What's wrong with the Euro? What does it mean for Croatia?
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
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
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
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
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
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
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
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.
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.
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
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
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
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”)
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
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
“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.
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.
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
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?
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 . . .
“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)
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
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
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
“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