LAYOUT GREECE, PORTUGAL, SPAIN, IRELAND AND ITALY: DETAILED REVIEW CAUSES OF THE CRISES IN GENERAL OPTIMUM CURRENCY AREA THEORY FROM EMS TO EURO
GENESIS OF “THE IDEA OF A COMMON CURRENCY”After the end of WW II in 1945, many EU leaders agreed that economic cooperationand integration among the former belligerents would be the best guarantee againsta repetition of the 20th century’s two devastating wars.The result was a gradual ceding of national economic policy powers to centralizedEU governing bodies such as European Commission in Brussels and EuropeanSystem of Central Banks, headquartered in Frankfurt, Germany. The first significant step was the European Monetary System
EUROPEAN MONETARY SYSTEM Germany Italy (2.7% inflation) (12.1% inflation)In 1979, with a wide divergence in inflation rates, the prospects for asuccessful fixed rate area looked bleak However, through a mix of policy cooperation and realignment, the EMS fixed exchange rate club survived
FROM EMS TO EUROGreater degree ofEuropean market Eliminatingintegration. costs to traders of converting one EMS currency into another ECB would be more considerate of other countries problems A SINGLE EU CURRENCY WAS INTENDED AS A POTENT SYMBOL OF EUROPE’S DESIRE TO PLACE COOPERATION AHEAD OF THE NATIONAL RIVALRIES, AND ACTING AS ONE TO COMPETE AGAINST THE DOLLAR
THE THEORY OF OPTIMUM CURRENCY AREASThis theory predicts that fixedexchange rates are mostappropriate for areas closelyintegrated through internationaltrade and factor movements.THE MORE EXTENSIVE ARE CROSS BORDER TRADE AND FACTORMOVEMENTS, THE GREATER IS THE GAIN FROM A CROSS BORDEREXCHANGE RATE
GG SCHEDULE LL SCHEDULE GGMonetaryEfficiency Economicgain Stability Loss LL Degree of economic integration between the joining country and the exchange rate area GG Schedule shows how the potential gain to a particular The cost of joining the Euro is that the country will have to country from joining the Euro Zone depends on the give up its ability to use the exchange rate and monetary country’s trading links with that region. policy for the purpose of stabilizing output and employment. This economic stability loss from joining is related to the country’s economic integration with exchange rate partners and graphically shown by LL schedule
Gains and GG Schedulelosses for thejoiningcountry Gains exceed losses Losses exceed gains LL Schedule Q1 Degree of economic integration between the joining country and the exchange rate area The country should only join the single currency, if its degree of economic integration is greater than Q 1
IS EUROPE AN OPTIMUM CURRENCY AREA?The overall degree of economic integration can be judged by looking at the integrationof product markets, that is, the extent of trade between the joining country and thecurrency area, and at the integration of factor markets, that is , the ease with whichlabor and capital can migrate between the joining country and the currency area. People changing region of residence in the 1990s(% of total pop) Britain Germany Italy USA 1.7 1.1 0.5 3.1 Source: Peter Huber There is evidence that national financial markets have become better integrated with each other as a result of the Euro, and this has promoted intra-EU trade. But while capital moves with little interference, labor mobility is nowhere near the high level countries would need to adjust smoothly to product market disturbances through labor migration.
CAUSES OF THE EURO CRISIS 2008 crisis made Exports from tax revenues prosperous Domestic demand Tax revenues collapse. Govt. Euro Introduced The prices of Eurozone Demand spurred Pan-European and consumption increased in PIIGS, spending => Interest rates domestic activities countries increased wage monetary policy in PIIGS increased govts. increased unfeasible & decline in PIIGS rose=> Investment increased costs. Emergence , loose on PIIGS & => increased spending.Blatant competitivenesscountries to those in non-tradable following the of China =>lower tight on spending led to fiscal decreased, soof Europe’s stable sectors increased growing demands competence of Germany=> loss of higher foreign mismanagement foreign demand countries vis-à-vis ExIm in PIIGS. PIIGS competitiveness debts in Greece couldn’t be Deutschemark tapped higher than Euro
Debt repayment With any debtor, there is a chance they will not be able to repay their debts. These figures in the above graph express the likelihood as a percentage called the Cumulative Probability of Default (CPD) The figures express the probability of a country defaulting sometime over the next five years
Greece : Economic Woes• Its government owes about 300bn euros ($400bn; £260bn)• spread over three years - but on condition that Greece slashes public spending and boosts tax revenue.• Ratings agency S&P has already downgraded Greek debt to "junk", which means it views Greece as a highly risky place to invest.• As the money flowed out of the governments coffers, tax income was hit because of widespread tax evasion.
