Euro area governance and the sovereign debt crisis

Zsolt DarvasBruegel

Conference on "Economic Crisis and Governance”IOBE - The Foundation for Economic & Industrial Research, Athens, 16 May 2011

Euro area 12 (excl. Greece up to 2000): number of countries missing the Maastricht convergence criteria

0

2

4

6

8

10

12

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Nu

mb

er

of

cou

ntr

ies

General government balanceGeneral government debtInflationInterest rateMissing at least one criterion

Source: Author’s calculations using data from Eurostat, ECB and May 2011 forecast of the EC

Note: The 2011 data for the interest rate is based only on values up to April.

Causes of the sovereign debt crisis

• Greece: fiscal misbehaviour + structural weaknesses

• Ireland: unsustainable housing booms and banking sector fragility

• Portugal: weak economic growth before the crisis, reflecting structural weaknesses

• Yet it is not impossible to have fast and balanced growth inside the euro area: Finland & Slovakia

• Question 1: Was the pre-crisis euro-area governance framework (also) responsible?

• Question 2: Will the new euro-area governance framework resolve the current crisis and avert similar crises in the future?

3

Outline

1. Pre-crisis governance framework

2. The new governance framework and its assessment

3. Transition to the new governance system

4. Fiscal and structural adjustments: examples of Greece, Hungary, Iceland, Ireland and Latvia

5. Euro crisis?

6. Summary

4

1. Pre-crisis governance framework

Price stability: independent central bank

Prevention/correction:• Stability and Growth Pact (SGP): Stability and Convergence

Programmes (SCPs), Early warning mechanism, Excessive Deficit Procedure (EDP)

• Macro imbalances: no formal mechanism; only Commission warnings

• Macro-financial stability: no mechanism

Crisis management and resolution:• no mechanism (neither for sovereigns, nor for banks; only facility

for sovereigns outside the euro area)

Structural:• Lisbon strategy, National Action Plans (NAPs)/National Reform

Programmes (NRPs)

Largely failed even before 2008 (apart from overall price stability)5

2. Sketch of the new governance framework

Price stability (no change): independent central bankPrevention/correction:• Budgets (more teeth to SGP; national fiscal frameworks)• Macro imbalances: EIP – Excessive Imbalance Procedure• Macro-financial stability: ESRB – European Systemic Risk BoardCrisis management and resolution:• Sovereign liquidity assistance (temporary: EU govts, EFSF, EFSM,

permanent: ESM) + IMF• Sovereign crisis resolution regime: from mid-2013 for newly issued

bonds• Bank resolution: national frameworks (Euro Pact)• ECB: targeted bond purchases, collateral policy, lifeline for banksStructural:• EU2020, NRPs, European Semester

Unprecedented number of reforms, couple of good initiatives Ability to learn lessons and to reform

6

2. Issues 1. – A general observation

• Scope of reforms:

– While ambitious in certain respects, largely fixes current bugs and maintains the decisive role of intergovernmental processes and national frameworks

Not a problem for big countries with history of strong national frameworks (eg Germany) and for small countries with good starting positions (eg Finland, Slovakia)

But will be difficult to achieve a sustainable status (in terms of fiscal and competitiveness) for countries with bad starting positions (ie corrective arms request fiscal austerity and wage moderation in a falling economy)

7

2. Issues 2. – Some specific observations

• SGP & EIP:– Commission proposes, but largely inter-governmental (even

if reverse majority voting rule)– Strong emphasis on sanctions

• Sovereign liquidity provision: – Last resort and only if risking ‘euro area financial stability’– Strong conditionality– Punitive interest rate (in contrast to non-euro area facility) Do these three features adequately address moral hazard?– Inter-governmental (unanimity)– Financed/guaranteed by national resources subject to

national interest

8

2. Issues 3. – Some specific observations

• Sovereign insolvency procedure: – ‘contractual approach’ (collective action clauses to all bond

issuances from 2013), as opposed to ‘statutory approach’ (international bankruptcy mechanism)

• Bank resolution:– National frameworks, but no EU-wide mechanism

• Eurobonds (up to a certain % of GDP):– Rejected by core countries fearing enforcement in the

absence of fiscal integration (a real issue) and interest rate rise (an unlikely issue)

– Would be better for fiscal discipline, thereby making the euro area more crisis-proof

9

2. Sanctions

• Is the reliance on sanctions the right solution to compensate for the lack of fiscal/political union?

• If applied before the crisis: – Greece: perhaps– Ireland for 25% and Spain 40% pre-crisis debt???– Italy: high debt and slow reduction???

