The Euro Area Crisis - 99 Q & A, March 2012

The Euro Area Crisis 99 Q & A March 27, 2012

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 quarterly basis. Comments and suggestions for changes will be most appreciated. Cecilia Hermansson Group Chief Economist2 The Euro Area Crisis - 99 Q & A • March 27, 2012

A. The cause and starting point of the euro area crisis ............................................................ 8 1. When did the crisis in the EMU start and what role did the global financial crisis and recession play? .......................................................................................................................... 8 2. Why was the Stability and Growth Pact not adhered to?.......................................................... 8 3. In what way is the crisis a sovereign debt crisis, and why? ...................................................... 9 4. Why did yields on sovereign debt, which had been closely correlated despite country differences, start to diverge, especially in 2010? .................................................................... 10 5. In what way is the crisis a trade and competitiveness crisis, and why?.................................. 10 6. In what way is the crisis an issue of confidence for politicians and other policymakers? ..... 11 B. The economic, political and social impact of the crisis ........................................................ 12 7. How much must the euro area consolidate in fiscal terms and what is the impact on .growth? 12 8. Will the crisis cause a recession in the euro area? .................................................................. 12 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? ................................................................ 14 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, not least since many feel alienated from the newly created technocratic governments? ......................................... 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? ....................................................................................................... 16 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. How large is the credit default swap market in the euro area, and what impact does this 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 Fulfiled these? ............................................................. 20 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? ......................................... 233 The Euro Area Crisis - 99 Q & A • March 27, 2012

D. European politicians’ response to the euro area crisis ......................................................... 25 23. How have politicians in the euro area responded to the crisis, i.e., what are the major policy measures? ................................................................................................................................ 25 24. The process of politicians addressing the crisis has been described as “kicking the can down the 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? ..................................................................................... 30 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? ...................................................................................32 32. How has the ECB conducted monetary policy throughout the crisis?.................................... 32 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?33 34. What role do the LTROs play in bank capitalisation and credit austerity (direct role), and in the sovereign debt crisis (indirect role)? .................................................................................34 35. What is the difference between ECB support and some other central banks’ quantitative easing?..................................................................................................................................... 34 36. Will the ECB policies increase inflation? ............................................................................... 35 37. Should the ECB follow the private sector and write off its Greek debt? ................................ 35 38. What is the role of national central banks, how can they alleviate the crisis, and how are they related to the ECB? ................................................................................................................. 36 F. The involvement of the International Monetary Fund (IMF) in the euro area crisis….... 38 39. How does the IMF get its resources, and how much can it lend to countries in crisis? ......... 38 40. What role has the IMF played in the euro area crisis? ............................................................ 38 41. How is the IMF, as part of the EC/ECB/IMF (the “Troika”), supporting the crisis-struck countries in the euro area? ...................................................................................................... 39 42. Which countries have so far received loans from the IMF, in what ways, for how much, and under what conditions? ........................................................................................................... 40 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? ............................................ 41 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? ................................... 424 The Euro Area Crisis - 99 Q & A • March 27, 2012

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?................................................................ 42 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)?.......................................................... 43 G. Greece, Ireland, and Portugal – experiences of the first crisis-struck countries .............. 45 47. Why has Greece been hit the hardest by the crisis? ................................................................ 45 48. In what way has Greece received support? .............................................................................45 49. What are the reforms needed to get Greece out of the crisis? ................................................ 46 50. What has happened politically in Greece since the crisis started?.......................................... 46 51. Will and should Greece default, and should Greece leave the EMU? .................................... 47 52. Why did Ireland get into a sovereign debt crisis? ...................................................................48 53. How has the reform programme proceeded in Ireland, and why are risk premiums coming down? ...................................................................................................................................... 49 54. What have been the political consequences of the crisis in Ireland? ......................................49 55. Why did Portugal have to apply for a support programme? ................................................... 49 56. How will Portugal get out of the crisis economically and politically? ................................... 50 57. Will Portugal need a new rescue package? ............................................................................. 50 H. The spread of the crisis from periphery to core ............................................................... …52 58. Spain’s sovereign debt is not very high; why did financial markets lose confidence in the country?................................................................................................................................... 52 59. How has the crisis affected politics in Spain? ........................................................................ 52 60. What reforms is Spain planning to get out of the crisis? ........................................................ 53 61. Italy has had a high sovereign debt for a long time; why did the crisis only recently become acute? ...................................................................................................................................... 53 62. What have been the political consequences in Italy of the crisis? ..........................................54 63. What reforms will solve Italys problems? ............................................................................. 54 64. How have credit rating institutions rated creditworthiness in the euro area, including countries like Germany and France, and support mechanisms like the EFSF? ...................... 55 65. What is the risk that even countries such as France and Belgium could be hit by a sovereign debt crisis? .............................................................................................................................. 55 66. Will the support mechanisms be sufficient if the crisis spreads to the core? .......................... 56 I. The possible breakup of the EMU – how it would come about and how likely is it? …….58 67. Is there currently a legal way of leaving the EMU? ............................................................... 58 68. Does a country defaulting on sovereign debt have to leave the EMU? .................................. 59 69. Why would a country or several countries want to leave the EMU?...................................... 59 70. What would happen if a weak country, like Greece, left the EMU? ...................................... 595 The Euro Area Crisis - 99 Q & A • March 27, 2012

71. What would happen if a strong country, like Germany, left the EMU? .................................. 60 72. What are the pros and cons of breaking up the EMU? ........................................................... 61 73. What would happen to the EU if the EMU broke up? ............................................................61 74. How likely is the breakup of the EMU? ................................................................................. 62 J. The EMU in the longer term: how to fix it and why is this important? ............................. 63 75. What institutions are needed to make a currency union function well? ................................. 63 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? .............................. 64 77. What are the pros and cons of a Eurobond market? ............................................................... 64 78. What structural reforms are needed to boost competitiveness in the crisis-struck countries? 65 79. Is internal devaluation the only cure for Greece, and will it be successful, perhaps resembling the experiences of the Baltic countries?.................................................................................. 66 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? ............. 67 81. How will the EMU crisis affect euro area enlargement? ........................................................ 68 82. Why is it important from a longer-term perspective to save the EMU? ................................. 68 K. The EMU crisis – implications for Sweden and the Baltic countries ................................. 69 83. How important is foreign trade with the euro area for Sweden and the Baltic countries? ..... 69 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? .......................... 69 85. How is Estonia, as an EMU member country, affected differently by the crisis than Latvia, Lithuania, and Sweden? .......................................................................................................... 70 86. How likely is that Latvia and Lithuania join the EMU in 2014 as planned, and what are the challenges? ..................................................................................................................................... 71 87. In what way has the EMU crisis changed the likelihood of Swedens joining the EMU? ...... 72 88. How would Sweden and the Baltic countries be affected if the EMU crisis worsened and the currency union broke up?........................................................................................................ 72 89. What are the implications of the crisis for companies in countries outside the EMU, in relation to hedging foreign exchange risk? .............................................................................73 90. How are households in Sweden and the Baltic countries affected by the EMU crisis? ......... 73 91. Is the euro at risk and should therefore euro savings be avoided?.......................................... 74 L. The history and characteristics of the EMU ......................................................................... 76 92. Why and when was the EMU created? ................................................................................... 76 93. Which countries are members of the EMU and when did they adopt the euro? .................... 77 94. What are the conditions for membership? .............................................................................. 776 The Euro Area Crisis - 99 Q & A • March 27, 2012

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? ......................................................... 78 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? ............................................... 79 97. How does the euro area differ from the US as a currency area? ............................................. 80 98. How has the euro developed since it was created? ................................................................. 81 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? ............................................................................... 81 Acronyms ...................................................................................................................................... 837 The Euro Area Crisis - 99 Q & A • March 27, 2012

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.pdf8 The Euro Area Crisis - 99 Q & A • March 27, 2012

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.9 The Euro Area Crisis - 99 Q & A • March 27, 2012

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, rising10 The Euro Area Crisis - 99 Q & A • March 27, 2012

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.11 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. Will the crisis cause a recession in the euro area? Yes, a mild recession is expected in 2012 in the euro area as a whole, with negative GDP growth in the first quarters of 2012 before a gradual recovery in the second part of 2012. Large differences between countries are expected, however. Most vulnerable are those countries with the largest imbalances in public finance and with unfavourable competitive business sectors. Greece, e.g., is facing a very deep and long recession, or depression, whereas Germany’s recession is likely to be milder and shorter. 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 the12 The Euro Area Crisis - 99 Q & A • March 27, 2012

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 coordinate 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, including higher capital requirements, is a major difference compared with the treatment of the Japanese banking sector. 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.13 The Euro Area Crisis - 99 Q & A • March 27, 2012

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 the beginning of 2012, the unemployment rate was above 10% 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, with unemployment rates higher than 20% of the labour force. Youth unemployment has also reached record levels, with unemployment rates above 40% in Greece, Spain, and Portugal. In Germany however, total unemployment has fallen and was below 7% in the beginning 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, not least since many feel alienated from the newly created technocratic governments? Technocratic governments are nothing new in the EU. Italy formed several such cabinets in the 1990s to overcome financial crises, and Greece had a similar interim government in 1989-1990.The current technocratic governments in Greece14 The Euro Area Crisis - 99 Q & A • March 27, 2012

and Italy are temporary and will be replaced through ordinary parliamentary elections. In Greece, a parliamentary election is planned for April 2012. The Italian government will last longer and has more support for reforms and budget consolidation. 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. 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 • March 27, 2012

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.2 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 will be raised already in June this year, and banks must add EUR115 billion of extra capital to reach the new standard. 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.3 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 USD620 billion as of September 2011, according to data from the Bank for International Settlements in Basel (BIS); 60% 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 USD456 billion and USD326 billion, respectively. The largest exposure ratio to GDP is in France (22%), Portugal (17%), the Netherlands (16%), and Belgium (14%).2 ”Breaking up? A route out of the euro zone crisis”, RMF (Research on Money and Finance) Occasional report 3 // November 2011. www.researchonmoneyandfinance.org3 “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.pdf16 The Euro Area Crisis - 99 Q & A • March 27, 2012

Bank exposure to European debt to crisis-struck countries, September 2011 ($ bn) Greece Italy Portugal Spain Ireland Total % of GDP France 47.9 372.4 25.8 144.5 29.0 620 22.4% Germany 18.6 144.7 30.0 160.9 101.6 456 12.7% UK 11.5 61.3 23.4 93.1 137.1 326 13.5% Netherlands 4.1 38.2 5.2 70.0 15.9 133 15.9% Spain 1.0 35.5 78.8 8.6 124 8.3% Belgium 1.4 22.2 3.2 21.2 23.4 71 13.9% Switzerland 2.5 24.1 2.0 21.2 14.6 64 10.1% Italy 3.2 3.5 29.5 15.9 52 2.4% Portugal 8.7 2.5 24.5 5.2 41 17.2% Austria 2.6 21.4 1.2 6.2 2.4 34 8.1% 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 full 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%17 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. 4 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. 5 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 CDSs 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 selling 6 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. 7 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.4 “What are bankers doing inside EU summits?”, January 24, 2012 http://www.neurope.eu/blog/what-are-bankers- doing-inside-eu-summits5 “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#axzz1pjUPpxbZ6 Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without firstborrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. Whenthe seller does not obtain the shares within the required time, the result is known as a "failure to deliver”. Thetransaction generally remains open until the shares are acquired by the seller, or the sellers broker settles the trade.7 “Has the CDS market amplied the European sovereign crisis?“, Anne-Laure Delatte, Mathieu Gex, Antonia López- Villavicencio, September 10, 201018 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. 8 A number of rigorous economic studies have since shown that this thesis of speculatively driven CDS prices is largely unfounded. 9 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 USD3.2 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.10 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 began 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.8 “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#axzz1pjUPpxbZ9 An AIMA Research Note (2011), “The European Sovereign CDS Market”10 http://www.raymondjames.com/bond_market_update.asp19 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. 11 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 the 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.11 http://www.basel-iii-accord.com/20 The Euro Area Crisis - 99 Q & A • March 27, 2012

The new capital requirements to restore stability and confidence in the markets are the following. First, those institutions that are affected by the initiative should 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 EUR114.7 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? 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 EUR26.8 billion. • Between January and April 2011, a further net amount of some EUR50 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 EUR2.5 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 to21 The Euro Area Crisis - 99 Q & A • March 27, 2012

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 EUR114.7 billion (EUR8 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 EUR39.4 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 8th), 2nd – as published on Oct 26th) Thirty-seven banks failed the EBAs stress test in December. The test identified that German banks will have to raise EUR13 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 EUR3.2 billion and Commerzbank EUR5.3 billion. French banks will require EUR1.5 billion less22 The Euro Area Crisis - 99 Q & A • March 27, 2012

capital than the EUR8.8 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 EUR6.3 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. 12 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 banks 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 re-assess 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 EUR3 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 operation (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 EUR529.5 billion in cheap loans as the ECB conducted its12 http://www.eba.europa.eu/23 The Euro Area Crisis - 99 Q & A • March 27, 2012

second and possibly last three-year LTRO in February 2012. The ECB said a total of 800 banks were allotted funds under the LTRO. 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%.24 The Euro Area Crisis - 99 Q & A • March 27, 2012

D. European politicians’ response to the euro area crisis 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 mandate 13. 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. 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 the crisis. Instead, the crisis response has been characterized as cosmetic measures13 For more details, see Question 2625 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. 14 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) 15, “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 create money – once their public finances threaten to become unsustainable, banks can14 http://www.ft.com/intl/cms/s/0/622595e2-37c7-11e1-a5e0-00144feabdc0.html#axzz1o2bRWi6p15 Philipp Bagus (2010). The Tragedy of the Euro.26 The Euro Area Crisis - 99 Q & A • March 27, 2012

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. 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. 16 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 midyear be changed or complemented by the permanent European Stability Mechanism (ESM), whose capacity is EUR 500 billion. Its lending capacity may be increased to EUR 700 billion as the current capacity is thought to be too low if some bigger countries had to be bailed out. The euro area members, central bankers, and finance ministers plan to discuss the size of the bailout fund in Copenhagen on March 30-31. 17 Nevertheless, concerns have been expressed by IMF, ECB, and other officials that the size of the firewall is not sufficient and that it should be increased to EUR 1 trillion. 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. 18 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 be16 http://www.efsf.europa.eu/about/index.htm17 http://www.reuters.com/article/2012/03/16/us-eurozone-bailout-capacity-idUSBRE82F0JM2012031618 http://www.efsf.europa.eu/attachments/faq_en.pdf27 The Euro Area Crisis - 99 Q & A • March 27, 2012

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, extension of maturity, interest rate cut, and/or a “haircut.” 19 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 overturned only if a qualified majority of countries (12 out of 17 euro area states) opposes it.19 http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/10/63628 The Euro Area Crisis - 99 Q & A • March 27, 2012

3. Effective enforcement Noncomplying countries can be fined 0.2% of the previous year’s GDP. Even though the fines existed already under the Stability and Growth Pact, they were never enforced, whereas reverse voting now makes it difficult for states to overturn penalties. In addition, fines of 0.2% of GDP will be levied on countries that falsify debt and deficit statistics to meet EU requirements, as was the case in Greece. Penalties are first exacted in the form of interest- bearing deposits. They can be returned together with accrued interests if reforms are made. They are converted to non-interest bearing deposits and eventually fines if the country fails to reform. 4. Fiscal framework of the member states—setting of statistical and budgetary standards National accounts should cover all state agencies and public corporations. State accounts should be published monthly; regional accounts, quarterly. Debt and deficit limits should be written into law (except in the UK). Budget planning should be done over three years. Independent auditors should check all government accounts. These standards will be applied beginning in 2014. Macroeconomic imbalances 5. Prevention and correction of macroeconomic imbalances The excessive imbalances procedure (EIP) will identify and correct the gaps in competitiveness and macroeconomic imbalances, including public and private indebtedness, house prices, unemployment, current account balance, real effective exchange rates, etc. Preventive recommendation will be given to member countries in the early stage of forming imbalances. In the later stages, the countries will be required to submit a corrective action plan with a road map and deadlines. If after six months and two warnings no progress has been made, the country can be fined 0.1% of GDP. The fine can only be overturned by reverse qualified-majority voting. 6. Enforcement action to correct excessive macroeconomic imbalances in the euro area An interest-bearing deposit can be imposed after one failure to comply with the recommended corrective action. After a second compliance failure, this can be converted into a yearly fine of 0.1% of GDP. 20Sanctions can also be imposed for failing twice to submit a sufficient corrective action plan. At both stages, decisions can only be overturned if a qualified majority of countries (12 out of 17 euro area countries, with 157 out of 213 votes) opposes them.20 http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/89829 The Euro Area Crisis - 99 Q & A • March 27, 2012

