The Euro Area Crisis      99 Q & A       June 29, 2012        Version # 2
The Euro Area Crisis                          99 Q & A    INFORMATION MATERIAL ON THE CRISIS IN THE EURO AREA AND THE    M...
A. The cause and starting point of the euro area crisis ............................................................ 7    ...
24. The process of politicians addressing the crisis has been described as “kicking the can down        he road” – what do...
G. Greece, Ireland, and Portugal – experiences of the first crisis-struck countries ............... 46    47. Why has Gree...
76. Is there an alternative to creating a fiscal union, financial union, and a central bank as lender        of last resor...
A. The cause and starting point of the euro area crisis      1. When did the crisis in the EMU start and what role did the...
new fiscal compact, signed on March 2012, is supposed to fix the major flaws – the       structural budget deficit (adjust...
4. Why did yields on sovereign debt, which had been closely correlated despite       country differences, start to diverge...
faster than productivity, caused these countries to become uncompetitive both        inside and outside the EU. Difficulti...
B. The economic, political and social impact of the crisis     7. How much must the euro area consolidate in fiscal terms ...
economic slack and cyclical headwinds argue for a more supportive approach2.            Structural reforms, therefore, nee...
higher capital requirements, is a major difference compared with the treatment of        the Japanese banking sector.     ...
unemployment rates higher than 20% of the labour force. Youth unemployment has         also reached record levels, with un...
14. How is the crisis in the euro area affecting the global economy at large?        The global economic outlook is depend...
C. The effect of the euro area crisis on the financial sector     15. Why are banks affected by the sovereign debt crisis ...
16. In which countries have banks the largest exposure to the crisis-struck         countries, and how large are these exp...
30-year period. Bondholders will exchange 31.5% of their principal for 20 new          Greek government bonds with maturit...
rose, the price of the related bonds went down, and that, in turn, affected the price          of CDSs. A vicious spiral w...
applying its advanced approaches on January 1, 2008. The introduction of Basel II            revised the CRD framework. Ba...
Ministry of Finance, announced new rules that will require the four big banks –        Handelsbanken, Nordea, SEB, and Swe...
The aim of the 2011 EU-wide stress test was to assess the resilience of the banks     involved in the exercise against an ...
Thirty-seven banks failed the EBAs stress test in December. The test identified that            German banks will have to ...
believe they can reach the targets without having to raise new capital or resorting to       government recapitalisation. ...
23. How have politicians in the euro area responded to the crisis, i.e., what are          the major policy measures?     ...
crisis. Instead, the crisis response has been characterized as cosmetic measures         taken for the short term, without...
money – once their public finances threaten to become unsustainable, banks can            no longer use their bonds as col...
extension of maturity, interest rate cut, and/or a ―haircut.‖20         The ESM is planned to start in July; however, Germ...
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
The Euro Area Crisis - 99 Q & A - June 29, 2012
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The Euro Area Crisis - 99 Q & A - June 29, 2012

  1. 1. The Euro Area Crisis 99 Q & A June 29, 2012 Version # 2
  2. 2. The Euro Area Crisis 99 Q & A INFORMATION MATERIAL ON THE CRISIS IN THE EURO AREA AND THE MACRO ECONOMIC EFFECTS ON OUR HOME MARKETS The crisis in the euro area has several dimensions, ranging from the many causes of the crisis, to the consequences for the global economy and Europe, including Sweden and the Baltic countries. There have been numerous uncertainties discussed lately, such as a break-up of the currency union, and a Greek default and exit from the euro area. There are also many different views on the best response from politicians and central bank policy makers to alleviate the crisis. To support Swedbank‘s clients and staff, the Group Economic Research Department has prepared a material with 99 questions and answers (Q & A) on the euro area crisis. The material can be accessed on a topic by topic basis, using the hyper links in the document. It will be updated on a regular basis. Comments and suggestions for changes will be most appreciated. Cecilia Hermansson Group Chief Economist2 The Euro Area Crisis - 99 Q & A • June 29, 2012
  3. 3. A. The cause and starting point of the euro area crisis ............................................................ 7 1. When did the crisis in the EMU start and what role did the global financial crisis and recession play? .......................................................................................................................... 7 2. Why was the Stability and Growth Pact not adhered to? .......................................................... 7 3. In what way is the crisis a sovereign debt crisis, and why? ...................................................... 8 4. Why did yields on sovereign debt, which had been closely correlated despite country differences, start to diverge, especially in 2010? ...................................................................... 9 5. In what way is the crisis a trade and competitiveness crisis, and why? .................................... 9 6. In what way is the crisis an issue of confidence for politicians and other policymakers? ..... 10 B. The economic, political and social impact of the crisis ........................................................ 11 7. How much must the euro area consolidate in fiscal terms and what is the impact on growth?... .................................................................................................................. ..............11 8. How to balance austerity and growth? ? ................................................................................. 11 9. Will the euro area have a long period of no or low growth, i.e., stagnation and deflation, like Japan? ...................................................................................................................................... 12 10. What is needed to create a recovery? ...................................................................................... 13 11. How are the labour markets affected by the crisis? ................................................................ 13 12. Will the euro area crisis cause unrest, strikes, and riots in the short term, and what will be the impact on the EU social model in the longer run? .................................................................. 14 13. What are the longer-term effects on democracy of the euro area crisis? ................................ 14 14. How is the crisis in the euro area affecting the global economy at large? .............................. 15 C. The effect of the euro area crisis on the financial sector ..................................................... 16 15. Why are banks affected by the sovereign debt crisis in the euro area? .................................. 16 16. In which countries have banks the largest exposure to the crisis-struck countries, and how large are these exposures? ....................................................................................................... 17 17. How are banks affected by the private sector involvement (PSI) in Greece, and in what way could it affect interest rate premiums for other countries? ..................................................... 17 18. What impact does the credit default swap market in the euro area have on the crisis? .......... 18 19. What are the Basel rules and how will they be affected by the euro area crisis? ................... 19 20. Capital requirements have been raised before the new Basel III rules take effect – how much is needed and when must banks have fulfilled these?............................................................. 21 21. How are stress tests carried out in the EMU? ......................................................................... 21 22. Banks will shrink their balance sheets to meet the new rules, causing a credit squeeze or a credit crunch – how will companies and households be affected? ......................................... 23 D. European politicians’ response to the euro area crisis ......................................................... 24 23. How have politicians in the euro area responded to the crisis, i.e., what are the major policy measures? ..................................................................................................................... 253 The Euro Area Crisis - 99 Q & A • June 29, 2012
  4. 4. 24. The process of politicians addressing the crisis has been described as “kicking the can down he road” – what does this mean?............................................................................................. 25 25. To what extent has the EMU turned into a “transfer union” despite the EU Treaty? ............. 26 26. What characterises the most important support mechanism of the transfer union, the European Financial Stability Facility (EFSF), and in what way will the next measure, the European Stability Mechanism (ESM), be different? ............................................................. 27 27. What is included in the Six Pack EU budget rules?................................................................ 28 28. What are the rules of the new Fiscal Pact and which countries belong to the new pact? ....... 30 29. How will the sanctions system work? ..................................................................................... 31 30. In what ways have politicians focussed on other aspects than budget consolidation, i.e. e.g., growth, labour markets, and competitiveness, to solve the crisis? ......................................... 31 E. The roles of the European Central Bank (ECB) and national central banks .................... 32 31. What is the ECB allowed to do and not allowed to do in order to support EMU member countries, according to the EU Treaty? ................................................................................... 33 32. How has the ECB conducted monetary policy throughout the crisis?.................................... 33 33. What responsibilities does the ECB have for the functioning of the financial market and banks, and how does the ECB support the market with liquidity, i.e., what are its facilities?34 34. What role do the LTROs play in bank capitalisation and credit austerity (direct role), and in the sovereign debt crisis (indirect role)? ................................................................................. 