal policy is tight and credit creation dysfunctional

2. Economic growth is weakening and diverging

This politically and economically unsustainable

3. EMUs Road to Survival solidarity in return for discipline

It is not just about fiscal discipline, or even external indebtedness

Growth, especially in the periphery, is crucial too

Monetary policy to be loosened further and austerity scaled back?

More resources will have to be transferred to the periphery

Banking and funding union involve covert transfersbut fiscal union is thedestination. The challenge is to secure popular support

The Grand Bargain = transfers from the core ifthe periphery shows discipline

How Emu Break-up Can Be Avoided

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