28. What are the rules of the new Fiscal Pact and which countries belong to the new pact? The new Fiscal Pact, which was described as the first step towards fiscal union by ECB President Mario Draghi, was approved by 25 out of 27 member states at the end of January 2012 and was signed on March 2. The UK and the Czech Republic did not approve it. Now countries will have to ratify the pact or they will not be able to use bailout funds beginning in spring 2013. 21 The Fiscal Pact will add to the Stability and Growth Pact, which was adopted by all 27 countries. The new Fiscal Pact is an intergovernmental pact among 25 countries and therefore cannot be considered as a change to EU law. The aims of the Fiscal Pact are to insure greater fiscal discipline by introducing semi-automatic sanctions and stricter surveillance. 22 The main rules says that national budget has to be balanced or in surplus. This would be achieved if the structural deficit 23 did not exceed 0.5% of nominal GDP. If a country did not comply with this rule, the automatic correction mechanism would be applied. 24 Each country would also have to put this balanced-budget rule into national legislation, preferably on a constitutional level. In addition, countries will prepare reports on the plans for the issuance of debt. All major economic reforms should be coordinated. 25 The Fiscal Compact, which is the fiscal part of the Treaty on Stability, Coordination and Governance (TSCG) and the six-pack will run in parallel. On the one hand, a couple of provisions included in the TSCG are mirroring concepts existing in the Stability and Growth Pact as reformed by the six-pack. On the other hand, some provisions of the TSCG are more stringent than the six-pack. For example, it says that at each stage of the Excessive Deficit Procedure (EDP) "euro-area Member States" will support the Commissions proposals or recommendations in the Council if a "euro-area Member State" is in breach of the deficit criterion, unless a qualified majority of them is against it. In practice this means that if a "euro-area Member State" breaches the deficit criterion a kind of reverse qualified majority voting (RQMV) applies to all stages of the EDP, even if not foreseen in the six-pack. Moreover, as mentioned above, the TSCG requires Member States to enshrine the country-specific MTOs in national binding law, preferably of constitutional nature. In addition, the TSCG reinforces economic governance. 26 29. How will the sanctions system work? If a country did not include a balanced-budget rule in its national legislation within a year after the treaty was signed, the EU Court of Justice would have the right to decide upon this issue. The courts ruling would be mandatory, and, if a country did not comply, it could be fined up to 0.1% of GDP. If the country were in the euro21 http://online.wsj.com/article/SB10001424052970203986604577256862951941608.html22 see Question 27 on the “six pack”23 Structural deficit occurs when a deficit budget is in place even when the economy is at its full capacity24 look for more details on sanctions in Question 2925 http://www.european-council.europa.eu/home-page/highlights/the-fiscal-compact-ready-to-be-signed-(2)?lang=lt26 http://ec.europa.eu/economy_finance/articles/governance/2012-03-14_six_pack_en.htm30 The Euro Area Crisis - 99 Q & A • March 27, 2012

area, the fine would be paid to the ESM; if not, to the EU budget. 27 However, semi- automatic sanctions could be overturned by a supermajority of European countries. 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? The fiscal consolidation in troubled euro area countries, even though needed, is not enough to raise growth and increase employment in the longer term. Euro area countries, which do not have the possibility of devaluation, have to find other ways to restore their competitiveness. Euro area economic policies have been criticised for focusing less on growth than on budget consolidation. The euro crisis has called for an acceleration of vital structural reforms, which before had not been implemented. In February 2012, the Spanish government approved labour market reforms by which employees‘ maximum severance pay has been decreased from 45 days to 33 days salary for each year of service. 28 The purpose of this reform is, by increasing labour market flexibility, to raise employment and lower, in particular, long-term and youth unemployment. Italian Prime Minister Mario Monti has introduced reforms of his countrys generous pension system and inflexible labour market. The retirement age in Italy will rise; pensions will now be linked to contributions, rather than a workers final salary, as was previously the case. Also, more competition could be introduced into the transport sector. Greece also announced that it will lower the minimum wage by 22%, reduce pensions, and accelerate structural reforms of the labour, product and services markets. 29 However, time will be needed before these reforms, even if implemented successfully, begin to positively affect competitiveness, growth, and employment. In addition, reforms are important in the budget process and fiscal administration, to prevent corruption and ensure the rule of law.27 http://www.european-council.europa.eu/home-page/highlights/the-fiscal-compact-ready-to-be-signed-(2)?lang=lt28 http://www.france24.com/en/20120210-spain-economy-unemployment-severance-limit-debt29 http://www.bloomberg.com/news/2012-02-08/greece-to-pledge-20-cut-in-minimum-wage-pension-cut-draft- accord- shows.html31 The Euro Area Crisis - 99 Q & A • March 27, 2012

E. The roles of the European Central Bank (ECB) and national central banks 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? The primary objective of the European System of Central Banks (ESCB) and the European Central Bank (ECB) “shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2." (EU Treaty Article 127.1) According to the statute of the ESCB and the ECB, they may (i) operate in the financial markets by buying and selling outright or under repurchase agreement and by lending or borrowing claims and marketable instruments (any currencies and/or precious metals); and (ii) conduct credit operations with credit institutions and other market participants, with lending based on adequate collateral. Treaty Article 123.1.forbids overdraft facilities or any other type of credit facilities with the ECB or national central banks on behalf of public entities, as well as government bond purchases in the primary market. Treaty Article 124 prohibits privileged access of public entities to financial institutions if it is "not based on prudential considerations," while Article 125.1 states that the European Union shall not be liable for or assume the commitments of public authorities of any (including another) member state "without prejudice to mutual financial guarantees for the joint execution of a specific project." This implies that the ECB is not the lender of last resort for the member states (nor formally for banks, for which the national banks should serve as lenders of last resorts, but the ECB’s policies can relieve the situation for banks substantially; see question 33). 32. How has the ECB conducted monetary policy throughout the crisis? The ECBs monetary policy has been expansionary, employing both standard measures (e.g., policy rate cuts) and unconventional measures (e.g., increasing liquidity; see question 33 for more details). Following the collapse of Lehman Brothers in September 2008, the ECB lowered, within a period of seven months, the refinancing rate by 325 basis points (bps), from 4.25% to a historic low of 1%. It also allowed banks to borrow on more favourable terms (e.g., loosening collateral requirements), thus implementing an even more expansionary policy. The refinancing rate was kept at 1% until April 2011. With economic growth resuming and deflation pressures disappearing, the refinancing rate was then increased in two steps of 25 bps each to 1.5%. However, with the sovereign debt crisis and economic outlook worsening, the rate was cut by 25 bps in November and another 25 bps in December 2011 to its current level of 1%.32 The Euro Area Crisis - 99 Q & A • March 27, 2012

By injecting more liquidity in the banking system (see question 33 for more details), the ECB increased its balance-sheet liabilities from about EUR 1,400 billion (15% of euro area GDP) in early 2008 to about EUR 2,000 billion (about 23% of GDP) in late 2008. In 2009, this expansion was partly reversed, but the liabilities fluctuated close to this figure until late 2011 and early 2012, when they were boosted again to over EUR 3,000 billion (over 30% of GDP). 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? The financial crisis has required the ECB to go beyond the standard interest rate policy in three market segments: the interbank market, the covered bond market, and the sovereign debt market (the Securities Markets Programme). 30 In response to the financial market freeze in late 2008, the ECB adopted several measures that essentially replaced the missing intermediation in the interbank market by increasing intermediation through the central bank: • the fixed-rate full allotment policy, under which counterparties have their bids fully satisfied against adequate collateral, and on the condition of financial soundness (to ensure banks’ access to liquidity); • long-term refinancing operations (LTROs) with 6-month,12-month, and 3-year maturities (to reduce the funding risk faced by the banking system over a longer time horizon); • foreign currency operations, e.g., through swap arrangements with the US Federal Reserve (to reduce the threat from currency mismatches in the banks’ balance sheet); and; and • a broadening of the collateral framework (to increase the scope for banks to raise liquidity). The Covered Bond Purchase Programme (CBPP) was launched in July 2009 to reduce the sharply elevated money market short-term rates, ease funding conditions for credit institutions, encourage credit institutions to maintain or expand their lending to the private sector, and improve market liquidity in private debt securities markets. EUR 60 billion of covered bonds (i.e., securities backed by a separate “pool of loans,” usually public sector or mortgage loans) were purchased from July 2009 to July 2010. In October 2011, the second CBPP was announced, under which EUR 40 billion will be bought within the year, starting in November 2011. The objective of the Securities Markets Programme (SMP) is to repair the monetary policy transmission mechanism by intervening in public and private debt securities markets to ensure depth and liquidity in those market segments that are dysfunctional. As of February 2012, the outstanding amount of purchased securities was EUR 219 billion. In comparison to quantitative easing, which aims at injecting30 González-Páramo, José Manuel (2011) “The ECB’s monetary policy during the crisis”, Closing speech at the TenthEconomic Policy Conference, Málaga, 21 October 2011http://www.ecb.int/press/key/date/2011/html/sp111021_1.en.html33 The Euro Area Crisis - 99 Q & A • March 27, 2012

additional central bank liquidity in order to stimulate the economy (see question 35 for more details), the liquidity injected through SMP purchases is re-absorbed to neutralise the programme’s liquidity impact. 34. What role do the LTROs play in bank capitalisation and credit austerity (direct role), and in the sovereign debt crisis (indirect role)? The objective of the LTROs is to ease the funding pressures that banks are experiencing. Banks are free to use this funding to improve their liquidity and/or to increase credit to the real economy (especially small and medium-sized enterprises). Banks can also use this liquidity to buy sovereign bonds (particularly of troubled countries, where yields are higher). In this way, banks can profit on the risk premium differences and use the proceeds to increase their capital; meanwhile, they are causing prices for sovereign bonds to increase, thus reducing yields and easing the re-financing cost of public debt. The ECB lately started to wind down its euro area government bond purchases under the SMP. According to the ECB President, M. Draghi 31, the LTROs are a more effective tool for easing financial market tensions in the euro area. He argues that the three-year LTRO liquidity in December 2011 (as much as EUR 490 billion was lent at a 1% interest rate and under even broader collateral eligibility rules) not only helped to ease interbank funding pressures, but also stabilised the situation for troubled euro area countries by lowering sovereign bond yields. On February 29, 2012, the ECB extended an additional EUR 530 billion in three-year LTROs. Nevertheless, the amounts of funds deposited by euro area banks at the ECB hit record-high levels in late 2011 – early 2012 (over EUR 800 billion). This buildup suggests that a large part of the funding injected by the ECB into the banking system has yet to be put to use by the banks. Stress in financial markets is still high, and banks are very cautious about expanding credit volumes. 35. What is the difference between ECB support and some other central banks’ quantitative easing? In contrast to the ECB, the US Federal Reserve (the Fed) has the dual mandate of maximum employment and price stability. The main purposes of the Bank of England (BOE) are monetary and financial stability (the first one includes inflation targeting; the latter, being the lender of last resort). The objectives of the Bank of Japan (BOJ) include maintaining price stability, “thereby contributing to the sound development of the national economy,” and ensuring the "smooth settlement of funds among banks and other financial institutions, thereby contributing to the maintenance of stability of the financial system." Through quantitative easing, a central bank floods financial institutions with funding: it buys government securities or other securities from the market, in an effort to increase liquidity and lending. The EU Treaty prevents the ECB from buying government bonds in the primary market, while its bond purchases in the31 Interview with Mario Draghi (Financial Times), President of the ECB, conducted by Lionel Barber and Ralph Atkinson December 14, 2011 in Frankfurt, http://www.ecb.int/press/key/date/2011/html/sp111219.en.html34 The Euro Area Crisis - 99 Q & A • March 27, 2012

secondary market are sterilised so as not to increase liquidity (see questions 31 and 33). In contrast, the BOE and the Fed can buy government bonds to keep long- term interest rates low and help their governments finance debt. These two central banks are putting less weight on maintaining price stability than the ECB; for them, lack of growth is a bigger threat. For Japan, the main challenges at the moment are to fight deflation pressures and resist a stronger yen while helping the financial sector. Still, despite the different mandates, the balance sheets of all these central banks expanded notably during the crisis, e.g., from about 6% of GDP in 2008 to about 19% (end of 2011) in the US and UK, and, over the same period, from about 15% to about 30% in the euro area. 36. Will the ECB policies increase inflation? Whether increased liquidity will cause higher inflation will depend on (i) how much of it will end up as credit in the economy (liquidity held at the ECB deposit facility will not fuel inflation), and (ii) how timely the ECB will be in withdrawing the liquidity when the financial markets stabilise and the economy starts growing. Since the main objective of the ECB is price stability (it aims at inflation rates of below, but close to, 2% over the medium term), it is likely to react quickly if price pressures accelerates. This is especially so, if there is concern that the ECBs expansionary policies will lead to higher inflation expectations. The interaction of monetary and fiscal policy should also be borne in mind. As long as fiscal policy remains highly restrictive, an expansionary monetary policy should not increase inflation but rather decrease the risks of deflation. The ECB also tries to maintain incentives to consolidate budgets and implement structural reforms in the member states. For instance, a major LTRO was launched in December 2011 only after the EU leaders agreed on a fiscal compact that outlined rules for a more coordinated and restrictive fiscal policy, going forward. 37. Should the ECB follow the private sector and write off its Greek debt? Pressure on the ECB to write down some of its Greek debt has increased, with private investors arguing that the ECB should share the losses. About 90% of private investors are participating in the restructuring of Greek debt bonds. 32 This private sector involvement will reduce Greece’s debt by about EUR 100 billion (about 30% of the total debt, 75% of privately held debt in net present value terms). At the same time, there will be a new EUR 130 billion loan package from the European Financial Stability Facility (EFSF) and the IMF. It is argued by many experts that private sector involvement will not be sufficient (under the current programme, Greece is expected to reduce its debt to 120% of GDP by 2020), and the restructuring of debt owed to the public sector will be needed as well. 3332 Milne, Richard, Kerin Hope, Peter Spiegel, “Greek debt swap support close to 95%”, Financial Times, March 8, 2012http://www.ft.com/intl/cms/s/0/68a97dfc-6945-11e1-9618-00144feabdc0.html33 See, e.g., Roubini, Nouriel (2012) “A Sweet Greek PSI Deal Transfers the Bulk of Future Losses to the OfficialSector”, March 6, 2012 http://www.roubini.com/analysis/171289.php35 The Euro Area Crisis - 99 Q & A • March 27, 2012

In comparison to commercial banks, it is claimed that central banks can temporarily suffer “negative equity” – they should not be driven by profit motives, and, in case of insolvency, they have to be recapitalised by the public sector. The ECB fiercely resists the proposition to write down Greek debt, though. It claims that such write- downs, besides causing legal problems (referring to the ban on funding the member state governments; see question 31), might also weaken the credibility of the central bank and spark investor panic. The ECB also argues that their Greek bonds should be treated differently because they have been bought for policy reasons (to restore the proper functioning of markets). The ECB agreed, though, to distribute its profits from holding Greek bonds (estimated at about EUR 5 billion over three years 34) to the national central banks. These profits can then be used through the EFSF to finance the Greek programme. 38. What is the role of national central banks, how can they alleviate the crisis, and how are they related to the ECB? The national central banks (NCBs) of the Eurosystem (i.e., of those countries that have adopted the euro) are legal entities under the law of their respective countries. At the same time, they are an integral part of the Eurosystem and operate in line with the guidelines and instructions of the ECB. The NCBs are involved in conducting the single monetary policy of the euro area by carrying out monetary policy operations (e.g., providing central bank money to credit institutions) and ensuring settlement of payments. They also undertake foreign reserve management operations. In addition, the NCBs are largely responsible for collecting national statistical data and for issuing and handling euro banknotes in their respective countries. Under national laws, the NCBs can be assigned other functions unrelated to monetary policy functions, e.g., executing banking supervision and/or acting as the government’s principal banker. In their role as facilitators of payment settlements, the NCBs can inadvertently function as creditors to the national banking systems. When deposits are moved from a bank in one country to a bank in another, claims are routed through their national central banks, and, when these transfers are not equal, balances are built up. In fact, the Central Bank of Ireland has during the course of the crisis built up liabilities amounting to EUR146 billion, compared with EUR67 billion borrowed through the EFSF, and the interest on the former is substantially lower, 1% compared with 5%. Overall, the possible response of the NCBs by themselves to the crisis is very much limited because they, as intermediaries between local commercial banks and the ECB, play more of an assisting, administrative, and sometimes supervisory role. In addition, although the NCBs have the formal responsibility of being the lender of last resort to financial institutions in their jurisdiction, the lack of unlimited funding (I.e., by printing money, as well as the multicountry location of the financial institutions, restricts their actual ability to fulfil this role. On the other hand, the Governing Council of the ECB includes the governors of the central banks of the34 Atkins, Ralph, ”Draghi’s sleight of hand saves ECB from losses”, Financial Times, February36 The Euro Area Crisis - 99 Q & A • March 27, 2012

euro area countries. This implies that the NCBs participate in the decision making of the ECB as well.37 The Euro Area Crisis - 99 Q & A • March 27, 2012

