Thursday, 20 September 2012

Eurozone Crisis: Dimensions and Implications

Reproduced from the Finance Ministry (GoI) Working Papers: "The Eurozone Crisis: Dimensions and Implications", by Anand, Gupta & Dash, January 2012.
If you want to look at associated figures and tables please refer to the document directly.

What is the Eurozone?
On January 1, 1999 eleven European  countries decided to denominate their currencies into a single currency. The  European monetary union (EMU) was conceived earlier in 1988–89 by a committee
consisting mainly of central bankers which led to the Maastricht Treaty in 1991. The treaty established budgetary and monetary rules for countries wishing to join the EMU  - called the "convergence criteria". The criterion were designed to be a basis for qualifying for the EMU and pertained to the size of budget deficits, national debt, inflation, interest rates, and exchange rates. Denmark, Sweden, and the United Kingdom chose not to join from the inception.

The "Euro system" comprised the European Central Bank (ECB),with 11 central banks of participating States assuming the  responsibility for monetary  policy.  A large part of Europe came to have the same currency, but members continued to have their own tax systems.The ‗Euro‘ took the form of notes and coins in 2002, and replaced the domestic currencies. From eleven  euro zone members in 1999, the number increased to 17 in 2011.

Justification for the Euro: The overarching justification for  the Euro  was not merely economic, but political.
  • A single currency was perceived as a symbol of political and social integration in the post WW II Europe and a catalyst for further integration in other spheres. 
  • At the micro level, the use of a common currency was expected to increase crossborder competition, integration and efficiency  in the markets for goods, services and capital.
  • At the macroeconomic level, a single monetary policy in the euro area was expected to be geared to price stability. 
  • The Euro system's commitment to price stability was expected to contribute to the longterm stability and credibility of the euro and promote its attractiveness as a trading and investment currency. 
  • The Euro was also expected to become an important currency in the foreign exchange markets.

Sequence of developments with the introduction of Euro: The euro area money and financial markets saw rapid changes with the introduction of  a new currency.
  • Bond markets that were segmented got integrated in short period. 
  • From 1999 to 2002, and then on, there was convergence in the yields on government bonds. 
  • Interest rate dispersion between the rates offered by different banks in also declined.
  • Credit growth surged  as currency risk premium diminished and competition spurred financial innovations as financial institutions could borrow easily abroad. 
  • The growth in credit was concentrated in the housing sector. Construction and financial services  grew rapidly thereby  increasing macroeconomic vulnerability.  
  • While property prices boomed, the credit growth got translated into a buildup in debt. 
  • Faster growth hid the weakness in the fiscal system that got revealed with the worsening in the fiscal deficit and public debt. 
  • Growth was also accompanied by a rise in demand for imports and, in turn, a larger current account deficit from 2003. 
  • The rise in the twin deficits (Fiscal deficit and CAD) were financed largely through debt, especially, in the case of Greece. 
  • So long as growth was strong, it was hard to make out whether there had been an improvement in the fundamentals, or it was a bubble.  Till 2005, the general growth momentum was in place, perhaps waiting for a trigger. 

From Global crisis to the Euro zone crisis
The global financial crisis in 2007–08 acted as the trigger that set the snow ball of debt rolling  across Europe and in the euro zone as growth declined sharply. The financial crisis led to disruption in financial intermediation. The credit boom from 2003 lasting till early 2007 was supported by falling interest rates. But from 2006, interest rates across euro zone started to diverge, marking out the weak from the strong
economies. Excessive lending had left banks with bad debts and governments with large fiscal deficit and public debt in the peripheral economies (albeit of varying magnitudes).

In order to meet liquidity problem arising from financial crisis, on 11 October 2008, the EU held an extraordinary summit in Paris to define a joint action for the euro zone and agreed to a bank rescue plan to boost their finances and guarantee  interbank lending. The various emergency measures announced to counter financial crisis during 2008-2009, appeared to have been successful in averting financial crisis and supporting short-term domestic demand. However, they aggravated fiscal deficit and debt.

In late 2009,Greece admitted that its fiscal deficit was understated (12.7 % of GDP, as against 3.7 % stated earlier).  Ratings agencies downgraded Greek bank and government debt. In late 2009, its public debt was over 113 % of GDP, far more that the euro zone limit of 60 %. A crisis of confidence  due to high fiscal deficit and debt was marked by widening bond yields and risk insurance on credit default swap. By early 2010, a sovereign debt crisis in the euro zone was  clearly  on  hand with  Greece  in the  eye of the storm. The problems of Ireland, Portugal and Spain were also out in the open.