35 35. What is the difference between ECB support and some other central banks’ quantitative easing?..................................................................................................................................... 35 36. Will the ECB policies increase inflation? ............................................................................... 36 37. What is TARGET2 and why are its imbalances worrisome? .................................................. 36 38. What is the role of national central banks, how can they alleviate the crisis, and how are they related to the ECB? ................................................................................................................. 37 F. The involvement of the International Monetary Fund (IMF) in the euro area crisis ....... 39 39. How does the IMF get its resources, and how much can it lend to countries in crisis? ......... 39 40. What role has the IMF played in the euro area crisis? ............................................................ 39 41. How is the IMF, as part of the EC/ECB/IMF (the “Troika”), supporting the crisis-struck countries in the euro area? ...................................................................................................... 40 42. Which countries have so far received loans from the IMF, in what ways, for how much, and under what conditions? ........................................................................................................... 41 43. How does the IMF calculate debt sustainability, and, according to the IMF, how does the euro area fare in this respect compared with the US and Japan? ............................................ 42 44. There has been criticism that the IMF treats the euro area differently, i.e., compared with the Asian, Latin American, and African countries. Is the criticism valid? ................................... 43 45. Does the IMF have the resources necessary to continue its support if the euro area crisis escalates, and, if not, how can resources be found?................................................................ 43 46. What will be the impact on the IMF as a worldwide organization from the euro area crisis (and debt crises in other parts of the advanced world)?.......................................................... 444 The Euro Area Crisis - 99 Q & A • June 29, 2012
  5. 5. G. Greece, Ireland, and Portugal – experiences of the first crisis-struck countries ............... 46 47. Why has Greece been hit the hardest by the crisis? ................................................................ 46 48. In what way has Greece received support? ............................................................................. 46 49. What are the reforms needed to get Greece out of the crisis? ................................................ 47 50. What has happened politically in Greece since the crisis started?.......................................... 47 51. Will and should Greece default, and should Greece leave the EMU? .................................... 48 52. Why did Ireland get into a sovereign debt crisis? ................................................................... 49 53. How has the reform programme proceeded in Ireland, and why are risk premiums coming down? ...................................................................................................................................... 50 54. What have been the political consequences of the crisis in Ireland? ...................................... 50 55. Why did Portugal have to apply for a support programme? ................................................... 51 56. How will Portugal get out of the crisis economically and politically? ................................... 51 57. Will Portugal need a new rescue package? ............................................................................. 52 H. The spread of the crisis from periphery to core ................................................................... 53 58. Spain’s sovereign debt is not very high; why did financial markets lose confidence in the country?................................................................................................................................... 53 59. How has the crisis affected politics in Spain?......................................................................... 53 60. What reforms is Spain planning to get out of the crisis? ........................................................ 54 61. Italy has had a high sovereign debt for a long time; why did the crisis only recently become acute? ...................................................................................................................................... 54 62. What have been the political consequences in Italy of the crisis? .......................................... 55 63. What reforms will solve Italys problems?.............................................................................. 55 64. How have credit rating institutions rated creditworthiness in the euro area, including countries like Germany and France, and support mechanisms like the EFSF? ...................... 56 65. What is the risk that even countries such as France and Belgium could be hit by a sovereign debt crisis? .............................................................................................................................. 57 66. Will the support mechanisms be sufficient if the crisis spreads to the core? .......................... 57 I. The possible breakup of the EMU – how it would come about and how likely is it? ......... 59 67. Is there currently a legal way of leaving the EMU? ............................................................... 59 68. Does a country defaulting on sovereign debt have to leave the EMU? .................................. 60 69. Why would a country or several countries want to leave the EMU? ...................................... 60 70. What would happen if a weak country, like Greece, left the EMU?....................................... 61 71. What would happen if a strong country, like Germany, left the EMU? .................................. 62 72. What are the pros and cons of breaking up the EMU? ........................................................... 63 73. What would happen to the EU if the EMU broke up? ............................................................ 63 74. How likely is the breakup of the EMU? ................................................................................. 63 J. The EMU in the longer term: how to fix it and why is this important? ............................. 65 75. What institutions are needed to make a currency union function well? ................................. 655 The Euro Area Crisis - 99 Q & A • June 29, 2012
  6. 6. 76. Is there an alternative to creating a fiscal union, financial union, and a central bank as lender of last resort, e.g., rescue funds, and how sustainable is this alternative? .............................. 66 77. What are the pros and cons of a Eurobond market? ............................................................... 66 78. What structural reforms are needed to boost competitiveness in the crisis-struck countries? 68 79. Is internal devaluation the only cure for Greece, and will it be successful, perhaps resembling the experiences of the Baltic countries?.................................................................................. 68 80. Must Germany become weaker in order for southern Europe to become stronger, and if countries in the euro area continue to maintain different living standards and levels of competitiveness, as well as cultural and social values, can the EMU have a future? ............. 69 81. How will the EMU crisis affect euro area enlargement? ........................................................ 70 82. Why is it important from a longer-term perspective to save the EMU? ................................. 70 K. The EMU crisis – implications for Sweden and the Baltic countries ................................. 72 83. How important is foreign trade with the euro area for Sweden and the Baltic countries? ..... 72 84. Should companies in Sweden and the Baltic countries try to change the direction of trade away from the euro area if the crisis worsens and remains for a long time? .......................... 72 85. How is Estonia, as an EMU member country, affected differently by the crisis than Latvia, Lithuania, and Sweden? .......................................................................................................... 73 86. How likely is that Latvia and Lithuania join the EMU in 2014 as planned, and what are the challenges? .............................................................................................................................. 74 87. In what way has the EMU crisis changed the likelihood of Swedens joining the EMU? ...... 75 88. How would Sweden and the Baltic countries be affected if the EMU crisis worsened and the currency union broke up?........................................................................................................ 75 89. What are the implications of the crisis for companies in countries outside the EMU, in relation to hedging foreign exchange risk? ............................................................................. 76 90. How are households in Sweden and the Baltic countries affected by the EMU crisis? ......... 76 91. Is the euro at risk and should therefore euro savings be avoided?.......................................... 77 L. The history and characteristics of the EMU ......................................................................... 79 92. Why and when was the EMU created? ................................................................................... 79 93. Which countries are members of the EMU and when did they adopt the euro? .................... 79 94. What are the conditions for membership? .............................................................................. 80 95. What elements of the EU Treaty have the strongest impact on the EMU and have also influenced the handling of the current euro area crisis? ......................................................... 81 96. What characterises an optimum currency area in general, and what institutions were built up in the beginning to ensure the EMU would meet the criteria? ............................................... 82 97. How does the euro area differ from the US as a currency area? ............................................. 83 98. How has the euro developed since it was created? ................................................................. 84 99. How has the creation and use of the euro affected trade and investments within the euro area and with countries outside the euro area? ............................................................................... 84 Acronyms ...................................................................................................................................... 866 The Euro Area Crisis - 99 Q & A • June 29, 2012