F. The involvement of the International Monetary Fund (IMF) in the euro area crisis 39. How does the IMF get its resources, and how much can it lend to countries in crisis? The IMF derives its main funding from the member countries payments of their quotas (shares), which are calculated based on a formula that takes into account the relative size of the country’s economy, and its openness to international trade and capital flows. A country’s quota also determines its voting power in the board of the IMF. Currently, the US is the largest shareholder, with a quota of 16.5%, which means that the US can block decisions that require an 85% majority. The Nordic and Baltic countries, which together have one representative on the IMF Executive Board, have a quota of 3.3%, while large economies such as China and India have quotas of 6.1% and 2.5%, respectively. China and India represent roughly 14% and 6% of world GDP (at purchasing power parity) and are in these terms underrepresented in the decision-making process of the IMF. The IMF also holds gold, which it can sell to shore up its financing. In 2009-2010, 400 tons were sold (out of 3,200 tons), partly to support operating costs, and partly to finance concessional lending to low-income countries. The IMF can also borrow from its member countries. There are two standing arrangements--the New Arrangement to Borrow and the General Arrangement to Borrow--whereby the IMF borrows from its member countries. The IMF can also borrow bilaterally from its member countries by issuing notes to the official sector. The IMF determines its capacity to lend on a monthly basis by taking into account its available resources, including by projecting repayments and deducting already committed resources. As of end-January 2012, the IMF had a forward commitment capacity of USD391 billion, compared with USD158 billion in 2010. The increase is mainly made up of bilateral loans under the New Arrangement to Borrow arrangement. In addition there are limits on how much individual countries can borrow from the IMF, and this limit is based on the quotas. Under Stand-By and Extended Arrangements, for example, a member can borrow up to 200 percent of its quota annually and 600 percent cumulatively. However, access may be higher in exceptional circumstances. 35 40. What role has the IMF played in the euro area crisis? The euro area countries are all members of the IMF, and each has the benefits and obligations of a member country. Among the services the IMF provides to its members are regular economic surveillance and consultations (Article IV) and in- depth technical advice. The Article IV consultations focus on macroeconomic policies, and the technical advice on the effectiveness of economic policies, in35 For more information, see IMF Fact sheets (http://www.imf.org/external/np/exr/facts/eng/list.aspx)38 The Euro Area Crisis - 99 Q & A • March 27, 2012

areas such as tax policy, expenditure allocation, etc. Furthermore, the IMF carries out financial sector assessments in its member countries, focusing on financial stability. As with other currency/monetary unions (e.g., West African and East Caribbean) the IMF carries out an annual Article IV consultation with the euro area, in addition to the bilateral country Article IV consultations. In the consultation with the euro area, the analysis centres on monetary and exchange rate policies. The euro area countries can also individually apply for emergency borrowing in case of an economic crisis. Member countries’ obligations principally entail the payment of capital (see previous question), and timely and accurate reporting of macroeconomic data. Thus, given the membership of all euro area countries, the IMF’s involvement in the euro crisis predates the breakout of the crisis. For example, in its annual consultations with Greece, the IMF warned of growing imbalances and the need to strengthen competitiveness and lower the budget deficit. It also pointed out the lack of transparency in the accounts of the public sector. Following the outbreak of the crisis, the IMF has, together with the EU and ECB, provided emergency lending conditioned on policy reforms to restore macroeconomic balances and improve competitiveness. The IMF has also been involved in the European Bank Coordination Initiative (also known as the Vienna Initiative), together with other multilateral organizations, the EU and local institutions, and private sector banks. This initiative seeks to prevent large- scale and uncoordinated withdrawals of bank capital from crisis countries, which could cause systemic banking crises. 41. How is the IMF, as part of the EC/ECB/IMF (the “Troika”), supporting the crisis-struck countries in the euro area? The Troika is the coordination mechanism of the main financiers of the emergency loans to euro area crisis countries. The European Commission, which represents the EU countries, and the European Central Bank, which is responsible for monetary and exchange rate policy in the euro area, and the IMF have different rules and procedures, and it is therefore important to ensure that the assistance is not obstructed by differences in formalities. They also put forward different conditions for the lending programs and, by coordinating amongst themselves, can eliminate contradictory or overlapping demands. Furthermore, the Troika cooperation facilitates discussions with the recipient governments, in that they do not have to conduct negotiations separately with their three parties. The final decisions of the IMF, however, are taken independently by its 24-member Executive Board in Washington, where all member countries are represented, based on their quotas.39 The Euro Area Crisis - 99 Q & A • March 27, 2012

42. Which countries have so far received loans from the IMF, in what ways, for how much, and under what conditions? A total of 14 countries in Europe currently receive financial assistance from the IMF. 36 Of these, Greece, Portugal, and Ireland are part of the euro area. The IMF has created a number of different ways to provide loans to countries in economic crisis, referred to as arrangements, credit lines, or facilities. There are currently four different types of lending arrangements in Europe: the Stand-by Arrangement, the Extended Arrangement, the Precautionary and Liquidity Line, and the Extended Credit Facility. These are all non-concessional (i.e., the interest rate paid by the borrowing country is market related), in contrast to lending to low-income countries, which is subsidised. Greece was the first country in the euro area to receive an emergency loan from the IMF, in May 2010. 37 The total amount was EUR30 billion under a Stand-By Arrangement, and the loan agreement stretched for three years, with 12 quarterly disbursements. The euro area member states committed EUR80 billion in loans. The disbursements were conditioned on measures agreed and undertaken by the Greek government. In general terms, the conditionality included a reduction of the fiscal deficit to halt the buildup of public debt, sales of public assets (privatisation) to repay some of the existing public debt, and liberalisation of markets to increase efficiency and economic growth. The loan agreement between Greece and the IMF specified the conditions in detail. 38 For example, on fiscal policy, the Greek government had to reduce fiscal expenditures by cutting bonuses and by raising the value-added tax (VAT). It also had to specify a list of public assets to be privatised and pass new legislation that removed obstacles to competition in areas such as freight transport. However, the adjustment program was not successful, not least because growth was lower than anticipated and privatisation did not generate the amounts expected. Thus, in combination with a writedown of public debt by private creditors (the so-called PSI), the Troika and the Greek government have agreed to replace the existing agreement with a new one. The new loan amounts to EUR130 billion, of which the IMF provides EUR28 billion. Ireland applied and was approved for a loan from the IMF and EU countries in December 2010. 39 The total amount was EUR67.5 billion, of which EUR22.5 billion came from the IMF. In the case of Ireland, non-euro area countries also participated with bilateral loans (the UK, Sweden, and Denmark; included in the total). The main focus of the Irish adjustment program is to deal with and contain the large fallout from the financial sector collapse. The arrangement expires in December 2013. Portugal received a loan from the IMF and euro area member states in May 2011, amounting to EUR76 billion. 40 The loan period is also three years, and the arrangement expires in 2014. In the case of Portugal, the main issues were36 http://www.imf.org/external/np/exr/facts/europe.htm37 http://www.imf.org/external/np/loi/2010/grc/080610.pdf38 http://www.imf.org/external/pubs/ft/scr/2012/cr1257.pdf39 http://www.imf.org/external/pubs/ft/scr/2010/cr10366.pdf40 http://www.imf.org/external/np/loi/2011/prt/051711.pdf40 The Euro Area Crisis - 99 Q & A • March 27, 2012

identified as a long period of low economic growth, eroding competitiveness, and an increasing current account deficit. As a result, both the public and private sector debt had become unsustainable. Besides streamlining the public sector, reform efforts are directed at raising the competitiveness of the private sector. In particular, labour market reforms have been prioritised. 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? Debt sustainability is normally calculated by taking into account expected outcomes of the fiscal deficit, interest rate level, and economic growth rate. In a formal way, debt sustainability can be calculated as ∆D/dt = Pd + i×D; i.e., the change in debt over time (∆D/dt) is a function of the primary deficit (Pd - fiscal deficit, excluding interest payments) plus interest on the debt (ixD). It can also be expressed as a change in shares of GDP in the following way: D(D/Y)/dt = (Pd/Y) + (i-g)×(D/Y). Thus, change in debt as a share of GDP depends on the change in the primary deficit as a share of GDP (Pd/Y) and the difference between the real interest rate (i) and the real economic growth rate (g) times the existing debt level as a share of GDP (D/Y). The debt level is considered as unsustainable when, for reasonable interest rate and growth rate assumptions, a feasible fiscal policy cannot lower debt as a share of GDP. For the euro area countries as a whole, government debt as a share of GDP is estimated at around 85% in 2010, an increase from the previous year of about 5 percentage points and, compared with the period 2003-2006, of 15 percentage points. Thus, government debt is on an unsustainable but not irreversible path. Fiscal consolidation, increased growth, and lower interest rates would reduce the buildup. In comparison, the US public debt in 2010 is estimated at 93% of GDP, up from 61% in 2004. Furthermore, the debt trajectory is estimated to be significantly steeper than in the euro area, reflecting larger underlying fiscal deficits. Thus, while growth in the US is expected to be higher than in the euro area, the fiscal consolidation need is also larger. In Japan, public debt is estimated at 220% of GDP in 2010, significantly higher than in the euro area and the US. This high level is the result of repeated attempts to stimulate the economy through large primary balance deficits. Although the net debt in Japan is lower (117% of GDP when including government assets), the debt dynamics are not sustainable with no adjustment to the fiscal policy or with no increase in real economic growth. One important aspect in estimating debt sustainability is (implicit) contingent liabilities. This refers to either obligations that are not formally recognised by the government or public expenditures that, for structural reasons, are bound to increase. In the first category can be placed debt of public enterprises that, in case of default, would end up on the government’s balance sheet. An example of the41 The Euro Area Crisis - 99 Q & A • March 27, 2012

second category is age-related public spending. Both aspects are important to include in a debt sustainability analysis. 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? A common criticism of the IMF has been that the conditions imposed on the euro area countries that are receiving emergency loans is less harsh than the conditionality in the adjustment programs that had to be undertaken in crisis countries in Asia, Latin America, and Africa. To some extent, this critique is abating as the full impact of the reforms being felt by the populations in southern Europe becomes clear. However, it is clear that conditionality imposed on crisis countries has changed. In analysing the IMFs actions, the circumstances surrounding the various emergency packages—and, thus, the conditionality imposed-- are different. The conditions imposed on many sub-Saharan African countries were to a greater extent aimed at longer-term structural changes of the economies and were provided on more favourable economic terms (including subsidised interest rates and debt forgiveness). Thus, both the setting and the aims were different from the current euro area emergency programs. The Asian crisis in 1997-1998 was characterised by a sudden stop in capital inflows. The IMF conditions for providing emergency loans centred on exchange rate liberalisation and a tightening of fiscal policy. This, according to many, worsened the crisis as capital outflows escalated, further increasing the pressure on the exchange rate. In the Argentina program, the main criticism aimed at the support program and conditions was that the Argentinean government was allowed to maintain a fixed exchange rate policy for too long, and thus that the IMF was too accommodating in providing loans in an increasingly hopeless situation. Therefore, it is clear that the IMF has been treating different countries differently. However, the surrounding circumstances have also been different, and the IMF has learnt from mistakes. The IMF, along with other policymakers, expands its knowledge base with each case of crisis prevention and resolution. That means not only that the sovereign debt crisis in the euro area has to be interpreted in its own specific circumstances, but also that experience gained from earlier episodes should be used. 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? The IMF has estimated that the overall global financing need due to the euro crisis and the global financial crisis over the coming years amounts to USD1 trillion. 41 Thus, the resources that the IMF alone has available to date are not sufficient (see question 38).41 http://www.imf.org/external/np/speeches/2012/012312.htm42 The Euro Area Crisis - 99 Q & A • March 27, 2012

The ambition is to create, together with the euro area’s own resources, a financial firewall to stem speculation that, in particular, Italy and Spain will be next in facing financing problems. As of end-2011, Italy had a public debt of about USD2.3 trillion, and Spain’s public debt amounted to USD880 billion. Both countries are also facing significant rollovers in 2012: Italy approximately USD275 billion, and Spain USD50 billion. Thus, any IMF involvement in rescue packages for these countries would significantly exceed the programs in Greece, Portugal, and Ireland. For its part, the IMF aims to raise an extra USD 500 billion to enhance its lending capacity. 42 It is not yet clear how the IMF will fill this need, and it has called on individual members (including central banks) to increase their lending to the IMF. While some have responded positively (e.g., Norway and Sweden), the negative reactions have dominated. The US, facing internal political obstacles in an election year in that congressional approval is required, is arguing that the euro area countries can and should do more themselves before further external support is extended. Japan has requested a more credible plan from the EU, and Canada wants to prioritise low-income countries. China has maintained that, in order to support further IMF lending, it should receive more say in the decision making (i.e., get a larger voting share in the Board); it is also urging the EU to recognise China as a market economy, which will strengthen its position in trade disputes in the WTO. The euro area ministers have agreed to boost IMF resources to USD190 million, with an additional USD60 billion coming from other EU members. However, the UK has already declined to participate, and the Bundesbank has conditioned its participation on the involvement of other large countries outside the euro area. Furthermore, Germany has signalled that, in general, there is no urgent need to strengthen the firewall. 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)? Due to the euro area debt crisis (and, more generally, the global financial crisis), the IMF has returned to the centre stage of world macroeconomic policymaking and discussion. This is somewhat paradoxical as, just a year prior to the crisis, the relevance and purpose of the organisation on the global stage were widely questioned, and proposals were made to either merge the IMF with the World Bank or outright close it down. The reason for this questioning can mainly be attributed to two factors. First, criticism of IMF policy advice, in particular relating to the Asia crisis but also to the adjustment programs in the developing world, was widespread, and the IMF had lost some of its legitimacy. Second, international capital flows had grown significantly, and it was hard to imagine, at the time, that large countries would ever again need to turn to the IMF for assistance. Also, the big economies in Asia had after the Asia crisis built up sizable foreign currency reserves to be able to deal with economic emergencies without the involvement of the IMF. Although the global financial crisis and the subsequent European sovereign debt crisis have provided a role for the IMF, it will also change the nature of the organisation in the long run. It has become more evident that the governance system of the IMF, with voting shares not reflecting current global economic42 http://www.imf.org/external/np/sec/pr/2012/pr1258.htm43 The Euro Area Crisis - 99 Q & A • March 27, 2012

realities, will have to change if the IMF is to maintain its legitimacy and relevance. Voting power in the board will most likely switch from European countries to fast- growing Asian countries. This will also change the policy advice and recommendations of the IMF. The number of Executive Directors, 24, is considered to be too large to be efficient, and, to improve efficiency, it is not unlikely that, e.g., the EU will be represented by only one director instead of today’s seven. Furthermore, as the recent crisis has illustrated, many of the global economic risks stem from inter-economy sources and are exacerbated by weak national policies. This will likely change the IMF’s country- specific focus on economic policies (through the annual Article IV consultations) to a focus on intra-regional and international relations and interdependencies. This trend has already started, with increased attention paid to spillover effects and contagion risks.44 The Euro Area Crisis - 99 Q & A • March 27, 2012

