Its dimensions and implicationsMR Anand

GL Gupta

Ranjan Dash

Optimism and enthusiasm (1999-2007), replacedby pessimism and distrust (2009-11)

Origins of the crisis. 2 main causes, 1 anomaly.

2 causes (1 external, 1 internal):◦ 1. US financial crisis: collapse of markets→ downgrade

of rating on public bonds→dramatic rise in borrowingcosts (PIIGS) → fears of sovereign debt default

◦ 2. Increasing divergencies in a monetary union with economic and political tensions (growth; public accounts; productivity; external accounts etc.)

1 anomaly. ◦ The Euro crisis was not a typical «currency crisis»:

Loss of confidence in a country → capital flight → high interest rates / exchange rate depreciation → collapse of investments → everything goes bad other than exports

◦ The external value of the Euro remained stable/strong. Global investors kept reserves in Euro assets.

◦ The euro crisis was an attack toward the idea/project of European integration: «no man’s land» …

The project was already in the treaty of Rome

Attempt #1 of MU failed (Werner plan, 1970→1980)

Attempt #2 was part of the Single Market Process

SMP (goods, capitals, labor) led to the Maastricht Treaty

MT: “5 convergence criteria” …

budgetary and monetary rules; no real, fiscal, politicalconvergence

Jan. 1, 1999 11/15 countries decide a single currency(Dk, UK, Swe: opt out … Gr: not ready). Today: 19

European Central Bank: unique responsability for monetary policy

Many oddities:

◦ No European budget (very small), no fiscal policy, no tax coordination and harmonization.

◦ Very strict mandates for ECB. Two pillars

Price stability + all the rest (growth, unemployment, environmental sustainability etc.) that comes after

◦ Very strong independence of ECB

It is important for stability and growth

However indepencence of instruments or independence of objectives with no accountability?

◦ Very little was done for: Financial and banking crisis(no bailout clause but … with what credibility?)

Symbol of deep political and social integrationafter WW2: the currency and the army are the symbols of national sovereignty …

But also widespread expectations for … Microeconomic gains◦ Reduce transactions costs◦ Reduce currency risks and increase investments◦ Expected to increase cross-border competition,

integration and efficiency

Macroeconomic gains◦ Price stability◦ Acquire credibility and attractiveness for investments◦ Increase financial integration. Interest rate convergence◦ Create another reserve currency

1. A monetary union without a fiscal (and political) union

Spending-fiscal authorities remain national;

EU budget for public intervention is small

No role for the ECB in financing deficits and stability;

No role for the ECB as a LLR

No role for the ECB in bank supervision

2. US financial crisis provoked new divergencies

Varying productivity

Structural differencies between countries in terms of wages, unemployment, labor mobility, export surplus.

Impossibility to use the exchange rate in case of asymmetric shocks.

Convergence in interestrates on government

bonds

Convergence in interest rates offered by banks

Reduction of spreads to 0

More pronounced fall in nominal rates in the

peripheral economies.

Bond markets (public and private) were integrated

rapidly;

Collapse of the spread. Convergence survives after theUS financial crisis. The spread explodes at the beginningof the debt crisis

Between 1998 and 2008 the spread went and remained around 0 as if allgovernment debt issues had the same degree of riskiness: investors had the

same level of trust toward Germany, Italy, Spain …

Euro favoured a boom in the credit and real estate markets

As currency risk premium and spread went to 0, credit growth

surged.