The global financial crisis had brought home an important lesson  - that on the extreme,  all  private debt could  potentially be public debt. On 2 May 2010, to reassure investors confidence, the EU and IMF put together a €110bn bailout package for Greece conditional on implementation of austerity measures. This was
followed on 9 May 2010 by a decision by 27 member states of the European Union to create the European Financial Stability Facility (EFSF), a special purpose vehicle, in order to help preserve financial stability in Europe by providing financial assistance to euro zone states in difficulty.

The measures taken in May 2010 had a palliative effect. Serious doubts remained on the ability of Greece to service its debt and bond yields started to spike again. In April 2011, Portugal admitted that it could not deal with its finances and asked the EU for help. An extraordinary summit was  again  convened on 21 July 2011 in Brussels. The leaders decided to take measures to stop the  risk of contagion. They agreed on a further bailout for Greece for 109 billion euros. To prevent the possible contagion, the leaders agreed to increase the flexibility of the EFSF to be able to lend to states preventively on the basis of a precautionary programme. It was agreed that all the euro area member states would strictly adhere to the agreed fiscal targets.

All these measures have so far failed to assuage the financial markets. The indications are that the financial markets continue to be deeply sceptical about their effectiveness. While Greece remains an extreme case, the  problem of public and private debt (in varying proportions) in other peripheral economies like Ireland, Portugal, Spain and Italy are also a source of concern albeit with their own peculiarities.

This crisis is not a currency crisis in a classic sense. Rather, it is about managing economies in a currency zone and the economic and political tensions that arise from the fact that its constituents are moving at varying speeds, have dramatically different fiscal capacities and debt profiles  but their feet are tied together with a single currency. 

Some critical dimensions of the EZ crisis: By 2011, the euro zone crisis turned predominantly into a sovereign debt  crisis intricately woven with bank debt  and  claims across borders within and outside the
monetary union. In that respect, the euro zone problem is somewhat unique and sui generis.
1. A monetary union without a fiscal union:  The creation of the Euro zone had an inherent contradiction of being a monetary union but not a fiscal union. The introduction of the euro in 1999 explicitly prevented the ECB or any national central bank from financing government deficits. As a consequence the central bank has no power to monetize deficits. Although each country was encouraged to follow a similar fiscal path, there was no common treasury to enforce it. The spending authorities  remained national and subject to their own political compulsions. So long as growth across the region was strong, the fiscal capacity was not a source of worry. In such an arrangement the possibility of fiscal free riding is present as seen from the current episode for Greece.

The option of improving the competiveness of the economy through exchange rate  depreciation was not available from the very inception of the monetary union. The EU budget is only 1 % of the EU GDP and not an effective instrument for fiscal stabilization.  Had  there  been a fiscal union, with a system horizontal transfer and controls, the deficit and debt ratio of the peripheral economies may have been contained.
But in the present case, a fiscal crisis in the periphery automatically translated into zonal monetary and financial crisis with the central monetary authority not empowered to act as the lender of last resort.
This brings home an important lesson that setting up pacts and codes of conduct by themselves are not enough, unless, the underlying incentives to adhere to them are also reasonably well aligned. It has also been argued that the fiscal criteria proved difficult to enforce but generated a false assurance that as long as there was a criteria, all was well.

2. Varying productivity  and Structural differences: Within the euro zone, there is substantial variation in terms of productivity. The peripheral economies have  lower labor productivity compared to Germany (taken as a bench mark of 100) which clearly stands out in terms of unit labour costs.

On account of differences in the labor market conditions the unemployment rates are also vastly divergent. As compared to the peripheral economies, Germany has the lowest rate of unemployment rate due to its short-time working scheme and flexible time arrangements in  the manufacturing sector.  The fact that there has been a persistent difference in the unemployment levels shows that labour mobility remained far more limited as compared capital mobility despite there being a monetary union.

The above differences in  a currency union  could get sharply exaggerated when countries are subject to asymmetric shocks, or to put it the other way around, when their capacity to weather a similar shock is vastly different. Member countries cannot use the exchange rate adjustment to  improve their competitiveness. Large fiscal deficit and  public debt with interconnected and weak banking systems can then make matters worse if  debt is held across borders.