G. Greece, Ireland, and Portugal – experiences of the first crisis-struck countries 47. Why has Greece been hit the hardest by the crisis? Greece entered the euro area in 2001. Supported by substantially lower interest rates and risk perceptions, Greece enjoyed high economic growth rates for many years. However, this came on account of a fall in competitiveness, as evidenced by a worsening current account deficit and increasing unit labour costs. These conditions were further exacerbated by strong public sector spending, which, as was later reported by Eurostat, was also consistently misreported and for which data had been manipulated. When the global financial crisis started to bite into Greece’s economy, major downward revisions for budget deficit expectations and outcomes were seen in both 2009 and 2010. Also, forecasts for Greece’s public debt level (which was already the highest in the euro area) worsened considerably. Due to the poor public finances, the Greek government had few instruments at its disposal to cushion the effect of the economic crisis. As a result, the markets’ confidence in Greece’s ability to repay its debts plummeted and default fears sunk in. In May 2010, in an unprecedented move, euro area countries, supported by the IMF, stepped in and offered Greece a bailout programme, amounting to EUR110 billion, to help deal with the consequences of the economic crisis. The political and economic situation in Greece has subsequently been affected by political turmoil, wide-scale general strikes, and riots. 48. In what way has Greece received support? An unprecedented rescue package for Greece, amounting to EUR110 billion (49% of GDP), was agreed on by euro area countries and the IMF in May 2010, in order to help the Greek government to repay its debts, make its interest payments more affordable, and, consequently, lessen the nervousness of the financial markets. This support came with strict conditions: Greece had to implement wide-scale austerity measures and structural reforms, laid out by the programme, in order to secure future payouts. Its progress was to be monitored regularly by the European Commission, the European Central Bank (ECB) and the IMF to estimate whether and how the targets were being met. However, there were signs early on that Greece, possibly affected by the political situation and will, was struggling to comply with the conditions laid out in the bailout programme. Reforms were delayed or not fully implemented, and deficit-reduction targets were constantly not met (in part due to the deepening of the economic recession as wide-scale austerity measures kicked in); meanwhile, debt-repayment costs and debt forecasts were continually growing. The fear of a possible (disorderly) Greek default and/or exit from the euro area made the financial markets nervous again. Almost two years after the first bailout, a second bailout for Greece was agreed on by euro area member countries in February 2012, amounting to yet another EUR130 billion (64% of GDP) and lasting for three years. Money received from the45 The Euro Area Crisis - 99 Q & A • March 27, 2012

second bailout is mainly being used for making bond swaps, stabilising the banking sector, and paying interest. In addition, in a unique setup, private sector bondholders have been included this time, who have agreed to take losses on the Greek debt (specifically, more than a 50% haircut from face value, or about 75% in terms of net present value); this is expected to ensure for Greece a faster reduction of debt, i.e., from the current level of above 160% of GDP to about 120% of GDP by the end of the decade. Various decisions made by the ECB regarding Greek bonds are also helping the situation (e.g., passing on the profits from its Greek bond holdings to euro area governments). The conditions and monitoring of this second bailout, however, are much stricter than in the first programme; the new programme puts a permanent team of monitors in place to ensure the targets and terms are met in full. 49. What are the reforms needed to get Greece out of the crisis? Greece needs reforms in many areas of the economy. While the austerity measures are helping to get the deficit and debt levels under control, and to avoid an outright default, additional structural reforms are needed to spur economic growth, competitiveness, and long-term sustainability. Several reforms either already have been done or are scheduled to be implemented, as set out by the conditions of the bailout programmes. As Greece has one of the lowest tax-to-GDP ratios in the euro area, tax reforms are essential to increase tax revenues – by both improving tax collection and abolishing some exemptions and benefits. Also, as the Greece internal market is very rigid and rather closed to competition (especially for services), the EU one-market policies need to be more rigorously enforced to make the Greek economy more competitive. Being part of a single currency area with no possibility for currency devaluation forces the Greek government to pursue internal devaluation by cutting salaries and pensions, in order to gain competitiveness; these labour market reform measures also entail reducing public sector workers’ benefits and payouts, as well as making overall labour laws more flexible. Other necessary reforms involve privatisation programmes, financial sector regulations, and the reform of bankruptcy procedures to make them more efficient. Most of these reforms were also part of the first bailout programme and have been made even stricter and more specific in the second one. 50. What has happened politically in Greece since the crisis started? Greece held general elections in October 2009, when the economy was already suffering under the worsening economic situation. After taking office, the new government, led by George Papandreou, admitted that the actual public finances were in much worse shape than previously expected or reported, prompting him to introduce a set of different austerity measures, in order to fight the crisis and restore confidence in markets. These measures were, on the one hand, met by nationwide strikes in Greece, and, on the other, criticised by the EU as not doing enough. As a result, the situation kept worsening, forcing the Greek government to ask for financial help from the EU in April 2010; this resulted in the introduction of a bailout programme in May. Mr. Papandreou’s popularity kept falling in the eyes of both the Greek people, who resented the severe conditions of the bailout programme, and the EU/euro area46 The Euro Area Crisis - 99 Q & A • March 27, 2012

officials, who realised that, as the debt crisis in Europe continued to worsen, Greece was unable to meet the conditions set out by the programme. In June 2011, Mr. Papandreou managed to survive a vote of confidence in the Greek parliament, although very narrowly. In order to stem the growing frustration of the Greeks and to deal with his falling popularity, Mr. Papandreou decided in October 2011 to announce a referendum on a previously negotiated new bailout deal. This angered his EU/IMF partners, causing (I) them to lose confidence in Mr. Papandreou, (ii) him to drop his referendum plan, and, eventually, (iii) him to lose his position as Prime Minister. In November 2011, after intense negotiations, a new “grand coalition” was agreed on, consisting of three parties and led by the new Prime Minister, Lucas Papademos, a technocrat. Mr. Papademos set as his main priority meeting the bailout conditions in order to allow the programme to continue and to keep Greece in the euro area. New general elections are planned for April 2012. General strikes, social unrest, and even riots have been a constant part of Greek everyday life since the first announcement of the need for austerity at the end of 2009. These events have also deepened the economic recession in Greece, which has seen negative growth rates since 2008 and is forecast to face them for years going forward, as well. 51. Will and should Greece default, and should Greece leave the EMU? Speculation over a default in Greece, even a disorderly one, has been around since the crisis emerged and the need for a bailout became evident. Furthermore, in 2011, all three major rating agencies lowered the Greek debt outlook to “in default” (their definition) levels. The advocates of a default claim that Greek debt has spiralled out of control; the country has become insolvent and its ability to repay its debt in the long term is unsustainable. Specifically, the debt-reduction goal set out in the second bailout programme (to reduce it to 120% of GDP by 2020, from more than 160% in 2011) is widely believed to be unrealistic and unachievable. The harsh requirements of both of the bailout programmes have deepened the crisis and only delayed the inevitable painful solution. Thus, the best solution would be to let Greece default; the political focus should be not on if but on when and how. The key to this solution is avoiding a disorderly restructuring and minimising the negative effects on the rest of the euro area. Several economic and political problems will arise: maintaining financial sector stability, avoiding contagion to other euro area countries, and deciding whether Greece should exit the EMU (and even the EU) and start issuing its own currency again. The default supporters also argue that not letting Greece default and setting a precedent by saving an insolvent country that does not obey its commitments send a clear message to other debt-struck countries: playing by the rules and suffering the painful processes of austerity and internal devaluation does not pay off. On the other hand, it is believed that a possible default will have unexpected, severe, and costly consequences for the whole euro area, and even for the European integration project. While the costs of a well-organised default can be more muted, the cost of a panic or disorderly default is very high for Greece and includes bank runs, capital flight, the closing of the public sector, and overall47 The Euro Area Crisis - 99 Q & A • March 27, 2012

political and social unrest. Devaluation (together with a possible return to the drachma) will hurt households and enterprises by accelerating inflation (as imports become more expensive) and raising interest rates, which notably weaken the overall domestic demand; the positive effects of default on a more competitive export sector, meanwhile, are believed to be short term and not noteworthy. Thus, the political incentives for Greece and its EU/IMF partners to find a mutually agreeable solution are still rather strong. 43 Also, it is believed that Greece can eventually get out of the crisis, if it is given enough time and it has the political will; both conditions are now believed to be present. Most of the problems and solutions in this ongoing debt crisis stem from political will and decisions; this makes future events particularly difficult to predict. And the nervousness of the financial markets adds to the overall uncertainty. Thus, it is likely that the decision on whether to default will be based more on political than on economic reasons. 52. Why did Ireland get into a sovereign debt crisis? Ireland enjoyed an economic boom during the 2000s, fuelled by the real estate and construction sectors, and supported by cheap loan money and a growing financial sector. In addition, wide-scale reforms strengthened the labour market, raising competitiveness and making Ireland very attractive to foreign investors. At the peak of the boom in 2007, private sector debt, due to the rapidly expanding banking sector, exceeded the country’s GDP by several times. The public sector debt ratio, meanwhile, was one of the lowest in the EU, at 25% of GDP. When the global banking and property crisis hit at the end of 2008, the countries with real estate bubbles were affected the most, including Ireland. At the beginning of the crisis, the Irish government tried to calm the markets by securing all bank liabilities in their country. However, the crisis turned out to be much worse than previously expected, which made the costs of the crisis for the government unaffordable. Several Irish commercial banks were taken over, and the banking sector was restructured by the government. However, this came at a large cost to the public sector and taxpayers, eventually resulting in a budget deficit of 32% of GDP in 2010. Thus, outside financial help was also needed to deal with the crisis and calm the markets. As a result, Ireland was forced to accept an EU/IMF-funded bailout programme in November 2010. The programme amounted to EUR67.5 billion (42% of GDP) and is scheduled to conclude at the end of 2013. By the end of 2011, public debt in Ireland had grown to over 100% of GDP. This level, which is already four times higher than before the crisis, is estimated to continue growing to more than 120% of GDP by 2013, according to the European Commission.43 For more analysis on a possible break-up of the EMU, look at section I.48 The Euro Area Crisis - 99 Q & A • March 27, 2012

53. How has the reform programme proceeded in Ireland, and why are risk premiums coming down? Ireland was forced to accept an EU/IMF bailout, amounting to EUR67.5 billion, in November 2010. This programme is scheduled to conclude at the end of 2013. So far, Ireland has been able to meet all of its programme requirements and has received all payouts as scheduled. Recently, investors’ confidence in Ireland has risen, and risk premiums have come down (e.g., the yields on 10-year bonds have fallen from a peak of 14% in mid-2011 to around 8% in the beginning of 2012). This can be attributed to several factors. First, Ireland managed to return to economic growth in 2011 (0.9%), the only euro area country with a bailout programme to do so. Second, Ireland has been successful in meeting the deficit reduction targets set by the programme and implementing all the required reforms and austerity measures (e.g., public sector wage cuts, and reforms of the social system and banking sector). Finally, political stability and independent bank stress tests made in 2011 have boosted investors’ confidence. In January 2012, Ireland successfully returned to the international bond markets, the first time since September 2010, and the yields on Irish bonds fell below 6% in February 2012. Since investors’ interest in financing Irish debt is quite high, the government expects to continue to tap the bond markets in the short term. 54. What have been the political consequences of the crisis in Ireland? The decision to accept a bailout programme to deal with the severity of the financial crisis was widely condemned by the Irish media and public. The loss of public support and collapse of the coalition over political disagreements eventually forced the government to step down in the beginning of 2011. New general elections were held in February 2011; as expected, the incumbent Prime Ministers party, Fianna Fàil, was swept from power. The new government, led by the Fine Gael Party, is committed to solving the financial crisis as quickly as possible and successfully meeting the conditions of the bailout programme, so as to end it on schedule. A certain state of political stability (especially compared with other debt-struck countries) has also been an important factor in Ireland’s relative success in solving the crisis and earning back investors’ confidence. Despite wide public dissatisfaction with the political situation in 2010 and 2011, neither massive street protests nor social unrest have been seen in Ireland on a scale similar to those seen in other debt-struck countries, e.g., Greece or Spain. Some trade union demonstrations were held during these years, but all of them came off quietly. 55. Why did Portugal have to apply for a support programme? Portugal was not directly hit by the global financial crisis in 2008-2009. However, even before that, when the core euro area was enjoying healthy economic growth, Portugal’s economy was stuck in a pattern of slow growth and an uncompetitive labour market. When the euro area was hit with the aftermath of the financial crisis,49 The Euro Area Crisis - 99 Q & A • March 27, 2012

Portugal took only limited measures to deal with the economic hardship and had difficulty in enacting structural reforms. The public debt had grown to above 90% of GDP by 2010. With Greece and Ireland already bitten by the bailout bug, the markets then turned to Portugal. As a result, the then-Portuguese Prime Minister, Jose Socrates, was forced to ask for a bailout in April 2011, although he had previously lost a vote of confidence in the parliament and new elections were couple of months away. This decision, long awaited by the markets, did not come as a surprise because bond yields had continued to hit new highs and had thus become unaffordable for Portugal. Despite the political turmoil, the need to ask for a bailout was agreed by all political parties. The programme came into force in May 2011, amounting to EUR80 billion (47% of GDP), as Portugal became the third country in the euro area to apply for a bailout. 56. How will Portugal get out of the crisis economically and politically? Portugal needs to introduce a wide range of structural reforms; these reforms, which are essential to gain competitiveness and foster economic growth, are long overdue. They should aim at, among others, increasing the flexibility of the labour market, stimulating competitiveness, and reforming the financial sector. Wide-scale reform requirements are also part of the bailout programmes conditions. Also, budget reduction targets, set by the programme, need to be met, and the debt levels need to be capped in the long term. These measures will not only raise growth prospects, but also restore investors’ confidence, which is crucial for a successful return to the bond markets, currently scheduled for September 2013. Like politicians in other debt-struck euro area countries, Portugal’s political leaders had to pay the price of the crisis: the government fell from power, and early elections were scheduled. The Prime Minister was forced to step down in March 2011 after losing a vote of confidence e in the parliament over an austerity package demanded by the EU-led “troika.” As a result, early general elections were held in June. Thus, the need to finalise the bail-out programme in May was so urgent that it was agreed by political parties who were expected to lose power in a couple of months. The new government has struggled somewhat to meet the bailout requirements, but has nevertheless stayed committed to doing so and avoiding additional political turmoil, a loss of investors’ confidence, or a new bailout package. Greater stability in the political situation and better co-operation with unions are also important keys to getting out of the crisis. 57. Will Portugal need a new rescue package? Since the bail-out programme started in May 2011, Portugal has been struggling to meet all its fiscal target requirements. Structural reforms and austerity measures have either been delayed or not put in place in full, while the austerity measures that have been implemented have deepened the economic recession. Thus, the markets have been worried that Portugal might turn into “another Greece” – i.e., slip into the “austerity requirements vs. new payout” cycle and eventually need another bailout. Although Portugal has been trying hard to avoid contagion from Greece, yields on Portuguese long-term bonds reached new highs in the beginning of 2012 amidst investors’ fears that Portugal might need another rescue package. In50 The Euro Area Crisis - 99 Q & A • March 27, 2012

addition, rating agencies’ actions to lower Portugal’s debt to “junk” status, as well as slow growth prospects, have compounded the worries. More recent news, however, has been more positive for Portugal, as yields have started to fall. This development has been supported by intervention by the ECB, as well as by suggestions by the bailout programme partners that, if needed, Portugal’s rescue plan could be adjusted – as long as the government maintains its commitment to the scheduled structural reform and fiscal adjustment plans. The key for Portugal to avoid a second bailout will be just that – ongoing structural reforms to convince investors that Portugal will be able to solve the crisis without recourse to an additional rescue package. According to the current plan, Portugal is scheduled to return to the international financial markets in September 2013.51 The Euro Area Crisis - 99 Q & A • March 27, 2012