Options for Greece Europe/IMF continues to bail out Greece• Bail out are most effective for temporary and short term mismatches• Greece lacks any credible fiscal control program• Spending cuts have met with widespread resentment• Large current account deficit means a pressure to raise foreign savings Exit the EURO• Could default and devalue its currency, thereby providing scope for improving competitiveness• Would shift some of the debt burden to foreign creditors and avoid further debt build- up• Could trigger an even greater financial crisis• Reintroducing Drachma would lead to re-pricing of all contracts with no clear idea of how to achieve this• It will also antagonize other Euro members and have huge political risks• Will affect trade with Euro zone which accounts for 2/3 of its total trade• There is no provision in Euro treaty for a country exiting the same and thus it will affect all contracts and other legalities
Greece Defaults and Restructures its debt• Most viable option available• Will affect the banking system but that is a price for ignoring associated risks for such a long time• There are fears that this might lead to a Lehman king of moment due to huge interlinks in the banking systemSoft Restructuring involving private sector• Plans to share the debt burden with private sector akin to soft restructuring of government debt• Would involve creditors exchanging their soon to mature bonds with debt for longer maturity• Would however lead to large losses for banks and recapitalizing them would require further borrowing
The way out !!• Restructuring its debt while at the same committing to strong fiscal measures• Cut its budget deficit, or the amount its public spending exceeds taxation, to 8.7% of its GDP in 2010, and to less than 3% by 2012.• Just before the massive bail-out package was announced the Greek government pledged to make further spending cuts and tax increases totalling 30bn euros over three years - on top of austerity measures already taken.• Greece plans to freeze public sector workers pay, make further cuts in civil servants benefits, hike VAT (sales tax) and fuel duty, raise the retirement age and reduce pensions.• Greeces Socialist government says the nation faces "sacrifices" in a "choice between collapse or salvation".
• Unlike its most vulnerable Euro area counterparts, Portugal saw its boom that followed the adoption of the euro fade quickly.• In the run up to the launch of the euro, its GDP had grown at an average annual rate of almost 4 percent —one of the highest rates in the Euro• However, the demand boom, which was triggered by a sharp decline in interest rates and fueled by expansionary fiscal policy, was not followed by a parallel increase in potential supply• Between 1995 and 2000, private savings dropped by about 7 percentage points of GDP, while average gross fixed capital formation had accelerated. Household and non-financial sector debt more than doubled in percent of GDP terms between the mid-1990s and 2002.• Reflecting external borrowing’s role in financing consumption and investment, the current account deficit soared to 9.0 percent in 2000, up from near-zero in 1995.
After formal adoption of the euro, monetary policy in the Euro area, while clearly too loose forGreece, Spain, and Ireland, who saw housing booms, was too tight for Portugal, where housinginvestment as a percentage of GDP had declined over time and inflation had dropped.The euro’s adoption led interest rates to fall sharply in Portugal—from an average of 12.3percent in 1991–1995 to about 6 percent in 1996–2000—setting the stage for a consumptionboom.
Significant labor market tightening and rapid wage increases had characterized the boom. The consequence was anEffects of the appreciation in the realeuro boom effective exchange rate (REER)—about 12 percent from 1994 to 2000. This appreciation led to a build-up of macroeconomic imbalance & was reflected in current a/c deficits.
