LESSONS OF THE EUROPEAN CRISIS FOR REGIONAL MONETARY … · 2015. 1. 30. · §There is still a strong case for monetary and exchange rate cooperation in East Asia (e.g., Volz 2011)

© 2012 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)

LESSONS OF THE EUROPEAN CRISIS FOR REGIONAL MONETARY AND FINANCIAL INTEGRATION IN EAST ASIA

Ulrich Volz, German Development Institute

8 August 2012, United Nations Economic and Social Commission for Asia and the Pacific, Bangkok


Overview

1. Introduction

2. The causes of the European crisis

3. Lessons for East Asia

4. Conclusions


§ Europe currently faces a severe crisis

• The debt crisis in several member states of the euro area has raised

doubts on the viability of European Economic and Monetary Union

(EMU) and the future of the euro

§ Was European monetary unification a bad idea?

• While the launch of the euro in 1999 created a lot of interest in regional

monetary integration and even monetary unification in various parts of

the world, including East Asia, the current crisis has had the opposite

effect, even raising expectations of a break-up of the euro area

• Crisis has highlighted the problems and tensions that will inevitably

arise within a monetary union when imbalances build up and become

unsustainable

Introduction


§ The objective of this presentation is twofold:

• To review the causes of the European crisis and explain why the crisis

of a small member accounting for less than 3% of the euro area’s GDP

could cause so much havoc

• To draw lessons that East Asian countries can pick up from the current

Europe sovereign debt crisis so they can pursue further successful

development and economic integration in the region

Introduction


Overview

1. Introduction



4. Conclusions


§ What happened?

• The Greek tragedy and how it spread over to Portugal, Ireland, Italy and

Spain (“PIIGS”: Portugal, Ireland, Italy, Greece, Spain)

§ Underlying causes of the crisis

• Country-specific problems

• Banking crisis fuelling sovereign debt crisis and vice versa

• Mispricing of risk and misallocation of capital

• Imbalances in the euro area

• Lack of coherent and credible crisis response by European governments

The causes of the European crisis



5 Nov 2009: George Papandreou's new Socialist government says the 2009 budget deficit will be 12.7% of GDP – more than double the previously published figure

8 Dec 2009: Fitch Ratings, which had cut Greece to A- when the higher deficit was revealed, cuts Greek debt to BBB+, the first time in 10 years it has been rated below investment grade16 Dec 2009: Standard & Poor's cuts Greece's rating by one notch, to BBB-plus from A-minus, saying the austerity programme is unlikely to produce a sustainable reduction in public debt22 Dec 2009: Moody's cuts Greek debt to A2 from A1 over soaring deficits

What happened?


§ The revelation of the real Greek fiscal situation at the end of 2009 raised serious doubts on the country’s ability to repay its debt

• Rating downgrades and rising interest rates made it ever more difficult

for the government to refinance itself, creating a downward spiral for the

Greek economy

• Bail-out by other European countries and IMF failed to restore trust in

Greek economy

§ Greek crisis has also raised concerns over debt situation of other periphery countries of the euro zone

• Rising borrowing costs for several members of the euro area (the

PIIGS) as trust in their ability to repay vanishes

• Increased focus on structural/competitiveness problems of PIIGS and

imbalances within the euro area




10 year government bond yields, January 2007 – January 2012

Source: Datastream



Source: Eurostat

Sovereign Credit Default Swaps, December 2007 – January 2012


§ Underlying causes of the crisis

• Country-specific problems

• Banking crisis fuelling sovereign debt crisis and vice versa

• Mispricing of risk and misallocation of capital

• Imbalances in the euro area

• Lack of coherent and credible crisis response by European governments



§ Causes of the crisis: Country-specific problems

• Greece: Desolate public finances due to a dysfunctional fiscal system, a

massively oversized (and inefficient) public sector, and endemic

corruption

• Ireland: Banking crisis!

– In September 2008 the Irish government guaranteed all outstanding

obligations of the Irish banking system as a reaction to the Irish banking

crisis (these were initially €400bn. but have increased to €440bn.)

– Ireland did not have a fiscal or debt problem before the crisis!