H. The spread of the crisis from periphery to core 58. Spain’s sovereign debt is not very high; why did financial markets lose confidence in the country? Spain’s sovereign debt level was just above 60% of GDP in 2011, which is about 20 percentage points less than that of Germany and France. Although Spains accumulated sovereign debt is manageable, its total gross external debt is relatively high, standing at about 165% of GDP in 2011. It was built up from 1996 to 2008, largely driven by a massive real estate boom. 44 In addition, Spain’s debt problem is worsened by a lack of regional budget discipline. High debt makes the country and its banks dependent on access to external financial sources, which becomes more and more difficult when financial stress in the euro area increases. Spain’s housing prices eventually dropped (by about 20% from 2008 to 2011 45);, weakening the financial sector, particularly smaller regional banks, which were more exposed to housing loans. Loan overdues reached 15% of the banking credit portfolio. The government forced banks to raise capital, and weak banks were compelled to merge to reassure investors about the stability of the country’s financial system. The real estate bust slowed economic activity. GDP contracted by 3.7% in 2009 and 0.1% in 2010, and growth was only 0.7% in 2011. Unemployment jumped to 11.3% in 2009 and has been constantly rising, reaching 21.6% in 2011. With the fall in economic activity, the Spanish budget deficit rose to 11.2% of GDP in 2009. In response, Spain announced austerity measures to signal to financial markets that the country was safe for investments. However, reforms were slow to come and not deep enough, and the budget deficit decreased only to 9.3% in 2010 and to 8% in 2011, raising questions about the overall sustainability of the situation. Spain so far has managed to avoid the need for a bailout package from the EC/IMF/ECB “troika”. 59. How has the crisis affected politics in Spain? The Socialist government, led by Prime Minister Zapatero, won a mandate for a second term in spring 2008, primarily because the government was reluctant to react promptly to the economic slowdown. 46 It had to belatedly take more extreme measures, such as freezing pensions, cutting civil servants’ pay and unemployment benefits, raising the age of retirement, and hastily negotiating a constitutional reform to limit the deficit, and thus became unpopular. In December 2011, a new conservative government headed by Mr. Rajoy ended the Socialist Partys eight-year rule; the incoming government soon announced a new round of structural reforms and austerity measures intended to slash public44 http://iberosphere.com/2011/05/spain-economy-2802/280245 http://www.globalpropertyguide.com/real-estate-house-prices/S46 http://iberosphere.com/2011/10/spain-news-how-history-will-judge-zapatero/394452 The Euro Area Crisis - 99 Q & A • March 27, 2012

spending. The direction remained by and large the same as that of the Zapatero government. 60. What reforms is Spain planning to get out of the crisis? The deterioration in the economic indicators caused the 2011 budget deficit to reach 8% of GDP (the target was not to exceed 6%). The government announced immediate measures of EUR 15 billion (1.4% of GDP) to reduce the deficit to 4.4% of GDP in 2012. 47 However, the government recently agreed with the EC to set the target at 5.3% instead: • EUR 8.9 billion cuts in spending: a freeze of minimum wage and civil servants’ pay, a 20% reduction in subsidies to political parties and social agents, a rationalisation of administrative structures, and no new public employment in 2012; • EUR 6 billion in tax increases: a temporary increase in the personal income tax, a selective tax rate increase on real estate, and removal of oil subsidies; and • EUR 8 billion from a new programme combating tax evasion. The government plans to carry out a number of labour market reforms, including reducing dismissal costs and encouraging permanent labour contracts by offering tax deductions and bonuses if a company employs young workers and long-term unemployed. The government has approved reforms to stabilise the banking system and restore investor confidence. One reform requires banks to set aside provisions to cover toxic real estate assets by the end of 2012. The financial sector consolidation is to continue (the number of savings banks has already been cut from 45 to 17), and transparency and solvency requirements will be enhanced through provisioning and capital requirements. 61. Italy has had a high sovereign debt for a long time; why did the crisis only recently become acute? Italy has issued the largest amount of bonds of any euro area country; however, the average maturity is seven years and about a half is locally owned. This makes Italy less vulnerable to contagion from other crisis-struck countries. The economy has not been growing fast enough (lower than the EU average for over a decade) to compensate for the accumulating load of debt. Italys bond yields soared, exceeding in November 2011 the 7% “danger zone”, generally regarded as unsustainable. In 2010, Italys budget deficit was 4.6% of GDP, which is similar to Germany’s (4.3%) and much smaller than the UK’s (10.3%) or France’s (7.1%). Italy’s primary budget (which excludes debt interest payments) has been in surplus (except for 2009-2010), so Italy’s debt service puts a serious pressure on the public budget. The debt rose from 103% of GDP in 2007 to almost 120% in 2010 (EUR 1,842 billion). This has led investors to view Italian bonds as more and more47 Spain’s economic reform programme, Feb. 2012” http://www.thespanisheconomy.com/53 The Euro Area Crisis - 99 Q & A • March 27, 2012

risky, and the government 10-year bond yield rose from 4.8% to 7% during 2011. The need to roll over large debt volumes (e.g., about EUR 300 billion of Italys debt matures in 2012) has added to the market’s anxiety. 62. What have been the political consequences in Italy of the crisis? The crisis has changed the political scene in Italy. Mr. Berlusconi, the veteran leader who had dominated Italian politics for the last two decades, resigned in November 2011 after failing to deliver austerity measures quickly and deeply enough to reduce the financial stress weighing on Italy and the EU. He was replaced by a former EU commissioner, Mr. Monti, who formed a so-called technocrat government, which contains no elected politicians.48 On the one hand, such a government is more vulnerable to resistance in the parliament as it pushes through unpopular measures without the clear backing of particular political parties; on the other hand, these measures will not be associated with a particular political party and will thus be easier to win the parliament’s approval. The current government has been successful so far in reducing the stress in financial markets, and Italy is gradually regaining its place in the EMU crisis management team. Behind the slow growth of Italy’s economy are factors like poor financial regulation, vested business interests, weak investment projects, and an aging population. These problems can be handled successfully if the new Prime Minister gets all-out support from those who matter. The next election is not due until 2013, which provides some breathing space for bold reforms. 63. What reforms will solve Italys problems? The Berlusconi government adopted a EUR 70 billion (about 4.4% of GDP) austerity package in July 2011. 49 It included increases in health care fees, and cuts to regional subsidies, family tax benefits, and the pensions of high earners. The Monti government intends to balance the budget by 2013 and reduce Italys sovereign debt. 50 It has offered additional plans to cut spending and boost economic growth. Over three years, the package will provide about EUR 30 billion in spending cuts and tax hikes and EUR 10 billion to boost Italys weak growth. The latter consists of higher value-added tax, higher taxes on primary residences and luxury goods (like yachts, high-performance cars, and private airplanes), and an increase in the pension age. The programme includes deregulation measures to support economic growth, e.g., by opening up the rail transport industry to private competition. The package also includes measures on tax evasion. In the public sector, Italy has been cutting pay and freezing new recruitment. The Monti government is also seeking to reform the rigid Italian labour market. Existing legislation protects current employees, while discouraging new job48 http://www.bbc.co.uk/news/1016217649 http://www.bbc.co.uk/news/1016217650 http://www.reuters.com/article/2011/09/14/us-italy-austerity-idUSTRE78C7NF2011091454 The Euro Area Crisis - 99 Q & A • March 27, 2012

creation. Mr. Monti aims to overhaul the labour market to give more opportunities to young people (youth unemployment is running at over 30%) and women, and to increase the flexibility in a notoriously static system. 51 64. How have credit rating institutions rated creditworthiness in the euro area, including countries like Germany and France, and support mechanisms like the EFSF? All major credit rating agencies have responded to the EMU crisis by lowering sovereign credit ratings. The highest rating has been retained only for Finland, Germany, Luxembourg, and the Netherlands. Of the euro area countries that have entered EC/IMF bailout programmes, Greece and Portugal have been downgraded to “junk” status by all three major credit rating agencies; only one of the agencies has downgraded Ireland to junk status; the others are still rating it as “investment grade.” The European Financial Stability Facility (EFSF) still holds the best possible credit rating by Moody’s (Aaa) and Fitch Ratings (AAA). 52 But, in January 2012, S&P downgraded the EFSF from AAA to AA+ because of the reduced creditworthiness of the EFSFs guarantors. 53 S&P lowered to AA+ the long-term ratings on two of the EFSFs previously AAA rated guarantor members, France and Austria. The outlook for the long-term ratings of France and Austria is negative, indicating that there is at least a one-in-three chance that S&P will lower the ratings of the EFSF again in 2012 or 2013. 65. What is the risk that even countries such as France and Belgium could be hit by a sovereign debt crisis? Core EMU countries such as France and Belgium have also been hit by the financial crisis – their growth rates have slipped, budget deficits are up, their banks have been hit, and government bond yields in many cases have gone up. The core countries largely still retain market confidence as their overall macroeconomic situation is better. Of course, they remain susceptible to shocks from the weak EMU economies. For instance, if Greece defaults in a disorderly fashion, these countries will be hurt via both foreign trade links and their banking systems, which have not been adequately recapitalised yet. Belgiums sovereign debt was 96.2% of GDP in 2010, which at the time was the third highest in the euro area after Greeces and Italys. Belgium has not been able to prepare serious austerity measures because political infighting prevented formation of a government after the June 2010 elections. The government bond yields rose to 7% in December 2011 but have retreated somewhat after the formation of the new government in December 2011 and the ECB’s long-term refinancing operation (LTRO) interventions. So far, Belgium has been somewhat shielded from market pressures, and the situation seems manageable. One of the reasons is that, because the country’s household savings are equivalent to net51 http://www.france24.com/en/20120109-italy-begins-talks-labour-market-reform52 http://www.efsf.europa.eu/investor_relations/rating/index.htm53 http://www.telegraph.co.uk/finance/financialcrisis/9019001/SandP-cuts-EFSF-bail-out-fund-rating-statement-in-full.html55 The Euro Area Crisis - 99 Q & A • March 27, 2012

corporate and national debt combined, the debt can be funded internally if necessary. There are, however, certain concerns about the banks’ financial stability following the countrys financial crisis in 2008-2009. France is in a somewhat better position – its debt was 82.3% of GDP in 2010, and government bond yields are lower (having fallen from 3.4% to 3.2% during 2011). The government announced austerity measures (EUR 65 billion, or, in total, about 3.3% of GDP over three years) to reduce the budget deficit from 7.1% in 2010 to 4.5% in 2012, and to 3% by the end of 2013, and aims to achieve a balanced budget by 2016. 54 However, the main risk to France’s reforms comes from the presidential elections in spring 2012. One of Mr. Sarkozy’s key challengers, Mr. Hollande (a Socialist), is openly critical of European crisis management. In contrast to the current government, he wants to raise spending by EUR 20 billion over the next five years and to reverse Mr. Sarkozy’s pension reform, restoring to workers the right to retire at 60 rather than 62. 55 66. Will the support mechanisms be sufficient if the crisis spreads to the core? The euro area financial stability package for euro area countries consists of two temporary facilities: 56 • The Greek Loan Facility, amounting to EUR 80 billion, is to be disbursed over the period May 2010 through June 2013. • The European Financial Stability Facility (EFSF) supports all euro area states. The EFSF is backed by guarantee commitments from these states for a total of EUR 780 billion and has a lending capacity of EUR 440 billion. The EFSF has only EUR 250 billion left for supporting crisis-struck countries in need. In total, the euro area’s governments have to repay more than EUR 1.1 trillion in debt just in 2012, which includes about EUR 519 billion of Italian, French, and German debt maturing in the first half of 2012.57 If other euro area countries are not able to borrow in financial markets, European stabilisation actions will not be enough to finance the entire euro area debt. A new permanent crisis mechanism, the European Stability Mechanism (ESM), will be set up in the euro area as of mid-2012. Its main features will build on the existing EFSF. The ESM will complement the new framework for reinforced economic surveillance in the EU. This new framework, which will look more closely at members’ debt sustainability, contains more effective enforcement measures and focuses on prevention. It will substantially reduce the probability of a future crisis. Unlike the EFSF, which is backed by guarantees, in the ESM, euro area countries will have to pay in capital of EUR 80 billion. In addition, the ESM will have the right to call for additional capital from euro area member states for a total amount of EUR 620 billion. The ESM’s effective lending capacity will be EUR 500 billion.54 http://www.nytimes.com/2011/11/08/world/europe/french-austerity-measures-aimed-at-new-reality.html55 http://www.economist.com/node/2154601556 http://ec.europa.eu/economy_finance/eu_borrower/index_en.htm57 http://ciovaccocapital.com/wordpress/index.php/economy/the-problem-massive-amounts-of-debt-due-in-2012/56 The Euro Area Crisis - 99 Q & A • March 27, 2012

However, at the EU summit held on December 9, 2011, the EU heads of government and state agreed to reassess in March 2012 the adequacy of the EFSF/ESMs overall ceiling of EUR 500 billion.57 The Euro Area Crisis - 99 Q & A • March 27, 2012

I. The possible breakup of the EMU – how it would come about and how likely is it? 67. Is there currently a legal way of leaving the EMU? The Lisbon Treaty governing the EU does not make a provision for exiting the EMU (the Economic and Monetary Union), whether in a voluntary way or by expulsion. It only sets out a mechanism for countries to negotiate their exit from the EU (Article 50) 58. Given that EMU membership is compulsory for all EU countries unless they have negotiated an opt-out (the UK and Denmark have a legal opt-out, while that of Sweden is informal), exiting the EMU would mean exiting the EU. In addition to Article 50, there is another way a country could leave the EMU. The Lisbon Treaty refers frequently to the solidarity principle, under which member countries are expected to share the EU’s advantages (e.g., prosperity) and responsibilities (e.g., budget discipline). A country’s failure to repay loans to fellow member countries could serve as an excuse for its expulsion from the EU. Hence, at the moment, to leave the EMU would also mean leaving the EU, and thus to withdraw from the customs union, lose access to structural funds and direct transfers from the EU budget, lose access to ECB funding for a country’s banking system, etc. According to Article 50 of the Lisbon Treaty, withdrawal from the EU takes place in accordance with the exiting country’s constitutional requirements, which typically would involve a referendum by which its citizens would vote on the decision. This would create an extended period of anxiety, financial market panic, and bank runs. Leaving the EU involves a huge economic cost, and, to limit it, a search is ongoing for a legal mechanism as a contingency plan that would permit a country to exit the EMU while retaining the EU membership. Of course, this search is being conducted “behind closed doors” as open discussions and negotiations would create financial market panic and bank runs. One of the very few things so far seen in public is the discussion at the 24th Party Conference of CDU Germany, Germanys governing party, in Leipzig on November 14, 2011, where the relevant proposal reads as follows: “In case of insolvency, an orderly procedure to relieve debt must be implemented. Its aim must be to restore financial capacity while guaranteeing a continuation of public services. Such a restructuring process is to be overseen by an EU Savings Commissioner with the right to enforcement in case of non-compliance. Private creditors must participate during all stages of the restructuring process in order to prevent adverse market reaction and contagion to other Member States of the euro area. If a Member State of the euro area is permanently unwilling or unable to comply with the setting of regulations of the EMU, it may voluntarily leave the EMU without leaving the EU in accordance with the Lisbon Treaty. 5958 See, e.g., “Answers to 10 common questions on EMU breakup”, JP Morgan, December 7 201159 “German CDU’s European Roadmap Revisited: EMU Exit Clause in the Cards?“, Roubini Global Economics, January 9, 201258 The Euro Area Crisis - 99 Q & A • March 27, 2012

