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What's wrong with the Euro?  What does it mean for Croatia?
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What's wrong with the Euro? What does it mean for Croatia?



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  • 1. Empowered lives. Resilient nations. What’s wrong with theEuro? What does it mean for Croatia? Ben Slay Senior Economist UNDP Regional Bureau for Europe and CIS Zagreb 9 December 2011
  • 2. The good, the bad, and the . . . misunderstood• Good news: – The Eurozone is not likely to break up – Most likely outcomes—a weaker Euro, fiscal reform—could be a good thing• Bad news: – Europe is in for more economic trouble – It doesn’t matter whether you have the Euro, you’ll still be affected – There are risks of very bad outcomes: • A horrific financial/economic crisis • Break-up of the EU• Misunderstanding: It’s about fiscal policy and debt, not the common currency
  • 3. Europe took a big hit from theglobal financial crisis in 2008-2009 2007 2009 11.4%9.0% 7.2% 5.5% 2.9% 2.7% 2.4% -3.6% -3.4% -4.1% -6.4% -6.3% Regional GDP growth CIS SEE/NMS Euro zone USA Japan Other Asia IMF data
  • 4. Recovery in 2010— relatively weak 9.5% Regional GDP growth trends 6.1% 5.0% 4.6% 4.2% 4.1% 3.0% 1.9%Other Latin Africa CIS SEE/NMS Japan USA Eurozone Asia America IMF data
  • 5. Crisis impact on Europe, Central Asia: Five groups of economiesGroup EconomiesA: Crisis had minimal impact Central Asia, Azerbaijan, Albania, Kosovo, PolandB: Recession in 2009, strong Germany, Sweden, Finland, Balticsbounce in 2010-2011 , Slovakia, Turkey, Armenia, Georgia, MoldovaC: Recession in 2009, weaker Most other EU countries, Russia,bounce in 2010-2011 Ukraine, other Western BalkansD: No recovery in sight “PIIGS”, Romania, CroatiaE: Crisis put off until 2011 Belarus
  • 6. Whence comes the Euro?• Euro was introduced in 1999: – Part of 1991 Maastricht Treaty that formed the Economic and Monetary Union (EMU) – Reaffirmed by 2009 Lisbon Treaty – “Cash” Euro introduced in 2002• Economics: – Allows Europe’s monetary policy to be managed by European Central Bank • By contrast, there is no European fiscal policy – Reflection of deep financial integration• Politics: Symbolizes a united, prosperous Europe
  • 7. Eurozone today—17 members• 1999: Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, Netherlands, Portugal, Spain• 2001: Greece• 2007: Slovenia• 2008: Cyprus, Malta• 2009: Slovakia• 2011: Estonia
  • 8. Most EU countriesmust adopt the Euro • Only Denmark, the UK have “opt outs” • There are no legal provisions for withdrawing from the Eurozone • Croatia is obligated to adopt the Euro – It has to fulfill the “Maastricht convergence criteria” for financial stability
  • 9. How has the Euro fared? Not so badly . . . $1.47 Average annual exchange rates, $/€ $1.39 $1.39 $1.37 $1.33 $1.26 $1.24 $1.13 $1.07 ** Despite the “Euro crisis”, the Euro is still quite strong against the dollar. $0.95 ** The British pound, Russian rouble, and other currencies $0.92 have been weaker against the dollar than the Euro. $0.90 ** A weaker Euro would not be such a bad thing . . .1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ECB data, UNDP calculations.
  • 10. What are the convergence criteria?• Budget deficit must not exceed 3% of GDP (“Stability and Growth pact”—applies after Euro adoption, too)• Public debt must not exceed 60% of GDP (“Stability and Growth pact”—applies after Euro adoption, too)• Exchange rate: The currency should be stable against the euro for at least two years—no devaluation• Inflation must not be 1.5% percentage points above the average of the three economies with the lowest inflation.• Interest rates: Long-term government bond yields must not be more than 2 percentage points higher than in the three lowest inflation member states.