• During a crisis: makes no sense• For prevention: Even if Commission proposes and reverse

majority voting, active politicians decide fruitless debates and unsettling disputes

• Unwarranted political message: ‘Brussels fines us and does not understand our situation and social problems’

• Amount of EU fine is dwarfed by interest rate premium imposed by markets post-crisis Name and shame, but let markets do the dirty job 10

3. Transition to the new governance system

• Resolution of banking crisis, including real stress tests (with stressing the single most important source of stress)

• Sorting our sovereign insolvency from liquidity

• Markets will not lend to current programme countries: Will euro area partners ready to finance all debt? Would that be desirable?

• What if sovereign debt restructuring before 2013? Continuous denial is not a good option. Financial stability risks should be addressed

• ECB: How to get rid of sovereign bond holdings and bank lifeline, how to normalise collateral policy?

• Revive growth in Southern Europe (structural reform, single market, EU funds)

11

4. Fiscal and structural adjustments: 5 examples

12

EU membership

IMF/EU programme

Exchange rate regime

Greece Yes May 2010 €

Hungary Yes Oct 2008 float

Iceland --- Oct 2008 float

Ireland Yes Nov 2010 €

Latvia Yes Dec 2008 Peg to €

HIIL = Hungary, Iceland, Ireland, Latvia

4. Debt and deficit (% GDP), 1990-2012

13

0

20

40

60

80

100

120

140

160

180

19

90

19

95

20

00

20

05

20

10

GreeceHungaryIcelandIrelandLatvia

-20

-15

-10

-5

0

5

10

19

90

19

95

20

00

20

05

20

10

GreeceHungaryIcelandIrelandLatvia

General government gross debt

General government balance

Source: May 2011 forecast of the European Commission and EBRD

Note: the Irish deficit was 32% in 2010, but for better readability of the right-hand side figure, it has a cut-off at -20%

4. GDP and investment, 1995Q1-2011Q1

14

GDP (volume, 2007Q4=100)

Investment (volume, 2007Q4=100)

Source: Eurostat website

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia 30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia

4. Consumption, 1995Q1-2010Q4

15

Private consumption (volume, 2007Q4=100)

Public consumption (volume, 2007Q4=100)

Source: Eurostat website

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia

4. Trade, 1995Q1-2010Q4

16

Export (volume, 2007Q4=100)

Import (volume, 2007Q4=100)

Source: Eurostat website

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia 50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

20

05

Q1

20

06

Q1

20

07

Q1

20

08

Q1

20

09

Q1

20

10

Q1

20

11

Q1

GreeceHungaryIcelandIrelandLatvia

4. Current account and employment, 1990-2012

17

Current account (% GDP) Employment (2007=100)

Source: May 2011 forecast of the European Commission

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

19

90

19

95

20

00

20

05

20

10

GreeceHungaryIcelandIrelandLatvia

50.0

60.0

70.0

80.0

90.0

100.0

110.0

19

90

19

95

20

00

20

05

20

10

GreeceHungaryIcelandIrelandLatvia

4. Some structural indicators

18

Sources: Word Economic Forum, Transparency International, World Bank

Note: The index of Quality of institutions is composed of public institutions (75%) (property rights, ethics, undue influence, government inefficiency, security) and private institutes (25%) (corporate ethics, accountability)

Quality of institutions

Corruption perception

Ease of doing

business rank

Goods market

efficiency

Labour market

efficiency

Quality of the

educational system

Quality of scientific research

institutions

Greece 4.1 3.8 109 4.2 3.9 3.3 3.8

Hungary 3.9 5.1 47 4.2 4.2 3.2 5.0

Iceland 5.9 8.7 14 4.9 5.4 5.9 5.0

Ireland 5.4 8.0 7 5.3 5.0 5.6 5.3

Latvia 4.1 4.5 27 4.5 4.7 3.7 3.6

The higher the better for all indicators except the ease of doing business rank

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

Market rate (daily data)PPP conversion rate (annual data)

Euro against the US dollar4 January 1999 – 13 May 2011

Source: author’s calculations using data from the IMF and ECB.

PurchasingPowerParity

exchangerate

5. Euro crisis?

May 2011:

• Greek 5-year CDS have risen to a record of about 1500 basis points, implying a 80% probability of a default (with 50% haircut)

• But the euro continues to be very strong

6. Summary

• New governance framework: significant steps, but largely fixes current bugs and unlikely the ultimate solution

• Sanctions and too much inter-governmentalism carry risks

• Lack of Eurobonds: would be a better tool to enforce discipline and make euro area crisis-proof

• Transition is very unclear; time and growth (in core euro area) will not solve all issues: banks, solvency, growth, ECB

• Greek adjustment: the country has not suffered as much in terms of output, consumption and employment as HIIL, yet export is very weak. Structural indicators are also very weak

• Despite sovereign panic: markets do not expect euro area break-up, even in the likely event of a sovereign default

• But the currently small political risk to the euro can rise 20