68. Does a country defaulting on sovereign debt have to leave the EMU? Not necessarily. The second bailout package for Greece includes a 53.5% haircut (or write-off) on the face value (which is equal to a 75% haircut in net present value terms) of private sector-held Greek bonds issued under the legislation of Greece. Although the credit rating agency Standard and Poor’s recognises this as a selective default, Greece is still a member of the EMU. The Lisbon Treaty refers frequently to the solidarity principle, under which member countries are expected to share the EU’s advantages (e.g., prosperity) and responsibilities (e.g., budget discipline). 60 A country’s failure to repay loans to fellow member countries could serve as an excuse for its expulsion from the EU and, thus, the EMU. The EU has not exercised this option, but Greece has not yet defaulted on the EU bailout, either (though a second bailout package has been necessary). 69. Why would a country or several countries want to leave the EMU? A weak country may consider leaving the EMU in order to regain monetary independence and adjust its relative prices of tradables and nontradables by devaluing its national currency, i.e., to improve the competitiveness of its exports in order to restart growth. Within the EMU, exchange rate adjustment vis-à-vis other EMU member countries, which are often the major trade partners, is impossible, and the necessary relative price adjustment may be made only through (i) deflationary processes, which deepen deleveraging and/ or (ii) productivity improvements, which take time. Devaluation allows the overnight readjustment of relative prices and, in certain situations, could be viewed as a less cumbersome choice. Of course, devaluation by no means guarantees improvements in productivity and, thereby, sustained economic recovery. Furthermore, devaluation increases the price of imports and causes inflation (which is particularly the case for small, open economies); thus, the gains in competitiveness are usually only temporary, especially if social benefits and wages are indexed to price changes. By leaving the EMU, a country regains its ability to print its own money – which may ease the sovereign’s debt burden if the debt has been issued under local legislation and, thus, can be redenominated into the new national currency. A strong country may consider leaving the EMU in order to avoid a free ride for the weak economies in the form of, e.g., an increase in cost of its debt financing, as the strong EMU member may be forced to take over part of the weak members’ debt. 70. What would happen if a weak country, like Greece, left the EMU? For a weak country leaving the EMU, one may expect the following shifts. First, its currency would be devalued massively. Second, capital controls would need to be introduced both to support the new currency and to prevent capital flight from the banking system. Third, the risk of the banking systems being wiped out through runs on deposits would require limiting clients’ access to their accounts. Banks60 For more details see, e.g., “Answers to 10 common questions on EMU breakup”, JP Morgan, December 7 201159 The Euro Area Crisis - 99 Q & A • March 27, 2012

would need to be recapitalised, credit crunch would set in, and foreign trade flows would suffer. Fourth, no or very limited access to external financing would cause the weak country to resort to more austerity to balance its budget. Access to financing would be limited also for the private sector, which would mean sharp falls in household consumption and business investment. If fiscal austerity is not installed, the central bank would need to start printing money, which would entail high inflation and the risk of repetitive devaluations. Fifth, legal disputes on the currency denomination of existing debt would detain new capital inflows. Sixth, under existing legislation, leaving the EMU is the same as leaving the EU, which would mean losing access to EU financial support, trade agreements, etc. Belke (2011) 61 estimates the cost of exit for a weak country at 40-50% of its annual GDP. Of course, such costs are by no means trivial, even if the estimates are subject to various uncertainties and the errors are notoriously large. Even though the Greek economy is small and represents only 2% of euro area´s GDP, its exit would have serious spillovers to other EMU economies via not only foreign trade but, more important, expectations and psychological effects in financial markets. For instance, speculation would begin immediately on who is the next to exit the EMU, which would put enormous financial market stress not only on other weak economies, but also on the strong ones. Asset prices would fall sharply,, hitting the banking sector both through direct holdings of Greek assets and through indirect and possibly even more devastating effects of price falls in other asset classes. These indirect effects would kick in both as (i) safe assets are sold to meet margin calls for impaired Greek assets, and (ii) overall market sentiment dives. The banking sector would need to be recapitalised, which would very likely lead to an extended credit crunch. If a weak country exits in a disorderly fashion during extreme financial market stress, its impact would be worse than the Lehman Brothers’ exit since this time there would be fewer tools available to policymakers to stabilise the economies. On the other hand, the ECB, by issuing some EUR 1 trillion (see question 34 for more details), has signalled that it is ready to act to prevent contagion. The cost would be smaller if the exit is not disorderly, i.e., if it has been carefully worked out, the country does not need to leave the EU, and the exiting country is ring-fenced from other EMU countries prior to its exit in order to limit financial market contagion. 71. What would happen if a strong country, like Germany, left the EMU? A strong country would fare better after its exit from the EMU than a weak country (see question 69). Its currency would appreciate as it would rid itself of the ballast of the weak countries. It would be unlikely that a strong country would experience a run on its banking system. Instead of capital flight, capital is likely to flow into the strong economy from the weak ones, which would appreciate its currency more. The strong country would find it cheaper to service its existing euro-denominated debt as its own currency would have become stronger; thus, there would be no legal challenges to the currency denomination of its sovereign debt. However, under the current legislation, its EU membership would be at stake as well, which would mean, e.g., trade flow disruptions and the possible introduction of61 Belke, A. (2011) “Doomsday for the euro area: Causes, variants and consequences of breakup”60 The Euro Area Crisis - 99 Q & A • March 27, 2012

tariffs by the remaining EMU countries. Appreciation of its currency would worsen its external competitiveness and hit exports. Also, stagnation or recession in the euro area as a whole would worsen trade prospects. The balance sheets of banks would also be hit, and the banking system would need to be recapitalised – liabilities would by and large be redenominated into the new national currency, whereas, on the asset side, not all euro assets would be redenominated into the new currency. In general, leaving the euro area would mean a devaluation of the external assets held by the financial sector, households, and companies. One must also consider the loss of political influence of the country. Belke (2011) 62 estimates the cost of exit for a strong country at 20-25% of its annual GDP. Of course, such estimates are subject to uncertainties, and the errors are notoriously large. Yet, even if a potential loss is grossly overvalued, it is certainly nontrivial – in comparison to, e.g., the recent post-Lehman recession, when the German GDP shrunk by about 5%. The scenario that the EMU would still remain after strong countries exited is extremely unlikely. First, the cost to the strong countries if weak countries exit is less than the cost of themselves exiting the EMU. Second, the weak economies can survive within the EMU only because they can free ride on the strong ones. When the strong ones leave, there is no one to free ride on anymore; the system would thus cease existing or be transformed into something different, e.g., with a different mandate for price stability than the current EMU. 72. What are the pros and cons of breaking up the EMU? A breakup of the EMU and ensuing devaluation of the weak countries’ currencies and appreciation of the strong countries’ currencies would speed up relative price adjustment and improve (at least temporarily) export competitiveness for the weak economies. Higher inflation in these economies would reduce the depth of deleveraging that they need to go through. The evidence from the EMU countries shows that nominal price adjustment through deflation has been muted so far; most of the adjustment has been taken on through falling economic activity and rising unemployment, which increase the social cost of the adjustment. A breakup of the EMU (especially when disorderly) would create havoc in financial markets and push the economies into deep recessions (see the questions above in this section). Devaluations and ensuing shifts in asset prices would produce massive wealth reallocations away from savers (i.e., debt holders) towards spenders (i.e., debtors). Currency devaluation alone would not solve fundamental structural problems, such as inefficient labour markets – painful structural reforms would still be necessary to put the weak economies back onto a path of sustainable growth. 73. What would happen to the EU if the EMU broke up? Under the current legislation, if a country exits the EMU it must also exit the EU. 63 Only the UK and Denmark have negotiated a legal opt-out from the EMU while62 Belke, A. (2011) “Doomsday for the euro area: Causes, variants and consequences of breakup”63 See, e.g., “Answers to 10 common questions on EMU breakup”, JP Morgan, December 7 201161 The Euro Area Crisis - 99 Q & A • March 27, 2012

being members of the EU. Sweden has an informal opt-out. Thus, the breakup of the EMU would mean that the EU would consist of only the UK, Denmark, and Sweden – unless they choose to abandon the EU as well. However, given the large positive economic and political benefits of, e.g., the single goods and services market and the immense negative effects from renewed protectionism, it is very unlikely that the breakup of the EMU would lead to a breakup of the EU. It would be expected that policymakers would strive to adjust the legislation so as to maintain the EU. 74. How likely is the breakup of the EMU? The probability of the breakup of the EMU is very low. The key reason is that the cost of breaking it up is significantly higher than the cost of holding it together (see other questions in this section for details). If the overall economic situation improves, financial markets may ease immediate pressure on the weak economies and give them more time to correct their imbalances, thereby reducing social stress within the weak economies and thus the probability of an EMU breakup. However, if the economic situation were to improve in the strong economies while the weak ones kept underperforming, it would become easier to ring-fence the weak ones, and their contagion effects would grow smaller. In such a case, the probability of certain economies exiting voluntarily or being expelled would increase. In general, if euro area policymakers are unsuccessful in strengthening the EU institutional framework to support economic growth, ensure fiscal discipline, and strengthen crisis resolution mechanisms such as the ESM, the probability of an EMU breakup would increase over the medium term.62 The Euro Area Crisis - 99 Q & A • March 27, 2012

J. The EMU in the longer term: how to fix it and why is this important? 75. What institutions are needed to make a currency union function well? The basis for a well-functioning currency union is the theory on optimum currency areas, as developed by Robert Mundell in 1961. 64 (See question 96) In an optimum currency area, according to the theory, there should be a flow of labour, capital, and products between countries, and institutions need to be set up in order for the currency union to work well, especially when a crisis occurs. These institutions are often referred to as having a fiscal union, a financial union, i.e. one bank regulator only (not 17) and a central bank that is lender of last resort also to sovereigns (not only banks). See, e.g. Barry Eichengreen, Professor at University of California, Berkeley. As a parallel to, and 20 years after Mundell developed his “trilemma,” according to which no country can enjoy at the same time free capital flows, stable exchange rates, and independent monetary policies. Bruegel, the Brussels-based think tank, has described a new impossible trinity. 65 The euro area is facing another trilemma, due to the setup in the EU Treaties: the absence of co-responsibility over public debt, the strict no-monetary-financing rule, and the national character of banking systems. The “New Trilemma” Even if these three institutions are needed, the popular support to create them may not exist, at least in the short and medium term. Although the fiscal pact is one step towards closer fiscal coordination, a shared responsibility of public debt is lacking.64 Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". American Economic Review 51 (4): 657–665.http://www.jstor.org/stable/181279265 http://www.bruegel.org/publications/publication-detail/publication/674-the-euro-crisis-and-the-new-impossible-trinity/63 The Euro Area Crisis - 99 Q & A • March 27, 2012

The ESM, which is likely to start operating this summer, will be a kind of lender of last resort to sovereigns (or a mechanism of transferring funds as an alternative to these other institutions), with a capacity of about EUR 500 billion. This capacity would not be sufficient if larger countries such as Italy and Spain needed support at the same time. 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? As long as the EMU is not characterised as being either a fiscal union or a financial union, with the central bank also as lender of last resort to sovereigns, the alternative must be to transfer loans and other types of support to countries with payment problems, as these countries cannot print their own money. Originally, transfers between countries, or “bailouts,” were not allowed (see the EU Treaty.). However, with the crisis in the euro area, support mechanisms have been set up, such as the European Financial Stability Facility (EFSF), and the subsequent European Stability Mechanism (ESM) (see question 26) that in effect act as a transfer union. The sustainability and credibility of the euro areas crisis management will depend on the size of these support facilities, and the flexibility to be able to use them when a new crisis occurs. At the moment, the facilities are not large enough to be effective: they would need to be larger to create confidence in financial markets that the currency union would not collapse if any of the larger economies had problems similar to those of Greece, Ireland, or Portugal. 77. What are the pros and cons of a Eurobond market? It has been suggested that European bonds (or Eurobonds or Stability bonds) could be issued jointly by the 17 euro area countries. 66 Eurobonds would be debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate to the euro area bloc as a whole, which then forwards the money to individual governments. Eurobonds could have five major advantages: • Eurobonds could alleviate the current sovereign debt crisis, as the high-yield member states could benefit from the stronger creditworthiness of the low-yield member states. • Eurobonds could make the euro area more resilient to future adverse shocks and so reinforce financial stability. They would provide a source of more robust collateral for all banks in the euro area, reducing their vulnerability to a66 http://ec.europa.eu/economy_finance/consultation/stability_bonds/pdf/green-pepr-stability-bonds_en.pdf64 The Euro Area Crisis - 99 Q & A • March 27, 2012

deterioration in credit ratings of individual member states. • Eurobonds could improve the effectiveness of euro area monetary policy, as they would create a larger pool of safe and liquid assets, with ECB policies having a more direct effect on borrowing costs. Assuming a pooling of up to 60% of euro debt, that market alone would be large, amounting to EUR 5 000 – 6 000 billion, compared with EUR 7 250 billion for the US Treasury market. • Eurobonds would promote efficiency in the euro area sovereign bond market and in the broader euro area financial system. The liquidity and high credit quality of the Eurobond market would deliver low benchmark yields, reflecting correspondingly low credit risk and liquidity premiums. • Eurobonds would facilitate portfolio investment in the euro and foster a more balanced global financial system as they would promote the rise of the euro as a major reserve currency. At the same time, the use of Eurobonds could have disadvantages: • Taxpayers in core countries would guarantee the debt of the whole euro area. A country in trouble may, despite commitments, be unable or refuse to pay for its share. • Eurobonds could weaken fiscal discipline since, in the case of a complete pooling of bond issuances, there would be no national bonds, and therefore, markets would not be able to discipline governments. There is doubt about whether the reformed Stability and Growth Pact could keep countries disciplined. • Because the yield on the Eurobonds would be above the current German yields, it would be more expensive for Germany to pay its debt. The arguments against Eurobonds could be met by the proposal from Bruegel to set up a blue bond market for up to 60% of the debt, leaving the rest as a red bond market, i.e., bonds issued by individual countries. 67 The red bonds, with generally higher yields, would help to enforce fiscal discipline, while the yield for the blue market would be lower; because of this market’s size, its yield could even be comparable to or lower than the benchmark German bond. 78. What structural reforms are needed to boost competitiveness in the crisis- struck countries? The most important reforms should include measures (i) creating credible public sector institutions that would, inter alia, achieve budget discipline, and (ii) enhancing growth by achieving a better functioning of markets, e.g. for labour, products, and capital. There is a lot of room for “cutting red tape” in peripheral euro67 http://www.bruegel.org/publications/publication-listing/?author=10-jakob-von-weizsacker&category=&topic=&year=&sort=date&pp=1065 The Euro Area Crisis - 99 Q & A • March 27, 2012

zone economies – labour markets are overregulated and overprotected, and various sectors are shielded from competition, rendering companies dormant and uncompetitive. To improve the functioning of markets, measures should also be taken to increase competitiveness through better education and the direction of more resources towards research and investment (R&D). The results would be visible in the medium to long term. One important way to strengthen competitiveness is to attract foreign direct investment (FDI), as the inflow of capital, human resources, and ideas can create jobs and other spillovers in the economy, such as new companies. Also, FDI usually helps to increase productivity growth. 79. Is internal devaluation the only cure for Greece, and will it be successful, perhaps resembling the experiences of the Baltic countries? As countries in the euro area with payment problems do not have the possibility of printing their own money, a weaker currency is not a solution for a crisis-struck country. If the country is having an asymmetric shock, which means that other countries in the euro area are not affected, it could even be a situation in which the ECB increases interest rates, thus making monetary policy even more restrictive for the country in shock. If fiscal policy stimulus is not an option because budget deficits are large, and financial markets are not willing to lend more unless risk premiums are very high, the only way out for the country is to carry out an internal devaluation while implementing structural reforms to enhance growth over the longer term. An internal devaluation means that domestic production costs are lowered to restore international competitiveness. Costs are primarily related to the labour market, such as wages and employers’ fees, pensions, etc. At the same time, measures that increase productivity will also keep unit labour costs low. Compared with an ordinary devaluation of the currency, an internal devaluation takes longer and is sometimes considered more harmful to society. In the Baltic countries, wage costs were lowered, both by reducing wages and by laying off employees. Competitiveness has improved, but the process is not yet finished. Unemployment has increased, as well as emigration. If the internal devaluation sometimes risks causing deflation, currency devaluation could instead cause inflation since the price of imports increases, and, with indexed prices and wages, an inflation spiral may start. That way, savings would be eroded. Regardless of whether internal or ordinary currency devaluation is chosen, structural reforms to improve competitiveness and fiscal policy are often needed in order to get long- term positive effects from the devaluation.66 The Euro Area Crisis - 99 Q & A • March 27, 2012

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? In the US, where there is a fiscal union and a financial union, and where the Federal Reserve is a lender of last resort not only to banks but also to the US as a sovereign state, discussions are seldom held on the differences between South Dakota and Texas that are related to the viability of the dollar or the US as a currency union. People, goods and services and capital flow freely between states, and the US can be regarded as closer to an optimal currency area than the euro area. Nevertheless, there can still be cultural differences among states, and also within states. In the euro area, there are insufficient institutions to create confidence in a viable currency union, and labour and capital do not flow as freely between countries in the euro area due to various differences, such as language, culture, pension systems, etc. Nationalism is reappearing, mainly as a result of the crisis. The EMU’s future depends on increased integration and the creation of institutions necessary to support a currency union (see question 75). Germany has been criticised for building up large current account surpluses, and for having a too-low domestic demand as wage costs have risen more slowly than in other countries in the last decade. The critics mean that Germany should increase domestic demand, thus importing more goods and services from crisis- struck countries. But wages in Germany are set on the labour market by employers and labour unions, not by the government. It is, rather, a process in which Germany competes on the global markets, and must therefore stay competitive in terms of both costs and product quality. The surplus in Germany’s current account is a result of too-high savings, and/or too-low investments. While the demography factor contributes to a larger savings surplus, Germany could also increase investment, by both the private and the public sector, which would be an advantage to the euro area as a whole. The focus should be more on the crisis-struck economies improving their external balances, rather than on Germany. The crisis has reduced imports, and thus the current account deficit is decreasing, but efforts should also be made to improve competitiveness in the longer term, so that large deficits do not reappear when the business cycle improves. Development in the euro area is not a zero-sum game, such that if Germany lowers its surplus, the crisis-struck countries lower their deficits. Rather, there are possibilities for southern Europe to increase exports by finding new export markets, such as in North Africa, the Mediterranean, the Balkans, etc. The focus should be on improving competitiveness in the crisis-struck countries, rather than on lowering competitiveness in the more successful countries.67 The Euro Area Crisis - 99 Q & A • March 27, 2012