  • 11. What are the economic benefits of a monetary union?• Reduced exchange rate risks• Why is this important? – Promotes trade within a monetary union, by • Lowering transactions costs • Reducing uncertainty – Preventing balance-sheet mismatches • Example: Most Croatian banks’ assets are in Kuna, but their liabilities are in euros (or Swiss francs) • A devaluation would stress the financial system • This is why Croatia has not devalued the Kuna since the financial crisis began
  • 12. Benefits of monetary union: European context• Before the Euro, most of Europe was “tied to the Deutsche mark” anyway • Long history of post- WWII European monetary integration• For transition economies, adopting Euro can serve as an “anchor” promoting macroeconomic, financi al stability • This is why Kosovo, Montenegro have the Euro
  • 13. Downside of a monetary union?• Loss of independent monetary, exchange- rate policies – But for most EU countries, de facto policy discretion was very limited before the Euro – This is true today for: • Croatia (and Macedonia) with Euro pegs • BiH, Bulgaria, Lithuania with currency boards• Loss of ability to improve competitiveness via devaluation/depreciation – But most EU countries concluded that this benefit is of limited importance, because of: • “Competitive devaluation” syndrome • High inflationary pass-through of devaluation
  • 14. Downsides of monetary union, continued• Challenges of fiscal convergence criteria: – Maastricht created a European Central Bank— but not a European Ministry of Finance • What if the Stability and Growth Pact is violated after Euro adoption? – They can limit discretionary fiscal policy • All the burden is put on monetary policy• Productivity/competitiveness issues have to be addressed by non-monetary tools: – Fiscal transfers from rich to poor countries/regions (e.g., cohesion funds) – Wage, price, labour market flexibility — ”internal devaluation” (“Europe 2020”)
  • 15. These risks are now playing out in the Eurozone• Stability and growth pact has not been observed (no European minister of finance) – High budget deficits, public debt have resulted• Improvements in competitiveness require painful internal devaluations: – Fiscal transfers from rich to poor countries/regions (e.g., cohesion funds) are too small to have major macro impact – Within the EU, wages have been relatively inflexible, labour is relatively immobile• Result: intra- , inter-state political tensions
  • 16. Eurozone’s challenges today• Two key problems: • Debt and deficits • Loss of competitiveness• They are not problems of the Eurozone as a whole—they’re: • Problems of individual countries (PIIGS) . . . • . . . That are spread to other EU countries via the Eurozone
  • 17. “PIIGS” and friends: Bank bailouts, other spending boost public debts 143% 2008 2010 Stability and growth pact limit (60%) 119% 106%99% 97% 96% 93% 90% 80% 66% 62% 44%Greece Italy Belgium Ireland Portugal EU-27 Gross public debt as share of GDP. Eurostat data.
  • 18. Competitiveness trends Cumulative changes in industrial 68% unit labour costs, 1999-2010 Deterioration 42% Improvement 32% 31% 22% 6% 8% 0% -2% -14%-19% OECD data, UNDP calculations.
  • 19. Fiscal risk implications• Greece, Ireland, Portugal: – Have lost access to international capital markets – Can’t refinance their state debt when it comes due – Had to be bailed out by the IMF, European Financial Stability Facility• Greece is now undergoing “voluntary” public debt restructuring• What if Spain or Italy lost access to the markets? – Do the IMF, EFSF have enough “fire power”? – It’s not clear . . .• There’s not much “fiscal space” left in the Euro zone, to respond to recessionary conditions
  • 20. Financial sector risks implications• Financial institutions that own Greek debt are taking “haircuts”• Many of these banks: – Lost money in real estate bust . . . – . . . Need to raise new capital in order to ensure their own sustainability• Result: money, credit conditions are tightening, exacerbating recessionary tendencies• The ECB is buying PIIGS (and other countries’) sovereign debt on secondary markets – If more “haircuts” come, the ECB might be threatened – Who would bail out the ECB? BRICs?
  • 21. Social implications: EU-27 unemployment rate isn’t falling10.0% “Double dip” recession? 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2008 2009 2010 2011
  • 22. If things are so bad in the Eurozone, why not leave?• Legally—it’s virtually impossible • Can’t leave EMU without leaving EU • There’s no provision for leaving the EU• Presumably, a country that wants to leave would have to negotiate this with each of the other 26 member states . . .
  • 23. “Treaties are like roses and young girls. They last while they last”—Charles de Gaulle• Why not leave anyway?• Different possible scenarios – If Greece left the Eurozone, it could: • Reintroduce a national currency, regain control of its monetary and exchange rate policies, and • Devalue, to restore competitiveness – Or Germany (perhaps with some likeminded northern European countries) could: • Introduce a “new Euro” or “Northern Euro” • The “neuro” would appreciate against the Euro, helping to restore Eurozone competitiveness (for the PIIGS)
  • 24. Either scenario risks a European(possibly global) financial meltdown• A country preparing to leave the Eurozone would face massive capital flight• After leaving, it would face a: – Huge devaluation, high inflation, and bankruptcies – Multi-year legal nightmare as all its Euro-denominated contracts get renegotiated – In short: Its financial system would collapse• This would be a disaster for creditors as well – “Northern” European banks, governments could lose access to finance as well – Massive contagion: the good go down with the bad
  • 25. Europe faces a Hobbson’s choice• Optimistic scenario: • Slow (or no) economic growth • Financial instability • Socio-economic tensions • Weakening of EU’s • Cohesion • Vitality • Soft power• Pessimistic scenario: • Financial collapse • Global financial contagion
  • 26. What does this mean for Croatia? • Slower growth in exports, industry, touri sm, GDP • Larger trade, current account deficits – Larger foreign debt – Higher interest rates – Less growth in domestic demand • More poverty, social exclusion, regional disparities
  • 27. “Don’t worry, be happy”• Worst-case scenarios are unlikely to happen• Euro’s problems could strengthen European fiscal system• A weaker Euro could boost competitiveness• It’s better to be in the Eurozone than not in it – Croatia is tied to the Euro anyway – Adopting the Euro would remove balance- sheet mismatches