  7. 7. A. The cause and starting point of the euro area crisis 1. When did the crisis in the EMU start and what role did the global financial crisis and recession play? The euro area debt crisis is not a direct consequence of the global financial crisis and subsequent global recession; however, it was triggered and exacerbated by those events. Contracting global demand nudged central banks to cut interest rates and increase liquidity, whereas governments, resorting to ―good old‖ Keynesian economic policies, tried to stimulate their economies through more spending and larger deficits. In addition, the handling of some banks‘ solvency problems burdened public finances. At the same time, economies were contracting, as was tax income. All these factors caused budget deficits in Portugal, Ireland, Greece, and Spain to exceed 10% of GDP in 2009 and gave birth to a demeaning acronym – PIGS. These countries, along with Italy, remain at the heart of the euro area debt crisis. Although imbalances in the euro area (caused by cheap credit and diverging competitiveness) were building up gradually, the main trigger for loss of confidence in EMU cohesion and its foundations was the chronic problems in the Greek economy. Throughout 2009, despite contracting EMU economies and the raging global financial crisis, confidence in euro area countries remained high – the difference between Greek and German 10-year government bond yields was only around 1 percentage point. However, at the end of 2009, investors started to doubt whether Greece would be able to repay its debt and whether other EMU countries would be willing to bail it out – i.e., in one way or another to take over part of its debt. In a matter of a few months, Greek government bond yields exceeded 10 percent, the price at which it no longer made sense to borrow in financial markets. 2. Why was the Stability and Growth Pact not adhered to? Strict Maastricht convergence criteria are designed to ensure that all countries entering the EMU are able to sustain stable prices and exchange rates, as well as low budget deficits and debt, and are trusted by financial markets. The Stability and Growth Pact (SGP) was supposed to ensure that EMU members continued on a sustainable path by requiring that budget deficits not exceed 3% of GDP and public debt not exceed 60% of GDP, nor approach those levels. Initially, the SGP was supposed to set much stricter limits than those in the Maastricht treaty, e.g., by restricting the deficit to 1% of GDP and using automatic monetary sanctions. However, before the pact was signed, the requirements were watered down, e.g., a majority of two-thirds of the finance ministers was necessary to establish the sanctions.1 The absence of automatic monetary sanctions for breaching the requirements caused many countries, including France and Germany, to continually violate them. The pact was violated more than 60 times. Peer pressure was weak, and ―sinners‖ were somehow supposed to decide for themselves if they should be punished; since there were always so many sinners, the system never worked. A1 http://mises.org/books/bagus_tragedy_of_euro.pdf7 The Euro Area Crisis - 99 Q & A • June 29, 2012
  8. 8. new fiscal compact, signed on March 2012, is supposed to fix the major flaws – the structural budget deficit (adjusted to the economic cycle) will be targeted and semi- automatic monetary sanctions will apply for breaching it, unless a supermajority (85%) votes against. 3. In what way is the crisis a sovereign debt crisis, and why? Although this crisis has substantially increased the tension in the banking sector and lowered the confidence of all market participants, at the heart of it lies a mistrust in governments and their ability to repay the massive debt. Part of the mistrust arises from the fact that individual EMU countries have no power to print money and inflate or monetarise their debt. At the onset of the sovereign debt crisis, there were no institutions that could help the countries facing liquidity problems. As the economic situation in Greece worsened in 2009 – its GDP contracted by 3.3%, after a 0.2% contraction in 2008 – so did the markets‘ view about the sustainability of its debt, which jumped to 129.3% in 2009 from 113% in the previous year. Although the debt level in itself was not a disaster – Japan, e.g., has a public debt above 200% of its GDP – the contracting economy and the governments inability and unwillingness to rapidly cut the budget deficit and initiate other badly needed reforms indicated that the debt was about to become unsustainable, i.e., Greece would never be able to repay it. In 2010, other EMU countries continued implementing highly expansionary fiscal policies – none of them (bar Finland and Luxembourg) met the Maastricht criteria of a budget deficit below 3% of GDP. The bailout of Greece in May 2010 was not the only one – later that year, Ireland asked for help from the IMF and EU and received a EUR 67.5 billion loan. In May 2011, Portugal received from those two institutions an official loan of EUR 78 billion. A few months after that bailout, confidence in bigger EMU countries – Spain and Italy – started to wither. The ECB reactivated its Securities Markets Programme (SMP), under which it bought government bonds in a secondary market. Although there was no official bailout, from the reactivation of the SMP until the end of 2011 the ECB bought Italian and Spanish bonds worth more than EUR 130 billion. Meanwhile, Italian public debt, which had hovered above 100 percent of GDP for many years, in 2011 exceeded 120 percent of GDP; this is the second-highest level in the EU, below only the 160% of Greece. A big part of the mistrust in Italy was related to its lack of competitiveness, slow growth, and inactive government. Ireland is an exception in that it has been brought to its knees not by its reckless public finances – its debt was only 24.7% of GDP before the crisis – but by the governments decision to guarantee the liabilities of six Irish banks that had recklessly financed a huge real estate bubble. In a sense, the Irish government, wanting to avert a banking crisis, transferred part of the burden from the private to the public sector.8 The Euro Area Crisis - 99 Q & A • June 29, 2012
  9. 9. 4. Why did yields on sovereign debt, which had been closely correlated despite country differences, start to diverge, especially in 2010? Until the eve of 2010, markets had implicitly assumed that, if any EMU country were to experience temporary funding problems, other countries would bail it out – despite EU Treaty Article 125, which states that bailouts are not allowed. For that reason, investors eagerly lent to all EMU countries at a very similar price – borrowing costs throughout most of the last decade did not diverge more than half a percentage point. However, the Greek economy was hit particularly hard by the global recession due to its high dependence on the volatile tourism and shipping sectors. Only at the end of 2009, with a rapidly deteriorating economic situation in Greece, did the new and more transparent government reveal that the public deficit was going to exceed 15% of GDP, which was much higher than previously expected. This raised investors‘ concerns about Greeces ability to repay its debt. But the level of debt was not the only problem – the US and UK have higher debt- to-GDP ratios than the euro area on average. However, individual countries in the EMU are unable to influence monetary policy, and there was an expectation that the ECB would not resort to quantitative easing measures (buying bonds with newly printed money)--policies that have been used by the Federal Reserve and the Bank of England. At the same time, investors started to acknowledge the previously ignored fact that the Greek economy was uncompetitive, due to rigid labour markets and an oversized and inefficient public sector. Even still, this would have been less of a problem if the country could have devalued its currency, but this was not the case. 5. In what way is the crisis a trade and competitiveness crisis, and why? It can be argued that the current EMU is by far not an optimal currency area (see question 96), and that the countries in it are by far too different to share the same currency and monetary policy. One of the reasons for this is the divergent levels of real labour productivity, which is around two times lower in Greece and Portugal than in the EMU on average. Even accounting for price differences, Greeces productivity is only 87% of the EU-15 average. The differences in competitiveness are also reflected in the huge imbalances in foreign trade – in 2008, Greeces foreign trade deficit exceeded 20% of GDP. Portugal and Spain have also suffered from constant chronic trade deficits, which in both countries started to narrow somewhat only last year. At the same time, Germany, due to its higher household savings rate and productivity, was able to sustain large trade surpluses. In contrast, peripheral euro zone countries were able to sustain huge external imbalances due to cheap external credit, which caused a rapid accumulation of external debt by both public and private sectors. Productivity alone is not a very significant issue – Estonia, e.g., has the lowest productivity in the euro area but was the fastest-growing economy in the EU in 2011. Bigger problems in Greece, Italy, Portugal, and Spain are the rigidity of the labour market and the artificially constrained competition in many manufacturing and services sectors. Laws that overprotected the rights of employees and gave excessive powers to interest groups created a situation in which wages, rising9 The Euro Area Crisis - 99 Q & A • June 29, 2012