81. How will the EMU crisis affect euro area enlargement? It is difficult to say, but one assumption is that there will be a more careful analysis by the EU Commission and the ECB of countries applying for membership before acceptance, in relation to both fulfilling criteria in the short term and sustainability in the longer term. More focus will be on the current account and other areas that were not explicitly included as criteria. At the same time, potential new members could be more reluctant to apply for membership as long as the crisis continues. These countries may want to see how the EMU institutions will be built up before deciding on membership. Whether the EMU has a fiscal union or not is a crucial factor for many voters and politicians in the countries where there is national independence. However, most EU members (except the UK and Denmark) have legal obligation at some point to become EMU members, regardless of national taste. 82. Why is it important from a longer-term perspective to save the EMU? If the EMU collapsed, with several countries or a large country leaving the currency union, it is probable that the EU would also have severe problems. Relations between EU countries would deteriorate, nationalism would reappear, and the integration achieved in the EU with the single market, etc., would take a step backwards. A single currency and a single market both help to improve effectiveness in the EU. The economic, social, and political costs would therefore be large if the EMU broke down. From a longer-term perspective, it would become more difficult for Europe to compete with other regions, such as Asia and North America, as markets would disintegrate and each country would again have to build up its external relations.68 The Euro Area Crisis - 99 Q & A • March 27, 2012

K. The EMU crisis – implications for Sweden and the Baltic countries 83. How important is foreign trade with the euro area for Sweden and the Baltic countries? The euro area is the most important trading partner for Sweden and for the Baltic countries. About one-third of total exports for all of these countries goes to the euro area, and even a larger share of imports. Sweden is the most dependent on the euro area for its exports (about 38%), while Lithuania and Estonia are the least dependent. Latvia exports more than 35% of its total export volumes to euro area countries. Moreover, foreign trade with all EU countries is even more important. Latvia, Lithuania, and Estonia channel more than 60% of their total exports to the EU countries. Most dependent is Latvia, which exports more than 70%, and imports more than 75%, from the EU. Although Sweden and the Baltic countries trade mostly with the larger EMU countries, the effects of continued recessions in peripheral countries will be felt indirectly through financial market turbulence and weaker demand in general. 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? A common piece of advice in all economic activities is to “not to put all the eggs into one basket.”This means that concentrating commercial relationships in one market will increase risks from possible downturns, and this is especially true today. Therefore, it is rational to diversify to other markets outside the EU, especially to large and fast-growing regions like Southeast Asia and South America. Even so, it is essential to keep important volume markets in Europe, and to focus on maintaining good trade relations with EU countries.69 The Euro Area Crisis - 99 Q & A • March 27, 2012

Companies in debt-stricken countries will have to regain competitiveness by cutting costs and may look for cheaper intermediary goods or services of similar quality outside their countries; this creates opportunities for countries in central and eastern Europe. Furthermore, firms in Baltic countries have strengthened their productivity and competitiveness during the past crisis years, which will be beneficial as markets continue to become more price sensitive. This means that there are opportunities for entrepreneurs to increase their market shares in Europe. Companies should thus maintain good relations with customers throughout the EU – the purchasing power and geographical location of this region will remain very attractive and will become even more so after the euro area emerges from the debt crisis. 85. How is Estonia, as an EMU member country, affected differently by the crisis than Latvia, Lithuania, and Sweden? Estonian fiscal policy has been prudent for a long time – up to 2010, the main goal was to balance the budget to meet the Maastricht criteria. The current government has shown a very strong political will to keep the budget balanced. The same is true in the case of government debt – the share of general government debt to GDP is around 6%, which is well below levels seen in western Europe. In addition, the Estonian government has accumulated reserves that will be helpful if the government needs additional funding. There are fears that being part of the EMU, where there is a sovereign debt crisis in many countries, also harms the creditworthiness of more fiscally prudent countries. However, the German governments historically low borrowing costs indicate that investors are looking for safe havens within the EMU, and that member countries with sound public finances can thus be rewarded. The biggest difference in being a member of the EMU comes from the required and substantial contribution of Estonia to, first, the EFSF (and later to the European Stability Mechanism (ESM)) – at the end of 2011, guarantee commitments amounted to close to EUR 2 billion. 68 However, these contributions are sometimes wrongly interpreted by the population as non-refundable transfers to ailing peripheral economies. In fact, both the EFSF and the ESM are funds in which Estonia, along with other EMU countries, owns a share that can also yield returns. Furthermore, the existence of the ESM could increase the creditworthiness of all EMU countries and lower their borrowing costs. Estonia’s down payment to the ESM, which will come into force in July 2012, will amount to EUR 149 million; it is scheduled to be paid out in equal sums during a five-year span starting in 2013. The decision whether these payments will come from reserves or from additional borrowing will be made each time in accordance68 www.efsf.europa.eu/attachments/faq_en.pdf70 The Euro Area Crisis - 99 Q & A • March 27, 2012

with the current situation. The parliament ratified the changes to the base EU Treaty, which are needed for the legal framework for the ESM to come into effect, in February 2012; however, in March the Estonian justice chancellor found that the ESM Treaty is in conflict with the Estonian constitution: a part of the treaty allows the ESM to make decisions on monetary contributions to member countries with conditions that could be uncontrollable by Estonia, thereby jeopardizing the parliament’s fiscal competence. Depending on how this conflict will be solved and on what the final result will be, there is a threat that Estonia could remain out of the ESM. This would not be a major hit to the ESM financially but could definitely hurt Estonia’s position politically. 86. How likely is that Latvia and Lithuania join the EMU in 2014 as planned, and what are the challenges? To join the EMU in 2014, Latvia and Lithuania will have to fulfil the Maastricht criteria in early 2013. Although this is likely (i.e., if these economies do not enter into deep recessions), the main challenges are to meet the targets on inflation and budget deficits. Prospects regarding inflation reduction are very similar in Latvia and Lithuania, since consumer price growth in both countries is now largely influenced by the dynamics of global commodity prices (while local price pressures are still weak due to fragile private consumption growth and high unemployment). Unless there is a notable rise in oil and food prices in 2012 (due to geopolitical conflicts and/or unfavourable weather conditions), consumer price growth is expected to continue to decline in Latvia and Lithuania. At the same time, it is important that both countries continue to promote domestic competition; they both have the potential to strengthen this competition and thereby ease inflationary pressures. According to our base scenario, the average annual consumer price growth in early 2013 should be marginally above 2%in both countries; this is likely to be adequate to fulfil the criterion (no more than 1.5 percentage points above the average of the three EU member states with the lowest inflation). However, the slower the price growth in the EMU countries, the harder it will be to fulfil the criterion for Latvia and Lithuania. Given that economic growth is decelerating in Europe, the same is likely to happen with inflation. The governments plan budget deficits for 2012 of 2.5% of GDP in Latvia and of 3% in Lithuania (the Maastricht criterion is that it should not exceed 3%). However, tax revenue collection will depend on economic growth. Consequently, if growth is weaker than forecast (2.5% for both countries under budget assumptions) due to, e.g., a worsening of the euro area crisis, the governments might need additional fiscal consolidation to keep the budget deficits under control. Here, the Latvian government is in a more comfortable position since (i) it has a safety margin and can accommodate somewhat slower economic growth, and (ii) the political cycle is71 The Euro Area Crisis - 99 Q & A • March 27, 2012

more favourable. As parliamentary elections are planned in Lithuania in autumn 2012, it could be difficult to agree before then on additional spending cuts or tax hikes. Despite these pressures, inflation in both countries is likely to be the biggest hurdle on the road towards the EMU. Overall, Latvias chances to join the EMU in 2014 currently seem to be a tad better than Lithuanias. We cannot exclude the risk, though, that the EMUs ability and/or willingness to accept new members may be reduced due to uncertainty, recession in the euro area, and the debt crisis. 87. In what way has the EMU crisis changed the likelihood of Swedens joining the EMU? Sweden had a referendum in 2003 on the adoption of the euro as its currency. More than 55% of the eligible voters cast a negative vote. Since then, and in particular after the outbreak of the euro sovereign debt crisis, support for joining the EMU has plummeted. Recent opinion polls suggest that around 80% are against giving up the Swedish krona for the euro. Thus, it is unlikely that Sweden will join the EMU in the short or medium term. In several areas, the Swedish economy is in a stronger position than the euro area. The Swedish economy has demonstrated flexibility and strong dynamics and was among the top performers in Europe during 2010-2011. A small surplus in public finances and a decreasing public debt means the Swedish economy is keeping the highest credit rating, while several countries in the euro area have seen their ratings cut. Large imbalances in the euro area and uncertainty about the euro, together with the perceived strength of the Swedish economy, have contributed to the negative domestic attitudes toward Swedens joining the EMU. 88. How would Sweden and the Baltic countries be affected if the EMU crisis worsened and the currency union broke up? An EMU breakup would have severe negative effects on Sweden and the Baltic economies. The effects would be manifested through three major channels: financial markets, confidence, and foreign trade. A managed breakup (in which Greece, e.g., left the union with the agreement of other members) would have a less negative impact on the financial system than a disorderly breakup, which would lead to additional speculation about the next country to exit (see Section I for more details). In either case, the recession in the EU would likely be prolonged and affect Sweden and the Baltic countries primarily through weakened external demand, and also through renewed volatility in the financial markets and weakened confidence. In the case of a disorderly breakup of the EMU, the EU single market’s functioning would be affected and Sweden’s and the Baltic countries’ trade flows would be severely hit. Most likely, there would also be changes in the competitiveness72 The Euro Area Crisis - 99 Q & A • March 27, 2012

between the countries, e.g. with weak countries’ currencies depreciating and those of stronger countries appreciating (see question 78 for more details). The Baltic countries would need to take a decision that would then influence their competitiveness: which exchange rate regime to choose (a peg to, e.g., Germany, a currency basket, freely floating, etc.)? Increased pessimism would also hold back consumption and investments in Sweden and the Baltic countries. Governments would, furthermore, be forced to adjust fiscal balances due to difficulties in borrowing as financial markets would become dysfunctional globally. A total euro area disintegration would also cause chaos in domestic financial markets and severely hit banking sectors, and credit to the real economy would likely contract. 89. What are the implications of the crisis for companies in countries outside the EMU, in relation to hedging foreign exchange risk? At the end of last year, an increasing number of international firms started developing strategies on how to hedge themselves for a potential breakup of the euro area. Recently, the risk of breakup of the EMU has declined, but for prudential reasons it still makes sense to look for natural hedging possibilities, in which a company matches its assets and liabilities (as well as revenues and expenses) in a particular currency. If a currency exposure is large, it is worthwhile hedging the currency risk with forward contracts, regardless of the situation in the euro area. Companies trading with EMU countries should have in their agreements clauses that describe scenarios and liabilities in case a country abandons the euro area and adopts a new national currency. Due to the recession and low confidence, the euro will most likely remain weak throughout this year and may depreciate further against other major currencies. This will negatively affect the companies that operate in countries with appreciating currencies and that export goods to the euro area (e.g. possibly Norway and Sweden). A weaker euro will have no negative impact on exports of countries that have their exchange rate fixed to the euro. On the contrary, depreciating national currencies (along with the euro) may improve their competitiveness in third countries, e.g., the CIS. 90. How are households in Sweden and the Baltic countries affected by the EMU crisis? The primary effect of the EMU crisis on households is through deteriorating confidence in these countries’ economic outlook, and also through lower household income and higher unemployment expectations. Reduced expectations on future profits also dampen stock exchange developments, which, in turn, affect household wealth negatively. Abundant negative news on the developments in the euro area has caused consumer confidence indicators to fall in most of the countries. Lower73 The Euro Area Crisis - 99 Q & A • March 27, 2012

confidence causes households to increase savings and, consequently, consume less. This reduces domestic demand and, thus, economic growth. The biggest impact on households is through developments in the labour market, with companies deciding to postpone investments and job creation. Weaker foreign demand and lower exports may also cause some companies to reduce the number of employees. This means that, even if we do not consider future possible cuts in job creation together with a fall in investing activity, cuts in employment might jeopardize households purchasing power already through the decisions made by companies today. Furthermore, uncertainty about the developing euro area debt crisis, resulting in cost-cutting and efficiency-boosting measures (at least in some companies), will reduce employees wage-bargaining power and lower income. At the same time, there is a positive impact from the EMU debt crisis – the ECB has lowered interest rates and will probably keep them at historical lows for quite some time. This and other liquidity measures have pushed interbank interest rates and household borrowing costs lower. It is likely that the Riksbank also will keep its repurchase rate low for some time, although mortgage rates may not follow exactly due to higher borrowing costs for banks (as they are required to increase the maturity of their liabilities). If the EMU crisis intensifies and the financial sector faces liquidity or solvency problems, this could result in a severe credit crunch in Europe; this would also affect households in Sweden and the Baltic countries due to the financial integration in EU and the banks’ need of international financing. However, households in Sweden and the Baltic countries are not equally dependent on the availability of credit. In Lithuania, household debt is among the lowest in the EU and makes up only some 40% of households annual income. Estonian households, on average, have a debt ratio equal to their annual income, whereas in Sweden this ratio is around 180% (debt in relation to disposable income). 91. Is the euro at risk and should therefore euro savings be avoided? Although the risk of a breakup of the Economic and Monetary Union (EMU) and, thus, the euro is not negligible, the likelihood is still very low. The main reason for this is the huge uncertainties surrounding the possible costs of such a breakup. The costs would mainly stem from a disruption in capital flows and trade, and also from widespread uncertainties in the financial sectors and amongst banks. The result would likely be a contraction of credit in Europe and sharply lower growth rates for a number of years. The main policymakers in Europe (and the world) would do their utmost to avoid such a scenario. However, there is also a possibility that the EMU would change due to one or several countries leaving the union, and this would in some sense constitute a breakup of the euro. One could see reasons for countries that are affected by debt and competitiveness crises (Greece, Portugal, and Italy) leaving and adopting their74 The Euro Area Crisis - 99 Q & A • March 27, 2012

own currencies. This would make it possible for them to devalue and quickly improve competitiveness and economic growth. But also in this case the uncertainties would be substantial and the risks to the banking sector significant. This will at least in the immediate term, in our view, prevent these countries from leaving the EMU. A case could also be made for some of the “stronger” countries to leave the monetary union (Germany, the Netherlands, and Finland). The rationale in this case would be that they want to avoid the fiscal costs of preserving the union through transfers to the crisis countries. Also, in this case, there would be costs, but now mainly due to a sharp increase in the value of the currencies of the departing countries. Although richer, they would find it much harder to compete in the global market and would likely see growth rates falling and unemployment rates rising. As the likelihood of a breakup is low, there is, in our view, no immediate reason to avoid euro savings, but investors should pay attention to the quality of the issuer of the assets (banks as deposit holders, etc.) and to possible exchange rate volatility. The euro is likely to weaken further, but by how much and for how long also depends on the situation in the US, the UK, China, and other countries. Households should avoid guessing and speculating about these trends and make sure that they have the appropriate currency hedges in their savings portfolios. As in all investment decisions, risk spreading has definite advantages. When saving and borrowing, apart from diversifying risks, there is a need to consider where future income from wages and pensions will come, and in what currency the expenditures have to be made. It is always good to relate the currency risks of saving and borrowing to the currency incomes, as well as to expenditures.75 The Euro Area Crisis - 99 Q & A • March 27, 2012