At the same time, labour productivity slowed & was well below EU average—32 percent inagriculture, for example—in all sectors of the economy.Reasons for it:• The country’s relatively low human capital formation• Limited use of information technologyCauses of end of Euro boom.• Portugal’s export structure at the launch of the euro was too weighted towards traditional slow-growing sectors where comparative advantage was shifting toward the emerging economies in Asia. The share of production in low-tech manufacturing sectors, for example, was 80 percent in 1995 and 73 percent in 2001.• Another important factor was the inflexibility of portugal’s labor markets.• Rapid deterioration of competitivenessAs household spending stalled amid high levels of debt—the investment and consumptionboom came to an end.
Current scenarioThe downturn also had a significant impact on unemployment, which reached 10.7 percent in2010, up three percentage points from two years ago—a relatively modest increase by thestandards of Spain and Ireland. • There has been Effect of crisis an increase in on unemployment unemployment after 2002• Portugal’s spending on R&D as a percentage of GDP is half of the average in the Euro area.• Furthermore, its governance and business climate indicators are today among the lowest in the euro area.
Increase flexibility in labour Increase competition in relatively markets. sheltered backbone services. Policy RecommendationsImprove the human capital base Implement a systematic approachso that productivity is improved to correct deficiencies in the and country regains business climate, especially in attractiveness with foreign starting a business, paying investors. taxes, and getting credit.
Euro timeline of Spain Problems After Euro adoption 2002 1999 • Huge misallocation of resources Issuance of euro1986 Adopted banknotes euro as and coins • Loss of competitiveness the official after a 3 Joined EU currency year transition • Large Deficits and rising public debt period Public Debt(% of GDP) Unemployment rate(%)
Causes of the CrisisHousing sector boom and bust: At Interest rates plummetedits peak, construction value-addedreached 17 percent of GDP. In just and confidence Labor cost and the unitten years, Spain’s housing prices soared, leading domestic labor cost increased bymore than doubled, and, at the demand and inflation to nearly 200% betweenpeak in 2006, Spain started more rise more than 1.5 times 2000-2010 which was nothomes than theUK, Germany, France, and Italy faster than the Euro area in line with productivitycombined. average. ULC(%) 8 7 ULC(%) 6 5 4 3 2 1 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 -1 -2
Remedies Start with Encourage government reallocation across spending sectors Remedies Demand aReduce the unit coordinated effort cost of labor across Europe
IRELAND- The Celtic TigerThe collapse of the Irish economy has come as a particular shock to manypeople, at home and abroad, because of its seemingly remarkable success in thepreceding yearsTHE GOOD OLD DAYS• Growth was largely based on the attraction of (mainly US) multinationals takingadvantage of Ireland’s low corporate profits tax rate• using the country as a base from which to export to the EU• ‘Transfer pricing‘ mechanisms used• After 2001, economic growth was based largely on a property price bubble
THE PROBLEMThe Main Reasons for the country specific problemAfter 2001, economic growth was based largely on a property price bubbleInvestment in buildings accounted for 5% of output in 1995 but for over 14% in 2008Fuelling the property price bubble was a massive rise in household debt, which shot upwards from €57 billion in2003 to €157 billion in 2008Lending for mortgages rose from €44 billion in 2003 to €128 billion in 2008Irish banks were themselves borrowing in order to lend on to their customers: the 6 main Irish banks borrowed €15billion from abroad in 2003 but this figure had risen to €100 billion by 2007.The European Dimension Bailing out the banks•This reckless splurge was facilitated by liberalised lending • When the global financial crisis hit, access to credit declinedpractices across the EU and by lax cross-border regulation of drastically worldwide and asset values tumbledthe financial sector • The Irish government chose to respond to the plight of the• The very design of Economic and Monetary Union (EMU) banks in an extraordinary manner: on 30th September 2008 allhelped cause the crisis by establishing exchange rates that left depositors and senior bondholders (creditors to the Irishperipheral EU countries uncompetitive relative to Germany banks) were guaranteed by the stateand encouraged the peripherals to rely on the accumulation of • An example of a contingent liability arises from the Irish statedebt to ‘compensate’ for this creating a National Assets Management Agency (NAMA) to• The Irish authorities also contributed to the property bubble buy up some of the worst property loans in the hope of sellingwith a range of tax incentives to property development. them on later