  10. 10. faster than productivity, caused these countries to become uncompetitive both inside and outside the EU. Difficulties in firing employees have prompted companies to be excessively cautious in creating new jobs and, e.g., pushed unemployment to close to 25% in Spain. However, structural differences and diverging competitiveness do not preclude the existence of a successful monetary union. The lack of a common fiscal and financial policy and of institutions to ensure the stability and liquidity of public finances were the major reasons why the situation got out of control. By improving existing legislation (e.g., the fiscal compact) and creating new institutions (the European Stability Mechanism, or ESM), the EMU should be able to function better despite country differences (see questions 75 and 76 for a further discussion on institutions needed to fix the EMU). 6. In what way is the crisis an issue of confidence for politicians and other policymakers? Although the US and UK have worse debt and budget deficit indicators, they are able to borrow at significantly lower interest rates than most European economies. This suggests that there are significant flaws in the design of the EMU, and investors doubt whether the politicians and the ECB will be willing to avert the default of a member country. Germany‘s initial insistence that the ESM, which will have the mandate to lend to members in need, should have elements of private sector involvement prompted investors to avoid EMU sovereign bonds in general. Only later was this idea dropped and did European politicians start to claim that the restructuring of Greek debt was a unique case that would never be repeated in any other EMU member country. Politicians‘ actions during this crisis can be described as ―kicking the can down the road‖ due to their unwillingness (or inability) to take quick measures and stop the contagion. The initial response of building the European Financial Stability Fund (EFSF) was clearly an insufficient and only temporary measure. Most probably, politicians were not in a hurry to build firewalls, stop the contagion, or rebuild confidence because of the moral hazard – a quick fix would have never forced Greece, Italy, and other countries to embark on the wide-scale reforms that they were able to initiate only with the markets breathing down their neck. Matters are made worse by the airing of public disagreements between member countries on why, when, and how they should bail each other out. Many important decisions had to be voted on in national parliaments, and this process did not go smoothly – in Slovakia, e.g., disagreement on this matter caused the government to collapse. In most of the troubled countries, politicians are unable to explain to the public that the path of fiscal austerity and structural reforms is the least painful way out of this crisis. Upcoming elections in Greece and France this year, and Italy next year, complicate matters further, as there is a risk that populist politicians will make decisions that, although less unpopular with their constituencies, may have negative consequences.10 The Euro Area Crisis - 99 Q & A • June 29, 2012
  11. 11. B. The economic, political and social impact of the crisis 7. How much must the euro area consolidate in fiscal terms and what is the impact on growth? To achieve long-term and sustainable public finances in the euro area, fiscal consolidation programs need to be implemented. At the EU Summit on December 9 2011, an agreement was reached on stronger fiscal cooperation, i.e., a fiscal compact. Countries are now required to limit their structural budget deficits (budget balance excluding cyclical influences, interest payments, and one-off items) to 0.5% of GDP, and public debt ratios to 60% of GDP over some 20 years. It is difficult to measure how growth will be affected. One simple rule of thumb is that, if the public deficit is cut by 1%, growth is reduced by 0.5 %. In the euro area, the need for austerity amounts to 3.3% of GDP – the level required in order for countries on average to reach a structural deficit of 0.5% of GDP. This would mean some 1.7% of GDP in negative growth effect, spread out over perhaps two years. However, for some countries like Greece, the difficulty will lie in reducing the debt level to 60%, as this means much larger negative growth effects since a very large primary surplus is needed for many years. In the current overall weaker economic climate, the large fiscal consolidations should be significantly contractionary, at least in the short term, for activity in those countries with the largest imbalances, such as Greece, Italy, Spain, and Portugal. If the planned fiscal consolidation does prove to be contractionary for the affected economies, this will imply renewed pressure on government revenues and fiscal positions. This suggests that fiscal consolidation in these countries will have to be carefully managed and highlights the desirability of policy measures to improve confidence, increase medium-term growth, and bring down bond yields, so as to offset the contractionary effects on the consolidation that is being undertaken. 8. How to balance austerity and growth? ? The discussion on how to create growth in the euro area has intensified after the fiscal impact was created and the ECB lent EUR 1 trillion to banks to reduce credit austerity and stabilise the situation. A distinct threat is that, in an environment of weak aggregate demand driven by austerities and structural reforms fail to boost growth leaving part of Europe in stagnation. Opinions on how to create growth diverge among politicians. Germany‘s Chancellor Angela Merkel is pushing for structural reforms in labor and product markets, divestment of state-owned companies, efficiency improvements in the public sector, and attempts to attract foreign investment in order to increase economic productivity and strengthen the labor supply. Meanwhile, French President François Hollande is thinking about investments in roads and rails, more quantitative easing from the ECB, and more hiring in the public sector. The problem is that structural reforms, which are necessary for the crisis countries, could hurt growth in the short term, while the positive effects would have to wait until the medium or long term. The current11 The Euro Area Crisis - 99 Q & A • June 29, 2012
  12. 12. economic slack and cyclical headwinds argue for a more supportive approach2. Structural reforms, therefore, need to be complemented by policies that boost aggregate demand. This is not a recommendation of simple fiscal stimulus—fiscal consolidation is inevitable — but of a combination of efforts to alleviate headwinds that, importantly, includes demand rebalancing within Europe and reallocation within countries. Monetary policy and banking sector repair and reform have an important role to play. Short-run growth needs more robust (ideally private) domestic demand in the North and firmer external demand in the South. There is little room for a debt-financed stimulus, except in countries with balanced budgets or surpluses. Even today, 13 of the 17 euro countries are expected to miss the Fiscal Pact‘s target next year. The EU Commission is open to the possibility of channelling funds through the European Investment Bank (EIB) that could be used for investment. Some form of Eurobond solution to finance these projects is also being discussed. However, the sums under discussion are small in relation to the need. The ECB has suggested liquidity support for banks to encourage lending to small businesses. Also, tax cuts for small businesses could lead to more hiring. Finally, unconventional fiscal policy is being discussed, e.g., lowering taxes on labour income to spur growth while raising consumption taxes. 9. Will the euro area have a long period of no or low growth, i.e., stagnation and deflation, like Japan? It depends on how economic policy develops in the euro area. If the structural reforms to increase growth, competitiveness, and labour market participation are not undertaken, the outlook for the euro area worsens and stagnation can be expected. Moreover, the likelihood for deflation and a new recession will increase in combination with political and social unrest. If the financial markets do not find the agreements in the fiscal compact credible, the debt problems could worsen, and the growth outlook would be very bleak. The euro area crisis has some similarities with the Japanese balance-sheet recession, but while Japan had a financial crisis resulting from a massive real estate bubble that burst, with a subsequent buildup of public debt, the euro area crisis is focussed on sovereign debt and insufficient monetary union institutions. To a large extent, the increase in the Japanese public debt was mainly driven by the overtaking of private debts—an action taken to avoid a collapse of the Japanese banking sector when asset prices fell dramatically in the beginning of the 1990s. In the euro area, the increase in the public debt is mainly explained by a fast growth in public expenditures to stimulate the economies after the deep recession in 2008- 2009. A different approach to policymaking in the euro area could prevent a long period of no or low growth. Measures to co- ordinate fiscal policy to reduce the public debt are more pronounced in the euro area than in Japan. Euro members will have to build up larger primary surpluses in order to reach the mandated debt ratio of 60% of GDP. A more rapid treatment of the banking crisis in the euro area, including2 http://www.imf.org/external/pubs/ft/sdn/2012/sdn1207.pdf12 The Euro Area Crisis - 99 Q & A • June 29, 2012
  13. 13. higher capital requirements, is a major difference compared with the treatment of the Japanese banking sector. If European politicians do not deal with the crisis, there is a risk that a Japanese type of economic development will occur. 10. What is needed to create a recovery? Establishing a credible economic policy in the euro area is an important step towards restoring confidence among households and firms and the financial market. The EU agreement in December 2011 of stronger fiscal cooperation, the ECBs measures supporting the banks, the strengthening of the European Stability Fund (ESM), and the large budget consolidations in the crisis-struck countries are small but positive steps towards improvement in the euro area. Long-term solutions to the euro areas problems also require economic reforms in the labour and product markets to increase competitiveness and reduce labour costs, especially in the peripheral countries. First, well-functioning labour markets are needed. Necessary labour supply-side measures include the reform of tax and benefit systems to strengthen incentives to work. Also, the use of flexible forms of work, such as part-time and temporary work, may provide further incentives. To stimulate labour demand, there is a need to promote wage flexibility and address labour market rigidities. Increasing competition is the second prerequisite for better economic performance. In order to improve competition, additional deregulation of the labour and product markets is needed in many member countries. Europe should step up measures to boost competition in services markets in order to support a higher level and growth rate of labour productivity and promote more dynamic economies. The third prerequisite for higher growth in the euro area is the unlocking of business potential by improving the entrepreneurial-friendly economic environment and lowering administrative costs imposed by the public sector. The immense importance of this issue is increasingly appreciated, and several initiatives at the national or EU level aim at better regulation. Fourth, to fully exploit productivity potential, labour and product market reforms need to be complemented by policies that help to diffuse innovation, including measures to support more investment in research and development. To be most effective, these measures should be accompanied by efforts to raise the labour force‘s level of education and expertise such that human capital is continuously adjusted to labour market needs. 11. How are the labour markets affected by the crisis? In the euro area, the unemployment rate has increased every month since its low in March 2008. In mid-2012, the unemployment rate was 11% of the labour force, which is the highest level reached in a decade. All member states in the euro area are seeing rising unemployment, but the magnitude of the increase varies considerably from country to country. The highest unemployment rates are in countries with the largest imbalances, such as Greece and Spain, with13 The Euro Area Crisis - 99 Q & A • June 29, 2012