It became easier for PIIGS to increase public and private debt

Banks borrowed more easilyfrom abroad, increasing their

leverage

Very strong growth in the Real Estate market: property prices

increased dramatically and favoured further indebtedness

houses were used ascollateral for financial operations

The rise in the twin deficits (public and current account • The crisis produced

a worsening in fiscal decifit (small for Italy, large for Spainand Greece)

• The crisis produceda rise in the demandfor imports and a larger currentaccount deficit from 2003 (G, P, E)

• Key country (Germany) was the only «surplus» economy and didnot act as a leadingcountry (no increasein expenditure)

• DIVERGENCE•

From the financial crisis to the Euro Zone crisis

The US financial crisis triggered the sovereign debt crisis in Europe

The credit boom ended and interest rates start to diverge

Growth declined sharply, 2008-2009

Excessive lending increased bad debts and NPL for banks

Deficit/GDP and Debt/GDP were aggravated by emergency measures

Increased divergence in fundamental indicators (GDP, productivity) and growth of economic imbalances

Before the crisis, large intra Euro Zone capital flows

Countries built up external deficits (PIIGS);

Countries built up external surpluses (G, NL, B)

Poorer nations were attracting investors from richernations … is there anything wrong with that?

Nothing, in principle. However … A big problem was that foreign capital flows were invested in non-

traded sectors (housing, government welfare)

Investment did not increase productivity, competitiveness, exports

Increase in liabilities for Greece etc. was not sustainable and, worse, it contributed to the housing bubbles that inevitably burst

The sudden stop was critical because, in a MU, countries cannotdevalue and the EZ had no bailout mechanism

Strong countriesin surplus, weakcountries in deficit

It’s ok if nationsborrow to investin capacity thathelps the economy

This was not the case: in all GIIPS funds ended up in non tradedsectors

Every crisis hasa trigger: in Europe it wasthe revelation of the Greekdeficit deceit

In October 2009 the newly elected Greek gov. announcedthat the previous gov. had cheated the true size of deficit

The Greek crisis acted as a detonator in two ways:

Large and hidden violation of common fiscal rules can occur (and did occur)

The risk of sovereign default became real and the EU faced it without a mechanism of bailout and a LLR

Fear of debt unsustainability (endless increase of Debt/GDP)

Austerity cycle was started … only to make things worse

Emergency measures were announced after the 2008-9 financial crisis

They were successful in the short run and the financialcrisis was halted;

However they worsened fiscal deficits and debt …

The austerity cycle

Tax rises collapse of aggregate demand recession reduction of tax revenues further increase of deficit further increase of the ratio «deficit/GDP»

Confidence crisis led to a differentiated rise of bond yields and increased costs of risk insurance on CDS (credit default swaps).

Confidence crisis: bond yieldswidened after the Greek deceit (butnot after Lehman bankruptcy)

CDS are financialinstruments thatprovide an insurance againstthe risk of debtdefault

CDS exist since 90s

After 2010 the fearof default increasedand CDS premiumswidened

Could Europe remain still?

A large share of public debt is held across borders

with European banks.

Direct exposure was veryhigh for Germany and

France, particularly

This produced a strong conflict of interest among

European nations

Hard to find a solution.

Decision making system in the Euro zone: financial

assistance requiresunanimity

European banks’ exposure in weak countries

Institutional innovation:the European FinancialStability Facility (ESFS)

2010: bailout packages for Greece (150bn), Ireland (41bn), Portugal(50bn). EFSF loans at low interest rates conditional on theimplementation of austerity measures.

After countries successfully implement fiscal programmes, then (toincrase growth prospects) EIB helps in absorbing public bonds.

However, all these measures failed to convince financial markets;scepticism on their effectiveness. Problems with peripheral countries

EFSF was created to defend financialstability and prevent contagion.

Provides financial assistance (loans) to countries in difficulty.

It is authorised to borrow up to E450bn, issuing EU bonds.

Who paid for emergency funds? Germany, France, Italy account for almost 75%

…have they really succeded in convincing financial markets? NO

No. Apart from Greece “primary surplus” increased on average by only 0.5% GDP

Main reason: confidence crisis in the debt repayment capacities. Interest rates spreads skyrocketed from 0 to 550bps – 1500bps. Confidence crisis depended on:

Greek crisis contagion

Low competitiveness and divergent indicators

High level of indebtedness and fears of debtrestructuring

Lack of efficient EU bailout mechanisms and institutions

Approval of fiscal austerity programmes (Monti gov.) re-established confidence that was then enhanced by Draghi’sturn in monetary policy

A debt vortex in the Eurozone

Widespread fears triggered a rush to unload debt

Sales of the weak nation’s debt, drive borrowing costsup to the point where the nation actually goes broke

How do you break the vortex?