3. Role of cross border lending: The integration in the financial and money markets makes the euro zone crisis harder to untangle.This integration is seen in terms of the large share of public debt held across borders with European banks (German, French, British and others) having cross border exposure. Germany and France and non euro economies  like  UK and US have substantial exposure to bank debt of the peripheral economies. The interlocking and conflicting interests of the holders of the liabilities of the peripheral euro zone economies thorough cross border holding of debt makes the resolution of the euro zone crisis furthermore difficult. Given their large exposure, the European banks may find it difficult to wish away their engagement with the  peripheral economies.

4. Decision making system in the Euro zone:  Even at the national level where there are sub national entities, decision making is always problematic. In the case of the Euro zone decisions on financial assistance requires unanimity among  representatives of member states. In a monetary union, political decisions taken in one country affect the economies of other countries. Except for the ECB there are few organisations that have a euro zone wide view. But the ECB is a central bank with a limited focus on the macroeconomy. But economic policies remain controlled by national governments with fiscal  consequences. 

Implications of the Euro Zone Crisis and possible directions 
The the euro zone accounts for 19.4% of the world GDP (at market exchange rates). The Euro area accounts for about 10 per cent of the global  equity  markets turnover and the euro accounts for 26 percent of the allocated global holding of reserves.
  • The euro zone crisis has been moving from one peripheral economy to the next, and more recently, is affecting the core economies in the euro zone. 
  • The significance of this crisis is that it  threatens the pace of recovery of the global economy  especially because  the EU and within that, the Euro zone is a significant market for rest of the world.
  • The creation of the European Union and the euro zone has been part of the European dream of integration. A breakup of the euro would be painful in economic terms and in terms of its political fallout. 
  • A serious challenge is being faced by the two  European giants Germany and France because the banks of both these countries face large exposures as already indicated. The markets have been relentless in pricing them down.
  • The United States has a large financial stake in Europe. American banks have over $600 billion of exposure in the troubled economies of the euro zone. There are close trading links as Europe is US’s largest trading partner and the largest destination for investment by U.S. corporations. 
  • For both China and India, Europe and the euro zone accounts for a significant market. Therefore stagnation or worse, a downturn in the euro zone will dent their export growth.
  • Wrt China, the threats and the opportunities are somewhat interestingly balanced.  China has been looking for opportunities to diversify its foreign exchange assets. The current situation provides China an opportunity to make bargains during a fire sale that may follow to gain political mileage and acquire useful and perhaps strategic assets by simply offering to hold troubled assets of the troubled euro zone States. These assets could be in the form of sovereign debt as well as real assets like interest in public sector units that may be privatized.
India: the European Union is a major trade partner accounting for as much  as 20.2 per cent of India’s exports (in 2009-10) and 13.3 per cent of India’s imports. A slowdown in the euro  zone and the EU is likely to have a major adverse impact on India’s exports.

Three broad possible Actions to address the Eurozone crisis

1. Route of austerity, in particular, fiscal consolidation, including privatization. This is the default policy choice. A forgone conclusion is that this will impose social costs. While fiscal consolidation is desirable, the
question is whether, at all, this choice will lead to sustained growth in  the near future, since the compression at this juncture would be extreme. The possibility that the peripheral economies will grow themselves out of the problem seems remote. In any case, this choice does not address the structural problems faced in the peripheral economies. Therefore, the current strategy of announcing short term palliatives such as further bail outs along with sharp fiscal consolidation may only prolong the agony but not deal with the uncertainty prevailing in the euro zone.

2. Closer fiscal union: with
- a substantially enlarged European budget with a  limited  system of fiscal transfers from rich countries to the poor countries,
- a common form of protection for employment,
- greater cross border investment even if this implies takeover of sick and ailing public sector units by companies from the richer Euro zone states.
- to move the ECB into the role of a proper central banker and then floating euro bonds.

A fiscal union, if that be the future road, between what are clearly a few strong and other weaker economies is going to be a major political and economic challenge. But as of now, this option is hardly finding favour in the big two (Germany and France) due to the fiscal burden that may befall them.

3. Peripheral economies leaving the euro zone. A breakdown of the currency may be a very expensive proposition. But if that were to happen, it could lead to insolvency of several Euro zone countries, a breakdown in intra-zone payments. Given that public debt in these countries is present in the balance sheets of banks and insurance companies across the world, contagion effects and  instability could spread through the financial system. In comparison, the sub-prime crisis  may almost pale into insignificance (Pagano, 2010,  Eichengreen 2007).This outcome also means an end of the European dream.

None of the three choices are simple. Status quo is also not an option. The choices will have to be political, but the consequences will undoubtedly be economic.