  14. 14. unemployment rates higher than 20% of the labour force. Youth unemployment has also reached record levels, with unemployment rates of 40-50% in Greece, Spain, and Portugal. In Germany however, total unemployment has fallen and was below 7% in the first half of 2012. The differences within the European labour market have fuelled a growing mobility, with people moving to regions with smaller economic imbalances. Higher productivity growth and subdued wage increases will lower unit labour costs, particularly in the PIGS countries. But these countries will still be less competitive than the EU average unless structural reforms are implemented to strengthen competitiveness and increase the growth potential. 12. Will the euro area crisis cause unrest, strikes, and riots in the short term, and what will be the impact on the EU social model in the longer run? When the consolidation packages are implemented, the current EU welfare system will be significantly reduced in the short term, particularly in the crisis-struck countries. Lower wages, reductions in social benefits, and a high unemployment rate are expected to increase the number of people in poverty and homelessness. Increasing income inequalities within the euro area are also a ground for social unrest, nationalism, and the creation of populist parties. The sustainability and financing of the current EU welfare model will be more difficult to manage in the longer term due to a strict fiscal discipline, according to the fiscal compact, and an aging population. However, this could initiate a change in the social security system, driven by deregulation of the labour market and incentives to increase the participation rate in that market. 13. What are the longer-term effects on democracy of the euro area crisis? The gradual shift in decision making from the national to the central level (Brussels) will probably be accelerated due to the sovereign debt crisis and in order to speed up the structural reform process. Additional steps have been taken in the EU and its member states, including a new set of rules for economic and fiscal surveillance. These new measures, the so-called Six Pack, comprise five regulations and one directive proposed by the European Commission. This change represents the most comprehensive reinforcement of economic governance in the EU and the euro area since the launch of the Economic Monetary Union almost 20 years ago. The legislative package marks decisive step towards ensuring fiscal discipline, helping to stabilise the EU economy, and preventing a new crisis in the EU. A major element of the Six Pack is that a new numerical debt benchmark has been defined: if the 60% reference for the debt-to-GDP ratio is not respected, the member state concerned will be put into an excessive deficit procedure (EDP) (even if its deficit is below 3%). A new expenditure benchmark caps the annual growth of public expenditure according to a medium-term rate of growth. Stronger co-operation in fiscal policy and measures to reduce the imbalances mean the fiscal policy will be more norm oriented, like the monetary policy. The politicians in the member states will therefore have weaker mandates going forward; some will object to this as reducing democracy in the EU.14 The Euro Area Crisis - 99 Q & A • June 29, 2012
  15. 15. 14. How is the crisis in the euro area affecting the global economy at large? The global economic outlook is dependent on political and psychological factors in the euro area. One possible scenario is small positive steps towards improvement in the euro area and a mild recession, if the recovery picks up in the US and emerging markets growth momentum holds on. The main arguments for this scenario are the latest agreement of fiscal co-operation among the EU member states, the ECBs liquidity injections to support the European banks, and large budget consolidations and intensified structural reforms in several countries. A scenario of a gradual deterioration in the euro area, with lower confidence and increased financial stress fuelling larger demands for extended policy responses and leading, in turn, to a deeper recession in the difficult-to-gauge euro area, would have a much bigger negative impact on the global economy and on the financial markets. A scenario with a breakup of the euro would have even more significant effects on the global economy. Global growth would most likely be negative in this scenario since the euro area is heavily linked to the rest of the world through financial markets and trade. The long-term costs of a breakup would be large as well, as EU cooperation would be affected through the poorer functioning of the single market; moreover, the outlook for Europes ability to compete globally would be weakened.15 The Euro Area Crisis - 99 Q & A • June 29, 2012
  16. 16. C. The effect of the euro area crisis on the financial sector 15. Why are banks affected by the sovereign debt crisis in the euro area? Sovereign debt and banking difficulties are inextricably intertwined in the EMU and have become even more so in the course of the crisis. European banks face liquidity shortages, but for some banks their deeper problem is weak solvency as a result of exposure to sovereign debt, particularly in the periphery countries.3 The crisis therefore poses great risks to many of the continent‘s banks that invested heavily in government bonds. For these banks, raising money from private investors has become more difficult – especially as many of them also suffered deep losses from investing in troubled American banks in 2007 and 2008. Now, politicians have made regulations stricter, as capital requirements were raised this year. The effect on banks, financial systems, and economies at the epicentre of the crisis was immediate. However, the crisis also spread to a wider circle of countries around the globe. For these countries, the transmission channels were less direct, resulting from a severe contraction in global liquidity, cross-border credit availability, and demand for exports. Given the scope and speed with which the recent and previous crises have been transmitted around the globe, as well as the unpredictable nature of future crises, it is critical that all countries make their banking sectors more resilient to both internal and external shocks.4 Banks in the peripheral euro area economies have suffered severe capital flight. For example, almost EUR 100 billion in deposits fled Spain during the first quarter of this year, and the process intensified in May, when r political uncertainty has increased after election results in Greece and France. After the declining deposits in periphery countries and uncertainties about banks stability, the European Central Bank suggested forming a ―banking union‖ to oversee big banks. This would help shield countries and their taxpayers from the misfortunes of their troubled lenders. The proposal includes an EU-wide deposit guarantee scheme to protect savers in the event of a bank collapse and resolution arrangements. It would minimise the risks for taxpayers through adequate contributions by the financial industry.5 A controversial new bank bailout fund financed by a tax on financial institutions is also planned. A banking union might address one of the causes of the euro crisis: the tendency for sick banks to undermine entire countries. The costs of taxpayer-financed bailouts in Ireland and Spain, among other countries, were so large that they raised questions about the creditworthiness of national governments. Such a union would also allow countries to share the financial burden of banking crises, perhaps avoiding a repeat of Spain‘s woes caused by Bankia and other ailing lenders.3 ‖Breaking up? A route out of the euro zone crisis‖, RMF (Research on Money and Finance) Occasional report 3 // November 2011.www.researchonmoneyandfinance.org4 ―Basel III: A global regulatory framework for more resilient banks and banking systems‖, Basel Committee on Banking Supervision,December 2010 (rev June 2011). www.bis.org/publ/bcbs189.pdf5 European central Bank, http://www.ecb.int/press/pr/date/2012/html/pr120612.en.html16 The Euro Area Crisis - 99 Q & A • June 29, 2012
  17. 17. 16. In which countries have banks the largest exposure to the crisis-struck countries, and how large are these exposures? Rising current account deficits in the periphery countries were financed by foreign lending, both private and public; this was easy for much of the 2000s as the European Central Bank (ECB) kept interest rates low. The exposure of core banks – mostly French and German - to the periphery peaked in early 2008. French banks have the largest debt holdings in the five crisis-hit countries (Greece, Portugal, Spain, Italy, and Ireland), at USD 541 billion as at the end December 2011, according to data from the Bank for International Settlements in Basel (BIS); 61% of these holdings are in Italy. The banking sectors in Germany and the UK are the two next-largest lenders, with exposure to crisis-struck countries equivalent to USD 419 billion and USD 301 billion, respectively. The largest exposure ratio to GDP is in France (19.5%), Portugal (15.9%), the Netherlands (14.7%), and UK (12.5%). Bank exposure to European debt to crisis-struck countries, December 2011 ($ bn) Greece Italy Portugal Spain Ireland Total % of GDP France 44.4 332.3 21.8 114.7 27.5 541 19.5% Germany 13.4 134.0 30.2 146.1 95.3 419 11.7% UK 10.5 59.4 20.9 83.1 127.4 301 12.5% Netherlands 3.5 34.4 4.9 67.8 13.1 124 14.7% Spain 1.0 31.0 76.0 7.8 116 7.7% Switzerland 1.9 17.4 2.1 21.3 12.3 55 8.6% Belgium 0.7 12.4 2.8 13.1 21.9 51 9.9% Italy 2.2 3.2 27.7 15.5 49 2.2% Portugal 8.1 2.2 23.1 4.3 38 15.9% Austria 2.3 18.5 1.0 4.5 1.9 28 6.7% Source: Bank for International Settlements 17. How are banks affected by the private sector involvement (PSI) in Greece, and in what way could it affect interest rate premiums for other countries? European leaders agreed to provide a second loan rescue package for Greece worth EUR130 billion. The rescue package was conditioned on Greece‘s private sector creditors reducing their outstanding loans. It was thus agreed that private sector holders of Greek debt - mostly banks and investment funds - which own around EUR200 billion in Greek government bonds, will take losses of 53.5% on the nominal value of their bonds, equivalent to around a 75% loss on the net present value of the debt. Investors agreed to exchange Greek bonds for new securities with longer maturities and lower interest rates. The coupon on the new Greek government bonds will be structured so that it will be 2% for the three-year period from February 2012 to February 2015; 3% for the following five years from 2015 to February 2020; and 4.3% for the period from February 2020 to February 2042.The weighted-average coupon based on the weighted-average interest payments on the outstanding new Greek government bonds for the first eight years is 2.63%; it is 3.65% over the full17 The Euro Area Crisis - 99 Q & A • June 29, 2012
