The document summarizes the challenges facing the Eurozone, including high debt levels and loss of competitiveness in some member countries. While leaving the Eurozone could restore policy tools to some countries, it risks financial collapse and contagion. For Croatia, a Eurozone crisis means slower growth, larger deficits, higher debt, and increased social problems, though remaining in the Eurozone may be preferable to the alternative. The document argues the worst scenarios are unlikely but reforms are still needed to strengthen the Eurozone.

1. Empowered lives.
Resilient nations.
What’s wrong with the
Euro? 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 the
global 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 economies
Group Economies
A: Crisis had minimal impact Central Asia, Azerbaijan,
Albania, Kosovo, Poland
B: Recession in 2009, strong Germany, Sweden, Finland, Baltics
bounce in 2010-2011 , Slovakia, Turkey,
Armenia, Georgia, Moldova
C: Recession in 2009, weaker Most other EU countries, Russia,
bounce in 2010-2011 Ukraine, other Western Balkans
D: No recovery in sight “PIIGS”, Romania, Croatia
E: 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 countries
must 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 falling
10.0%
“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