L. The history and characteristics of the EMU 92. Why and when was the EMU created? The reasoning behind the creation of the euro, was that apart from making travel easier, a single currency would make economic and political sense. 69 It was seen as a logical complement to the single market in that it would make it more efficient. Using a single currency would increase price transparency, eliminate currency exchange costs, oil the wheels of the European economy, facilitate international trade, and give the EU a more powerful voice in the world. The size and strength of the euro area would also better protect it from external economic shocks, such as unexpected oil price rises or turbulence in the currency markets. Last, it was felt that the euro would give the EU’s citizens a tangible symbol of their European identity. The euro was launched January1, 1999 as a “book currency” alongside national currencies, and euro coins and bank notes came into circulation on January 1, 2002. This was the third stage in the creation of the euro, and it followed the first stage (1990-1993), when capital markets were liberalized so that capital could move freely between member states, and the second stage (1994-1998), when the convergence of the economic policy of member states was strengthened politically and legally, and when the preparations for the new currency were carried out, including a strengthening of r cooperation amongst the national central banks. The European Monetary Institute (EMI) was created in 1994 to coordinate the monetary policy among national central banks, and, in June 1998, the European Central Bank (ECB) replaced the EMI. Already, in March 1979, the European Monetary System (EMS) was launched. The EMS was based on the concept of fixed but adjustable exchange rates, defined with reference to a newly created European Currency Unit (ECU). An Exchange Rate Mechanism (ERM) was created to keep participating currencies within a narrow band. The EMS was an unprecedented coordination of monetary policies among member states – over a 10-year period, the EMS reduced exchange rate variability, and this reduction was thought to have brought about economic convergence. This success induced further discussions among member states on achieving a monetary and economic union. The Delors Report, named after the President of the European Commission, proposed three stages of preparations for the union over the 1990-1999 period. European leaders accepted the Delors Report, and the new treaty on the European Union (EU) was agreed on in December 1991 at the European Council, held in Maastricht (the Maastricht Treaty). In this treaty, the so-called Maastricht convergence criteria were also agreed on.69 http://ec.europa.eu/economy_finance/emu_history/documentation.htm76 The Euro Area Crisis - 99 Q & A • March 27, 2012

93. Which countries are members of the EMU and when did they adopt the euro? In May 1998, 11 member states met the convergence criteria and therefore formed the first wave of entrants (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland). After completing the first two stages of preparation, Denmark and the UK exercised the so-called opt- out from the third stage of the EMU, while Sweden and Greece did not fulfil the criteria. In Sweden’s case, the country’s decision not to join the Exchange Rate Mechanism (ERM II) was the reason for not fulfilling the criteria, and, since this situation prevails, Sweden is not a member despite lacking a formal opt-out. Greece joined the monetary union in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, and Estonia in 2011. The remaining EU countries--Latvia, Lithuania, Poland, Bulgaria, Romania, the Czech Republic, and Hungary--have no formal opt-out clauses and are foreseen entering the monetary union when the membership criteria have been met. 94. What are the conditions for membership? The Maastricht criteria, which are also known as the convergence criteria, are the criteria for allowing the EU member states to enter the third stage of the EMU. There are five main criteria: Inflation (price stability) Article 140(1) of the Treaty says “the achievement of a high degree of price stability […] will be apparent from the rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability.” 70 In other words, the applicant country’s inflation rate must not exceed the average of the inflation rates of the three best-performing (lowest-inflation) EU member states by more than 1.5 percentage points. Interest rates According to Article 140(1) of the Treaty, the Interest rate criterion is defined as “the durability of convergence achieved by the Member State with a derogation 71 and of its participation in the exchange rate mechanism being reflected in the long-term interest rate levels.” The nominal interest rate on the long-term government bond must not exceed by more than 2 percentage points the average of the long-term interest rate in the three EU member states with the lowest inflation.70 Convergence Report 201071 A member state that has been assessed as not fulfilling the necessary conditions for the adoption of the euro is referredto as a „Member State with a derogation“ (ibid).77 The Euro Area Crisis - 99 Q & A • March 27, 2012

Exchange rate The applicant country should have been a member of the Exchange Rate Mechanism (ERM II) under the EMS for two consecutive years and should not have devalued its currency during this period. In other words, the country’s currency exchange rate should not have fluctuated more than +/-15% against the euro during the ERM II period. Government finances The ratio of the annual government deficit to GDP should not exceed 3% at the end of the fiscal year. If the budget deficit is higher than 3% of GDP, the member is required to reach a level close to 3%. Exceptional cases include situations when a deficit is caused by exceptional and/or temporary increases in costs. In Article 140(1) of the EU Treaty, the criterion is defined as follows: “...the sustainability of the government financial position: this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 126(6).” Article 126(6) also deals with the next criterion, government debt. Government debt An applicant country’s general government debt must not be higher than 60% of the country’s annual GDP. If the target cannot be reached because of specific conditions, the ratio must have been sufficiently lowered and be approaching the reference value at a satisfactory pace In addition, according to Article 140 of the Maastricht EU Treaty, additional factors are examined as indicators of economic integration and convergence. These factors include financial and product market integration and developments in the balance of payments. The latter means that the focus is on the external balance, which is defined as the combined current and capital account (net lending/borrowing vis-à-vis the rest of the world). Therefore, all external transfers will be taken into account (including EU transfers). The external balance is observed to ensure that member states joining the EMU do not have excessive external imbalances. Product market integration is measured through trade, foreign direct investment (FDI), and the smooth functioning of the internal market 72. 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? The first important element of the EU Treaty is that governments in the euro area are individually responsible for the debt they have issued. It is even prohibited for the EU or any of the national governments to assume responsibility for the debt72 “Convergence Report 2010”, European Economy 3/2010http://ec.europa.eu/economy_finance/publications/european_economy/2010/pdf/ee-2010-3_en.pdf78 The Euro Area Crisis - 99 Q & A • March 27, 2012

issued by another member country. This principle, known as the ‘”no bail-out clause”, is enshrined in the EU Treaty, the relevant article of which (Article 125) deserves to be quoted in full: The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. The second element is the strict prohibition of monetary financing. Article 123 of the EU Treaty states the following: Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. The first element would seem to have been violated since funds are transferred from stronger to weaker countries, but there is still no mutual liability of debt. Even if the ECB is not purchasing directly from member states, the long-term refinancing operations (LTROs) are an indirect method of supporting member states. 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? An optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. OCA theory describes the optimal characteristics for the merger of currencies or the creation of a new currency. The theory is used often to argue whether or not a certain region is ready to become a monetary union, one of the final stages in economic integration. The theory was published by Robert Mundell in 1961. If uncontrollable asymmetric shocks are considered to undermine the real economy, a regime with floating exchange rates is considered better, because the global monetary policy (interest rates) will not be fine-tuned to the particular situation of each constituent region. The four often-cited criteria for a successful currency union are as follows:79 The Euro Area Crisis - 99 Q & A • March 27, 2012

1. Labour mobility across the region. This includes the physical ability to travel (visas, workers rights, etc.), lack of cultural barriers to free movement (such as different languages), and institutional arrangements. 2. Openness with capital mobility and price and wage flexibility across the region. These characteristics are required so that the market forces of supply and demand automatically distribute money and goods to where they are needed. In practice, this does not work perfectly as there is no true wage flexibility. The euro area members trade heavily with each other (intra-European trade is greater than international trade. 3. A risk-sharing system, such as an automatic fiscal transfer mechanism to redistribute money to areas/sectors that have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily. 4. Participant countries have similar business cycles. When one country experiences a boom or recession, other countries in the union are likely to follow. This allows the shared central bank to promote growth in downturns and to contain inflation in booms. Should countries in a currency union have divergent business cycles, then optimal monetary policy may differ, and union participants may be made worse off under a joint central bank. With respect to the criteria, it has been shown that prices and wages in EMU countries are not flexible (see seminal work by Blanchard, Gali, Gertler, Hall, Taylor, and others). Theoretically, Europe has a no-bailout clause in the Stability and Growth Pact, meaning that fiscal transfers are not allowed; however, during the euro area crisis, the no-bailout clause was de facto abandoned in April 2010. In the EMU, the idea of a single market was widespread; partly because of its influence, in 1994 the capital markets were liberalized (free movement of capital). However, there are still frictions affecting labour mobility. It has taken a long time for some of the old member states to open their labour markets. In addition, in many countries, fluency in the national language is essential for getting a job; this means, on the one hand, that the availability of jobs for citizens of other countries is limited, and, on the other, that movement between member countries is also rather limited. 97. How does the euro area differ from the US as a currency area? The economies of the US and EU differ in many ways. First, prices and wages have been proved to be more flexible in the different US states than in the EU. Second, the labour movement in the US is larger (fewer cultural, language, etc. obstacles). Third, the US has a unified fiscal policy, with a degree of autonomy for member states, and is more integrated politically.80 The Euro Area Crisis - 99 Q & A • March 27, 2012

Fourth, there are differences in the central bank systems. The Federal Reserve System (the central bank system in the US) is governed by the Federal Open Market Committee, which determines monetary policy. The corresponding body in the European Central Bank is the Governing Council of the ECB. Both of these bodies (the FOMC and the GC) consist of the presidents of either Federal Reserve Banks or national central banks. The Federal Reserve System acts, in addition, as the federal government’s banker – the US Treasury maintains accounts in the Federal Reserve. These accounts handle federal tax deposits and outgoing government payments. 98. How has the euro developed since it was created? On January 4, 1999, the euro traded at USD1.1789. Over the next two years, the euro fell, hitting a low of USD0.8252 per euro on October 26, 2000. The value of the euro against the dollar was around 1USD again on July 15, 2002 (EUR 1.0 = USD1.0024) and then rose to a high of USD1.36 at the end of 2004. The euros highest value ever against the US dollar, USD1.5999, was reached on July 15, 2008. Thereafter, the euro lost value, dropping to USD1.246 per euro on October 27, 2008. After fluctuations in value during the last month of 2008, the euro started to gain value in 2009, reaching a new high of USD1.512 on December 3, 2009. On July 8, 2010, the value of the euro against the dollar was down to USD1.1942, after which the euro somewhat regained value. In the beginning of 2012, the euro value against the dollar was somewhat lower than in March 2011, reaching USD1.3 on average this January. Thereafter, the euro has regained some strength; at the end of February, it was worth USD1.3454. 73 The importance of the euro has grown steadily – the share of the euro in foreign exchange reserves increased from 18.4% in 1999 to 25.9% in 2003. The same share rose higher, reaching 26.3% at the end of 2010 (US dollar reserves had fallen from 68% in 1999 to 61% by the end of 2010. 74 Even though some optimism has been voiced [by whom, about the EMU’s single currency area, scepticism has been widespread mainly among academic scholars. The latter have been influenced by the essence of the OCA theory (See question 96). 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? Micco, Stein, and Ordonez 75 found in their paper on bilateral trade between euro area countries that this trade increased by 5% to 20% relative to trade between those countries that had not adopted the euro. Baldwin (2006) and Baldwin,73 Data from ECB, http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html74 ECB, 2011, “International role of the euro”; http://www.ecb.int/pub/pdf/other/euro-international-role201107en.pdf75 Micco, A.; Stein E.; Ordonez, Q., (2003); "The currency union effect on trade: early evidence from EMU," EconomicPolicy, CEPR, CES, MSH, vol. 18(37), pp 315-356, October.81 The Euro Area Crisis - 99 Q & A • March 27, 2012

Skudelny, and Taglioni 76 found that the average effect of the single currency on trade was around 5-10%.In addition, Mongelli, Dorrucci, and Agur 77 showed that launching the euro has boosted extra-euro area trade, together with intra-euro area trade. Intra-euro area FDI has grown considerably since the launch of the euro (catching up with extra-euro area FDI). Between 1998 and 2004, total FDI grew by 180% in nominal terms, and cumulative total FDI amounted to approximately 24% of euro area GDP (Mongelli (2007)). All in all, financial integration is helping to reduce the cost of country specific shocks – i.e., over time, greater financial integration makes it easier for individuals to insure themselves against such shocks through borrowing and lending. In addition, cross- country ownership of financial assets allows more income smoothing. 7876 Baldwin, R. (2006) „The Euros Trade Effects“, ECB Working Paper No 594; Baldwin, R., Skudelny, F; Taglioni D.(2005); „Trade Effects of the Euro: Evidence From Sectoral Data“, ECB Working Paper Series no 44677 Mongelli, F.P.; Dorucci, E.; Agur, I. (2007) „What does European Institutional Integration tell us about the OptimalCurrency Area Properties?“ Journal of Common Market Studies, Volume 43 No3 pp 607-3578 Giannone, D and Reichlin L. (2006) „Trends and cycles in the euro area: how much heterogeneity and should weworry about it?“ ECB Working Paper No 59582 The Euro Area Crisis - 99 Q & A • March 27, 2012

AcronymsBIS – Bank of International SettlementsBOE – The Bank of EnglandBOJ – The Bank of JapanCAC – Collective action clauseCDS – Credit default swapCEE – Central and Eastern EuropeCRD – Capital Requirements DirectiveCT1R – Core Tier I ratioEBA – European Banking AuthorityEC – European CommissionECB – European Central BankEDP - Excessive Deficit ProcedureEFSF – European Financial Stability FacilityEIP – Excessive Imbalances ProcedureEMU – The Economic and Monetary UnionESCB – European system of central banksESM – European Stability MechanismEU – European UnionFed – The US Federal ReservePIIGS – Portugal, Ireland, Italy, Greece and SpainGDP – Gross Domestic ProductIMF – International Monetary FundLTRO – Long-term refinancing operationMTO – Medium-Term budgetary ObjectiveNCBs – National Central BanksPSI – Private sector involvementRWA – Risk-weighted assetSGP – The Stability and Growth PactSMP – Securities Markets ProgrammeUK – United Kingdom83 The Euro Area Crisis - 99 Q & A • March 27, 2012

Economic Research DepartmentSweden Cecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.se Group Chief Economist Chief Economist, Sweden Magnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.se Head of Economic Forecasting Jörgen Kennemar +46 8 5859 7730 jorgen.kennemar@swedbank.se Senior Economist Anna Ibegbulem +46 8 5859 7740 anna.ibegbulem@swedbank.se AssistantEstonia Annika Paabut +372 888 5440 annika.paabut@swedbank.ee Chief Economist Elina Allikalt +372 888 1989 elina.allikalt@swedbank.ee Senior EconomistLatvia Mārtiņš Kazāks +371 67 445 859 martins.kazaks@swedbank.lv Deputy Group Chief Economist Chief Economist, Latvia Dainis Stikuts +371 67 445 844 dainis.stikuts@swedbank.lv Senior Economist Lija Strašuna +371 67 445 875 lija.strasuna@swedbank.lv Senior EconomistLithuania Nerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.lt Chief Economist, Lithuania Lina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.lt Senior Economist Vaiva Šečkutė +370 5 258 2156 vaiva.seckute@swedbank.lt Senior Economist84 The Euro Area Crisis - 99 Q & A • March 27, 2012

DisclaimerThis research report has been prepared by economists of Swedbank’s Economic ResearchDepartment. The Economic Research Department consists of research units in Estonia, Latvia,Lithuania and Sweden, is independent of other departments of Swedbank AB (publ) (“Swedbank”)and responsible for preparing reports on global and home market economic developments. Theactivities of this research department differ from the activities of other departments of Swedbankand therefore the opinions expressed in the reports are independent from interests and opinionsthat might be expressed by other employees of Swedbank.This report is based on information available to the public, which is deemed to be reliable, andreflects the economists’ personal and professional opinions of such information. It reflects theeconomists’ best understanding of the information at the moment the research was prepared and dueto change of circumstances such understanding might change accordingly.This report has been prepared pursuant to the best skills of the economists and with respect to theirbest knowledge this report is correct and accurate, however neither Swedbank or any enterprisebelonging to Swedbank or Swedbanks directors, officers or other employees or affiliates shall beliable for any loss or damage, direct or indirect, based on any flaws or faults within this report.Enterprises belonging to Swedbank might have holdings in the enterprises mentioned in this reportand provide financial services (issue loans, among others) to them. Aforementioned circumstancesmight influence the economic activities of such companies and the prices of securities issued bythem.The research presented to you is of informative nature. This report should in no way be interpretedas a promise or confirmation of Swedbank or any of its directors, officers or employees that theevents described in the report shall take place or that the forecasts turn out to be accurate. Thisreport is not a recommendation to invest into securities or in any other way enter into any financialtransactions based on the report. Swedbank and its directors, officers or employees shall not beliable for any loss that you may suffer as a result of relying on this report.We stress that forecasting the developments of the economic environment is somewhat speculativeof nature and the real situation might turn out different from what this report presumes.IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT THEN YOU ACT SOLELYON YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THE ECONOMICREASONABILITY AND THE RISKS OF SUCH ACTION INDEPENDENTLY.85 The Euro Area Crisis - 99 Q & A • March 27, 2012

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