  18. 18. 30-year period. Bondholders will exchange 31.5% of their principal for 20 new Greek government bonds with maturities of 11 to 30 years replicating an amortisation of 5% per annum commencing in 2023, and the remaining 15% will be in short-dated securities issued by the European Financial Stability Facility (EFSF). The new securities will be governed by UK law. This would reduce Greece‘s debt by EUR107 billion (out of a total of about EUR360 billion). This second bailout package, designed by the so-called Troika-- the International Monetary Fund, the European Union, and the European Central Bank- - will enable Greece to repay bonds totalling EUR14.5 billion that come due March 20, 2012, thereby avoiding a default and a potential exit from the European single- currency area. Most investors (86 %) accepted the deal. It was better for banks to accept a reduction of the value of their assets than to risk the contagion of an uncontrolled Greek default. Because banks have already written down the value of their Greek debt, the impact should be limited. Due to the high exposure, Greek banks will still be hard hit. Thus, creditors will be reimbursed for more than 50% of the nominal value of the Greek bonds, whose real price in the secondary market is around 36% of their face value. The banks will exchange today‘s ―junk bonds‖ for AAA-rated bonds. On top of that, they will receive 15% (or EUR30 billion) in cash.6 This decision has raised the cost of financing in the euro area by introducing additional risk for private investors. But it is not without a useful purpose. The PSI risk has raised (disproportionately) the cost of financing member states with larger- than-projected levels of debt. Thus, it serves as a disincentive to fiscal profligacy, thereby guarding against moral hazard and reducing the risk of future crises. Adding the PSI risk could therefore improve governance.7 In the short term, there are large economic costs from higher risk premia. On the other hand, since political leaders have concluded that the PSI risk in Greece is unique, and necessary to stop the increase of yields in other crisis-struck countries, the effects on governance are likely to be less pronounced. However, since investors still feel uncertainties with regard to future PSI, interest rates will not come down as if there were total certainty; in this respect, some governance effects could remain. 18. What impact does the credit default swap market in the euro area have on the crisis? The European sovereign debt crisis of 2010 has created concerns regarding the abuse of the credit default swap (CDS) market by speculators. In particular, governments have accused investors of using CDSs to make bets about sovereign defaults and to exacerbate the financial crisis by panicking investors. It is argued that a heightened or speculative activity in CDS markets caused the prices of protection against the respective sovereign defaults to go up. As the price of CDSs6 ―What are bankers doing inside EU summits?‖, January 24, 2012 http://www.neurope.eu/blog/what-are-bankers-doing-inside-eu-summits7 ―Time to jettison the plans to hit Greek creditors‖, January 5, 2012. http://www.ft.com/intl/cms/s/0/5560c714-36dc-11e1-b741-00144feabdc0.html#axzz1pjUPpxbZ18 The Euro Area Crisis - 99 Q & A • June 29, 2012
  19. 19. rose, the price of the related bonds went down, and that, in turn, affected the price of CDSs. A vicious spiral was started whereby CDS market activity led to a continuing rise in prices of CDS and plummeting of the underlying bond prices. In response, German financial regulators banned naked short selling8 of CDSs on euro area governmental bonds in May 2010, and the European Parliament did the same in November 2011. Though naked trading did not cause the euro area debt crisis, it can aggravate price declines in distressed markets. Indeed, the premiums on CDSs of Greek, Spanish, Portuguese, and other European sovereign bonds reached record highs, creating suspicion that a few hedge funds were driving up prices to spread panic and make large profits.9 The small size of the CDS markets can mean they are easier to manipulate. Certain hedge funds are believed to have squeezed prices higher in the CDS market so that they could then sell protection later for profit. But there is a risk that political interference in the CDS markets may end up hurting the peripheral and other economies by forcing borrowing costs higher and ushering in tighter lending conditions for banks and companies, rather than helping to navigate the continent‘s debt crisis.10 A number of rigorous economic studies have since shown that this thesis of speculatively driven CDS prices is largely unfounded.11 The Greek parliament voted to include retroactive collective action clauses (CACs) on domestic Greek debt when it gave the go-ahead to the impending debt swap. If Greece had not received the required voluntary participation rate, the use of the CACs would have triggered a CDS on the USD 3.2 billion net notional amount of CDS contracts outstanding. While this is not a vast amount, the simple result of such an event might have led to some risk-averse trading. One aspect of the Greek swap that bears noting is the potential negative subordination effects that may spread to other peripheral European nations as a result of the ECB‘s exclusive swap on its Greek debt holdings.12 There is still a possibility that the part of the debt that has not been voluntarily written down will trigger a CDS. 19. What are the Basel rules and how will they be affected by the euro area crisis? The Basel Accord was implemented in the European Union via the Capital Requirements Directive (CRD), which was designed to ensure the financial soundness of credit institutions (banks and building societies) and certain investment firms. The CRD came into force on January 1, 2007, and firms began8 Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the securityor ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shareswithin the required time, the result is known as a "failure to deliver.‖.The transaction generally remains open until the shares areacquired by the seller, or the sellers broker settles the trade.9 ―Has the CDS market amplied the European sovereign crisis?―, Anne-Laure Delatte, Mathieu Gex, Antonia López-Villavicencio,September 10, 201010 ―Bankers fear political moves will kill off CDS‖, October 25, 2011 http://www.ft.com/intl/cms/s/0/dccc8d98-ff03-11e0-9b2f-00144feabdc0.html#axzz1pjUPpxbZ11 An AIMA Research Note (2011), ―The European Sovereign CDS Market‖12 http://www.raymondjames.com/bond_market_update.asp19 The Euro Area Crisis - 99 Q & A • June 29, 2012
  20. 20. applying its advanced approaches on January 1, 2008. The introduction of Basel II revised the CRD framework. Basel II was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. The Basel II framework introduced the concept of three ―pillars.‖ Pillar 1 sets out the minimum capital requirements that firms will be required to meet for credit, market, and operational risk. Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered in Pillar 1 and then take action accordingly. Pillar 3 aims to improve market discipline by requiring firms to publish certain details of their risks, capital, and risk management. The crisis in financial markets during 2008 and 2009 prompted a strengthening of the Basel rules, called Basel III, to address the deficiencies exposed in the previous set of rules. One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance-sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. Thus, the Basel III proposals sought to strengthen the regulatory regime applying to credit institutions. Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 9% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWAs). Basel III also introduces additional capital buffers: (i) a mandatory capital conservation buffer of 2.5%, and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The liquidity coverage ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the net stable funding ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.13 The new regulation aspires to make the banking system safer by redressing many of the flaws that became visible in the crisis. Improving the quality and depth of capital and renewing the focus on liquidity management are intended to spur banks to improve their underlying risk-management capabilities. The rationale is that, ultimately, if banks come to a fundamentally revamped understanding of their risks, this should be good for their business and for consumers, investors, and governments. The Basel III proposals are a long-term package of changes that are due to commence on January 1, 2013; based on the European Commission‘s timetable, the transition period is expected to run until 2021. Meanwhile, for the largest banks, Sweden, Switzerland, and the UK are implementing higher capital adequacy requirements than required by Basel III. The Riksbank, in collaboration with the Swedish Financial Supervisory Authority and the13 http://www.basel-iii-accord.com/20 The Euro Area Crisis - 99 Q & A • June 29, 2012