THE PROBLEM Austerity for ordinary How Ireland is linked people • Despite all the upheaval surrounding bank funding and debt problems in Greece and Italy, investors are betting that one country is seeing better days: Ireland • Its economy expanded 1.6% in the second quarter afterCorrective actions growing 1.9% during the previous quarter • Irish 10-year yields slipped below 10% for the first time since taken Portugals rescue, according to Bloomberg • To be immune a cautious measure which helps increase further exports and spending A loan of €58 billion from • In spite of this there can be further problems as there are the IMF and EU was higher risks of the contagion contracted in December 2010 - at an interest rate of 5.8% SOME OPTIONS
CAN EURO SURVIVE• In June 2010, banks in Austria, France, Germany and the Netherlands hadnearly one-quarter of their overall loans tied up in those weaker economies.Should the countries drop the euro and default on those loans, worth anestimated €1.9 trillion, the impact would be catastrophic for both the banksand their home countries• The countries that desert the euro and attempt to reinstate their oldcurrencies inevitably would face rapid, severe devaluation• Greeks, fearing the disastrous consequences of a return to the drachma ontheir personal accounts, they would naturally transfer their assets to Germanyor another euro zone state• European fiscal union• Eurobonds• The heads of state are confused and more of self interests are put forth.
Why is Italy in Crisis??? One of the largest economies of the world (6 times that of Greece itself) Problematic Sovereign Debt & Fiscal Deficit Fragile European Banks (holding the debt) Secular Loss of Competitiveness due to Euro adoption (too loose monetary policy) Political Instability, doubtful future Non-tradable investments increasing, hence exportables not keeping pace with boom Specializes in low-skill goods, has lost the most market share in its traditional geographic markets Heavily oil-reliant country that imports 93% of its supply
Numbers say it better…Italy - Current Account Balance Source: T,C&S & World Fact book
Numbers say it better…Italy - Unemployment Figures Source: Google Public Data
Numbers say it better…Household savings rate drop 5.7 % points from 1997 to 2007% increase in unit labour cost in Euros (Q1 2001 to Q3 2009) Italy: 32% Germany: 6% Source- Carnegie Endowment For International PeaceFrom 1996 to 2004, Total Factor Productivity declined at anaverage annual rate of almost 1 % Source- Carnegie Endowment For International Peace
What can/has to be done??? POLICY RECOMMENDATIONS Bring down debt-to-GDP ratio by increasing its primary balance by 4 percent of GDP at least Must cut its unit labour costs in order to regain its lost competitiveness Enact critical structural reforms that would include removing rules that create a dual labour market and increase the efficiency of backbone services
IS THERE LIGHT AT THE END OF THE TUNNEL?The first step to the solution of protecting the Euro is a political support of all thegovernments because its not about saving one country or region. It is about saving theworld from a downward economic spiral.ECB can soothe markets by buying bonds, but only to a certain point.If the 17 member states of the single currency area would be able to borrow in bondsissued by a European debt agency. These would be jointly guaranteed by all euro areacountries and underwritten by the most creditworthy of them i.e. Germany.Advantages:1. A common euro bond would create a large new government bond with lot of liquidity. This would attract a lot of investors particularly China, which is keen to diversify its dollar holdings.2. An underlying rationale for Eurobonds is that the public finances of the euro area as a whole look quite respectable…The IMF envisages that general government debt will reach 88% of the single currency zones GDP this year. This is lower than Americas 98% and not much higher than Britain’s 83%. The euro areas projected budget deficit will be a bit above 4% of GDP, rather better than Americas 10% and Britains 8.5%
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