Debt buyer-of-last-resort buys unlimited amounts of debt with no constraints due to market discipline

Fears+suspicion dissolve and investors hold the debt

Draghi’s speech, July 2012, after long delays

ECB would do «whatever it takes» to keep the Eurozone together Quantitative easing: purchases of bonds to stimulate the economy and increase liquidity.

Change of market expectations: borrowing costsreturned to pre-crisis level

Ireland:

The Celtic Tiger: 1997-2007 economy expanded. Rise in property valuations; drastic fall in corporate tax rates

Collapse in property prices; bankscame under pressure (heavywholesale borrowing)

2009 nationalization of the banking sector

Problems that stemmed from anexcessive build up of bank lending(vs public debt in Greece) thatturned into a fiscal problem

Spain

Very dynamic economy until 2005

2007 housing prices fell and the levels of personal debt rose

On the public finance front, the revenues collapsed, deficit soaredbut the public debt in 2010 is low by eurozone standards.

High foreign exposure to itsprivate debt.

Portugal Its fiscal deficit and public

debt deteriorated from -3.1% (2007) to -10% (2009).

It didn’t witness a boom-bustsituation. Howewer, a largeexternal CA deficit and external debt fuelled by private sector borrowing.

Low productivity because ofother social indicators: lowest% of educated population in Europe, unemployment.

Chronic low rate of growth

Italy Long term decline and 0 growth

with low productivity and bad-quality institutions (bureaucracy, justice, corruption);

fiscal deficit is low but public debtis extremely high with ratherlimited domestic holdings.

Unemployment rate lower thanthe EU average but increasingSouth- North dualism

The EU accounts for 26% of the world GDP, the EuroZone 20%

Implications for the advanced countries: Germany and France whoface large exposures; also the British banks and close trading linksbetween Europe and the US

For the EMEs (Ch, India, Brasil etc.), a downturn in the eurozone willdent their export growth and the globalised banking system couldthreat their financial stability.

Austerity Fiscal Union Euro-exit

•Fiscal discipline and consolidation, includingprivatization (default policy choice)

•Social costs, prospectsof low or stagnatinggrowth;

•it will not address the structural problems ofthe peripheral economiesbut it would be a short term palliative

•Enlarged Europeanbudget and transfersfrom rich to poor EZ countries

•Common measures of protection for employment

•Stimulate greater cross border investments

•Establish a multi speedEurope rather than hopefor complete convergence

• Breakdown of the currency that could leadto insolvency of severalEZ countries

• Contagion effects and instability: inflation and interest rates wouldincrease dramatically

•The new currencies willbe sharply devalued in terms of Euro•Protectionism and nationalism increase

• The end of the European dream

1. Ahead, thisway

2. Just the single market

3. Variablespeed

4.Do less, more efficiently

5. Do more, altogether

Foster furtherintegration in all real sectors

Deepening in some sectors

Who wantsmore, doesmore

Increase some integration:trade, euro, defence, borders

Federal union, one voice, cohesiveness

Small steps, ordinaryadministration

Back to nationalpolicies in others(foreign policy, migration

Differentiatedintegration

Decrease in others (state aids, social and welfare policies)

Redistributionpolicies

Search for consensus, case by case

Unbalancedintegration.Toward a «British» EU

Countries thatdo not agree→«ahead thisway»

Fascinating,thoughanother stepbackward

Greatestsurrender of sovereignty

Inadequate More conflictsand inequalities

Reasonable, realistic butmust prepare#5.

More conflictsand inequalities

Best option, though ratherunrealistic