  21. 21. Ministry of Finance, announced new rules that will require the four big banks – Handelsbanken, Nordea, SEB, and Swedbank – to hold a minimum 10% of RWAs in common Tier I equity by January 1, 2013, with the capital buffer rising to 12% of RWAs on January 1, 2015. As in Basel III, the levels include a capital conservation buffer of 2.5%, but no countercyclical buffer. In Switzerland, an expert committee has proposed progressive capital adequacy requirements for its two major banks, UBS and Credit Suisse, of 19%, at least 10% of which is to be common equity Tier I, with the remaining 9% supplied by contingent convertibles – debt instruments that can be converted to equity in certain circumstances. In the UK, the Vickers Commission has proposed measures to introduce a structural separation of retail and investment banking, with total capital in major banks amounting to 17–20%. 20. Capital requirements have been raised before the new Basel III rules take effect – how much is needed and when must banks have fulfilled these? At the European summit of October 26, 2011, it was decided to leave it to the European Banking Authority (EBA) to draft the text for an initiative to raise capital requirements in the EU. The EBA released its recommendations on December 8, 2011. This will help banks to continue their lending activities in 2012 and to avoid a spiral of forced deleveraging and the ensuing credit crunches, which would weaken the real economy. The new capital requirements to restore stability and confidence in the markets are the following. First, those institutions that are affected by the initiative have to achieve a core Tier I capital ratio of 9% by June 2012. Second, additional capital buffers have to be introduced to cope with possible losses from exposures to government debt in the euro area. The size of these buffers is determined by banks‘ exposure to central and local governments of the European Economic Area countries. The difference between market prices and the current balance-sheet valuations determines the required additional capital buffer. To avoid an immediate sell-off by banks of government bonds, the capital buffer is to be calculated on the basis of September 2011 data. The building of these buffers will allow banks to withstand a range of shocks while still being able to maintain an adequate capital level. According to the EBA, the new capital requirement of European banks, which is estimated at EUR 114.7 billion, shall mainly be achieved by increasing equity endowments and reinvesting profits. Accordingly, the EBA is appealing to banks to reduce dividend and bonus payments. The EBA additionally required banks to seek approval by their national supervisory authorities of their plans on how to fulfil the new capital requirements by January 20, 2012. The national supervisors will, in turn, consult with the EBA. This procedure should prevent extensive deleveraging. Hence, national supervisory authorities are likely to approve plans only if they believe that these will not unduly restrict the national credit supply. 21. How are stress tests carried out in the EMU?21 The Euro Area Crisis - 99 Q & A • June 29, 2012
  22. 22. The aim of the 2011 EU-wide stress test was to assess the resilience of the banks involved in the exercise against an adverse but plausible scenario. For the 2011 exercise, the European Banking Authority (EBA) allowed specific capital increases in the first four months of 2011 to be considered in the results. Banks were therefore given incentives to strengthen their capital positions ahead of the stress test. The 2011 EU-wide stress test results show the following:  At the end of 2010, twenty banks would have fallen below the 5% core Tier I ratio (CT1R) threshold over the two-year horizon of the exercise. The overall shortfall would have totalled EUR 26.8 billion.  Between January and April 2011, a further net amount of some EUR 50 billion of capital was raised.  Taking into account these capital-raising actions implemented by end-April 2011, eight banks fall below the capital threshold of 5% CT1R over the two-year time horizon, with an overall CT1 shortfall of EUR 2.5 billion, and sixteen banks display a CT1R of between 5% and 6%. On the basis of these results, the EBA has also issued its first formal recommendation: national supervisory authorities should require banks whose CT1R falls below the 5% threshold to promptly remedy their capital shortfall. The EBA notes that this is not sufficient to address all potential vulnerabilities at this point. Therefore, the EBA has also recommended that national supervisory authorities request all banks whose CT1R is above but close to 5%, and which have sizable exposures to sovereigns under stress, to take specific steps to strengthen their capital positions. These would include, where necessary, restrictions on dividends, deleveraging, issuance of fresh capital, or conversion of lower-quality instruments into core Tier I capital. The EBA will monitor the implementation of these recommendations and produce progress reports in February and July 2012. On December 8, 2011, the EBA published the results of its updated stress tests, which conclude that European banks must raise EUR 114.7 billion (EUR 8 billion more than estimated in October) as an exceptional and temporary capital buffer against sovereign debt exposures to reflect market prices as at the end of September. Furthermore, banks must reach 9% core Tier I capital by the end of June 2012. The announcement suggests that national authorities may allow banks to achieve this target through the sale of certain assets, where this will not reduce lending to the real economy. The announcement emphasises that banks should not be allowed to use changes to internal models to meet the capital target. Europe‘s banks are also required to raise a EUR 39.4 billion sovereign buffer to insulate themselves against losses in the government bond market. Aggregated shortfall required by country EUR million (1st column – new estimated (Dec 8), 2nd – as published on Oct 26)22 The Euro Area Crisis - 99 Q & A • June 29, 2012
  23. 23. Thirty-seven banks failed the EBAs stress test in December. The test identified that German banks will have to raise EUR 13 billion in additional capital, which is more than double the previous estimates. Six out of the thirteen German banks tested will have to raise additional capital, with Deutsche Bank needing to raise EUR 3.2 billion and Commerzbank EUR 5.3 billion. French banks will require EUR 1.5 billion less capital than the EUR 8.8 billion anticipated in October, reflecting third-quarter profits and reduced holdings in sovereign bonds. Dexia, which was identified by the EBA as having a shortfall of EUR 6.3 billion, is exempt due to its restructuring. After the cut-off date of September 30, the Dexia Group has been deeply restructured, and a state guarantee will be provided on the funding issued by Dexia SA and its subsidiary Dexia Credit Local, subject to the approval of the European Commission.14 Also, there is always a question about the credibility of stress tests: how big is the implication of having 17 bank regulators all interested in having ‖their nations‖ banks look the best? 22. Banks will shrink their balance sheets to meet the new rules, causing a credit squeeze or a credit crunch – how will companies and households be affected? Leading European banks say they would rather sell assets than raise expensive new capital to meet compulsory demands from European Union for higher capital ratios, thereby threatening a further contraction of credit to the enfeebled euro area economy. By shrinking assets – the denominator of capital ratios – many banks14 http://www.eba.europa.eu/23 The Euro Area Crisis - 99 Q & A • June 29, 2012
  24. 24. believe they can reach the targets without having to raise new capital or resorting to government recapitalisation. That is, banks will shrink to meet the targets by selling risky assets. This strategy of the banks is likely to prove controversial with politicians and regulators, if it were to lead to bankers‘ lending less money to customers, and thereby jeopardising the fragile recovery of the euro area. The new rules have forced lenders to reassess their clients more rigorously and either tear up lending agreements completely or attach higher costs to loans and funding. Europes banks are preparing to ditch up to EUR 3 trillion of loans in the next couple of years as they "deleverage" their balance sheets, roughly 5-7% of those banks assets. As a result, businesses must pay more to borrow money, leaving some firms scrambling to stay afloat and increasing the cost of their goods to consumers. Banks are cutting the number of firms they will lend to, or scaling back on loans, even to firms they have worked with for years. This is not only hitting Europes economy hard, but may also derail growth in Asia and the recovery in the US. Tighter borrowing conditions could squeeze domestic liquidity and raise domestic interest rates. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small-to-medium-sized enterprises). On the other hand, except for businesses that are countercyclical or in a niche that is doing well, fewer companies are trying to borrow right now. And in the countries where housing bubbles were a big part of the debt explosion, mortgage debt is going to shrink over time. The ECB introduced three-year long-term refinancing operations (LTROs) in December as it sought to quell fears of a potential near-term funding crisis for euro area banks. The injection of liquidity was credited with reopening some funding channels, though some still remain largely closed. European banks grabbed a larger-than-expected EUR 529.5 billion in cheap loans as the ECB conducted its second and possibly last three-year LTRO in February 2012. The ECB said a total of 800 banks were allotted funds under the LTROs. The loans could also influence banks‘ solvency since there are possible profits to make by borrowing at a 1% interest rate and lending to crisis-struck countries, where government bonds yield more than 5%. D. European politicians’ response to the euro area crisis24 The Euro Area Crisis - 99 Q & A • June 29, 2012
  25. 25. 23. How have politicians in the euro area responded to the crisis, i.e., what are the major policy measures? In May 2010, the EC, ECB, and IMF (commonly called the Troika) engineered a bailout of Greece and provided a EUR 110 billion loan, in exchange for implementation of harsh fiscal austerity measures. Despite the bailout, confidence did not return, and borrowing costs in most troubled countries continued to increase. European policymakers indicated that future bailouts must have private sector involvement, which further dissipated the illusion that no EMU country could default and that investments in their debt were virtually risk free. In March 2012, a second loan of EUR 130 billion was agreed, together with a debt write-down by private investors exceeding EUR 100 billion, with the goal of reducing the government debt to 120% of GDP in 2020. The initial response of building the European Financial Stability Fund (EFSF) was clearly an insufficient and only temporary measure. Most probably, politicians were not in a hurry to build firewalls, stop the contagion, or rebuild confidence because of the moral hazard – a quick fix would have never forced indebted countries to embark on the needed wide-scale reforms. The European Stability Mechanism (ESM) will replace the EFSF this year and will be a permanent rescue fund with more (yet widely considered insufficient) firepower and a stronger mandate15. These funds are supposed to work as firewalls that prevent a crisis from spreading to other vulnerable countries. Core euro area countries offered financial assistance in the form of loans to crisis- struck countries under the condition that fiscal austerity measures would be undertaken. However, short-term measures are not sufficient, and the underlying causes of the crisis have to be addressed to prevent it from reoccurring. In the medium term, it is important to restore competitiveness and limit government budget deficits. Therefore, together with financial assistance, structural reforms regarding labour and product markets are being pushed through. Furthermore, in order to prevent such a crisis in the future, more fiscal and economic unity is to be introduced, in the form of a Fiscal Compact. In the past, many countries broke the Stability and Growth Pact rules on national debt and budget deficit limits. In the new agreement, which all EU countries except the UK and the Czech Republic have approved, compliance should be achieved through more accountability and more application of automatic sanctions for those countries that do not respect the agreement. Responsible fiscal policy rules will also have to be included in the national legislation. Policymakers in the EU also claim that integration among the euro area countries should go beyond taxing and spending. One example of such integration discussed is a banking union, with some form of common deposit insurance and a common regulating institution. 24. The process of politicians addressing the crisis has been described as ―kicking the can down the road‖ – what does this mean? Although the short-term impact of the crisis has been addressed by Europe‘s policymakers, they have been criticised for not dealing with the root causes of the15 For more details, see Question 2625 The Euro Area Crisis - 99 Q & A • June 29, 2012
  26. 26. crisis. Instead, the crisis response has been characterized as cosmetic measures taken for the short term, without sufficient long-term solutions. As such, this has been described as ―kicking the can down the road.‖ However, quick solutions, such as Eurobonds, have not been offered, so as to prevent a moral hazard. A moral hazard is a situation in which bad behaviour is rewarded and good behaviour is punished. In addition, voters, primarily in Germany, are very sceptical about extending permanent support for the southern European crisis countries; meanwhile, voters in Greece have had difficulties accepting the far- reaching consequences of long-term reforms. Taxpayers in Germany, which is the largest donor in the rescue loans, do not feel that it is fair to charge them for the irresponsibility of southern member countries. Since there was resistance from populations in both countries to providing and accepting assistance, far-reaching, long-term agreements (like the Fiscal Compact) could be made only after the crisis deepened sufficiently to scare the politicians. Therefore, even though policymakers have been criticised for the policy of kicking the can down the road, it may have been the only possible response – there was no quick way to create necessary institutions during calm times. It is worthwhile to remember the ominous words of Romano Prodi, then-EU Commission President, more than ten years ago: ―I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.” These necessary institutions (financial union, fiscal union, and permanent lender or last resort to sovereigns) have not yet been created, but there is progress in the right direction. 25. To what extent has the EMU turned into a ―transfer union‖ despite the EU Treaty? By ―transfer union‖ it is meant that a country in the EMU supports another member country through a fiscal transfer. Article 125 of the EU Treaty forbids vouching or joint liability for other member states ‗debt. This means that the only option the treaty leaves is debt reduction by the insolvent sovereign country itself.16 However, euro area countries have provided and plan to provide financial assistance for troubled countries through the EFSF and the ESM. These mechanisms enable stronger countries to pool funds and lend money to the weaker ones, but, as they do not create mutual liability, they do not violate the EU Treaty. Some economists claim that the EMU is already a transfer union and was deemed to become one by its construction. According to the professor of economics Philipp Bagus (2010)17, ―by deficit spending and printing government bonds, governments can indirectly create money.― As the ECB accepts bonds as collateral, such bonds create money. This has enabled some countries in the euro area to run budget deficits and enjoy higher living standards at the expense of countries with smaller budget deficits. However, the ECB accepts only the highest-quality (investment- grade) government bonds as collateral and can always adjust this benchmark. This means that individual governments do not have discretionary power to create16 http://www.ft.com/intl/cms/s/0/622595e2-37c7-11e1-a5e0-00144feabdc0.html#axzz1o2bRWi6p17 Philipp Bagus (2010). The Tragedy of the Euro.26 The Euro Area Crisis - 99 Q & A • June 29, 2012
  27. 27. money – once their public finances threaten to become unsustainable, banks can no longer use their bonds as collateral to borrow from the ECB. Recently, the ECB was increasing its amount of money by buying government bonds in the secondary market via the Security Markets Programme and the long-term refinancing operation (LTRO); however, these are temporary measures meant to improve confidence and liquidity. Suggestions have been made to create more direct instruments, such as Eurobonds, also called Stability bonds. Such bonds, which would be backed commonly, would replace national ones. This would create a bigger market for euro area debt financing and might lower interest rates. However, Germany, together with some other governments, remains opposed to such a move. Germany is willing to consider creation of such bonds only after closer economic integration is achieved. Furthermore, it is unclear if such joint liability would not contradict the aforementioned Article 125 of the EU treaty. 26. What characterises the most important support mechanism of the transfer union, the European Financial Stability Facility (EFSF), and in what way will the next measure, the European Stability Mechanism (ESM), be different? The European Financial Stability Facility (EFSF) was created in 2010 by the euro area countries. Its mains goal is to safeguard financial stability in the euro area by raising funds in capital markets and to provide loans to euro area countries facing financial difficulties. It can also, on the basis of ECB analysis, intervene in the secondary bond market.18 The EFSF is backed by guarantee commitments from the euro area countries and had an initial lending capacity of EUR 440 billion. The fund has so far been used to support Greece, Ireland, and Portugal. The EFSF has remaining a lending capacity of EUR 250 billion. The temporary EFSF should by be changed or complemented by the permanent European Stability Mechanism (ESM), whose capacity is EUR 500 billion. The ESM will have the same main features as the EFSF; however, the new fund should be more robust as money will be put in up-front. In addition, there will be more flexibility and independence as the new treaty will have an emergency voting procedure, whereby financial assistance can be granted if supported by a qualified majority of 85% of the votes cast.19 The ESM also includes heightened economic surveillance of the EU. There will be more focus on the prevention of crises, debt sustainability, and more effective enforcement. Financial assistance will be conditional on the ratification of the Fiscal Compact by the ESM member state. Also, liquidity and solvency crises will be separated. In case of a liquidity problem, the ESM will step in with support, which will be conditional on an adjustment program. Private creditors will be encouraged to maintain their exposure. However, if an analysis reveals that a country could become insolvent, a plan will have to be negotiated with private creditors; assistance from the ESM will be provided as well. It is planned to facilitate cooperation between a debtor and creditors. For all new euro area sovereign bonds, collective action clauses (CACs) will be included in the terms and conditions. CACs will allow creditors to agree on and make legally binding a change to the terms of payment. Such changes could involve a standstill,18 http://www.efsf.europa.eu/about/index.htm19 http://www.efsf.europa.eu/attachments/faq_en.pdf27 The Euro Area Crisis - 99 Q & A • June 29, 2012
  28. 28. extension of maturity, interest rate cut, and/or a ―haircut.‖20 The ESM is planned to start in July; however, Germany‘s government has had troubles in passing the fiscal pact and other legislation enabling the ESM, as the opposition is demanding measures to boost growth in Europe and a tax on trade in shares, bonds, and derivatives before agreeing on this legislation.21 A new French president, François Hollande, was also elected as voters started protesting against the Fiscal Pact and other austerity measures, suggested mainly by Germany. The credibity of such suggestions is now undermined as Germany itself is not able to send a signal to its European partners that austerity is what is preferred as well. 27. What is included in the Six Pack EU budget rules? The Six Pack EU budget rules, which, except for the fiscal framework, came in force in 2012, are a set of measures that should ease the process of imposing sanctions on EU countries that do not comply with the rules. The six-Pack is made up of five regulations and one directive proposed by the European Commission and approved by all 27 EU countries and the European Parliament in October 2011. These rules address fiscal policy and macroeconomic imbalances. Fiscal policy 1. Strengthening of budgetary surveillance and coordination of economic policies The problem of sustainable budget planning was addressed by introduction of a country-specific medium-term budgetary objective (MTO). This involves a cap on the growth of public expenditure according to a medium-term rate of growth. If budgetary plans deviate significantly from the rules, a country may be requested to prepare and present a new plan. A non complying country may be subject to financial sanctions (an interest-bearing deposit of at least 0.2% of GDP, as a rule). The sanction can be overturned only if a simple majority of countries (9 out of 17 euro area states) opposes it. 2. Speeding up and clarification of the implementation of the excessive deficit procedure This says that the deficit cannot exceed 3% of GDP, and debt cannot exceed 60% of GDP. If the 60% reference for the debt-to-GDP ratio is not respected, the member state concerned will be put in the excessive deficit procedure (even if its deficit is below 3%!), after taking into account all relevant factors and the impact of the economic cycle, if the gap between its debt level and the 60% reference is not reduced by 1/20th annually (on average over three years). If the country fails to cut spending according to recommendations, it can face a penalty of at least 0.2% of GDP. The sanction can be overturned20 http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/10/63621 http://www.businessweek.com/news/2012-06-13/merkel-seeks-fiscal-pact-deal-with-opposition-as-clock-ticks28 The Euro Area Crisis - 99 Q & A • June 29, 2012

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