• Spain: Burst of housing bubble

– Spain did not have a fiscal or debt problem before the crisis either



§ Causes of the crisis: Banking crisis fuelling sovereign debt crisis and vice versa

• Government bail outs of banking systems in the course of the global

financial crisis has increase public debt

• Fiscal positions worsened as economies contracted and governments

responded with anticyclical policies

• Between 2007 and 2010, the debt to GDP ration of the Eurozone

increased from 66.3% to 85.4%

• Governments failed to recapitalise banks swiftly

• Sovereign risk has increased and worsens bank’s assets

• Further bail outs (of banks and states) make things worse

• Vicious circle set in motion




Public debt as % of GDP, 1995-2010

Source: Eurostat



Public debt as % of GDP, 2007-2010

Source: Eurostat



Credit default swap spreads of euro area(basis points, weighted by gross debt, excl. Greece), 2008-2012

Source: IMF


§ Causes of the crisis: Mispricing of risk and misallocation of capital

• Sovereign risk of the PIIGS was priced almost the same as German debt,

not least because the Eurosystem (the ECB and the national central banks

of the Eurozone) treated the sovereign debt instruments of the Eurozone

central governments as risk-free collateral when these were offered as

collateral for repos and other collateral financing trades

• Big drop in real interest rates in the periphery countries

• Low interest rates in PIIGS after entry into the euro area and inflowing

capital fuelled unsustainable developments, including excessive credit

dynamics and real estate bubbles in Spain or excessive fiscal spending in

Greece



Source: Eurostat


10-year government bond yields (% per annum), October 1990 – December 2011


§ Causes of the crisis: Imbalances in the euro area

• Divergences in current account balances across the Euozone have mostly

gone hand in hand with divergences in price competitiveness

• The domestic booms resulting from low interest rates and capital inflows,

in conjunction with existing labour market rigidities, led to large wage

increases in excess of productivity growth, triggering a loss in price

competitiveness and thereby impairing export performance

• Higher growth of inflation, wages and unit labour costs in PIIGS

• Appreciation of real effective exchange rates of PIIGS

• Loss of competitiveness of peripheral members of the euro area (PIIGS)

vis-à-vis the core countries (esp. Germany)

• Current account deficits of PIIGS



Source: OECD


Average annual wages (in 2009 USD, constant prices), 1990-2010


Source: OECD


Unit labour costs (OECD index base year 2005=100), 1990-2010


Source: IMF


CPI (differential over Germany CPI, in %), 2001-2010


Source: IMF


Real effective exchange rates based on relative unit labour costs, 1990Q1-2011Q1


Source: IMF


Current account (quarterly data, in million USD), 1990Q1-2011Q1


§ Causes of the crisis: Lack of coherent and credible crisis response by European governments

• European leaders were caught wrong-footed as they believed that a

balance of payments crisis was impossible within a monetary union

• No crisis resolution mechanism in place – the European Financial Stability

Facility (EFSF) had to be created in midst of crisis (following decisions

taken by members states on 9 May 2010)

• No coherent crisis response strategy from European governments and

weak Commission

• Differing opinions and open diversions between creditor and debtor

countries regarding a crisis solution strategy have further increased panic

in the markets





Overview

1. Introduction



4. Conclusions


§ Five lessons

• Don’t rush with monetary integration!

• Rethink costs and benefits of international financial integration!

• Bolster crisis prevention and resolution mechanism before crisis hits!

• Strengthen surveillance and monitoring of regional financial markets!

• Recapitalise banks swiftly after crisis!

Lessons for East Asia


§ There is still a strong case for monetary and exchange rate cooperation in East Asia (e.g., Volz 2011) but overambitious monetary and exchange rate integration schemes will backfire

• East Asian countries are not ready for a regional exchange rate system,

let alone monetary union

§ A high level of political agreement and commitment is needed among countries to pursue successful monetary integration, as well as close macroeconomic and fiscal coordination

• Just like the crisis of the European Monetary System in 1992, the current

crisis highlights the dangers that advanced monetary integration brings in

the face of economic and political divergences

• Macroeconomic imbalances within any kind of fixed exchange rate

system will cause problems at some point

Lesson 1: Don’t rush with monetary integration


§ East Asian countries should pursue a very gradual approach to monetary integration that allows for much flexibility and room for adjustment

• Managed floating guided by currency baskets are one option to keep

relative intra-regional exchange rate stability

Lesson 1: Don’t rush with monetary integration


§ The European crisis highlights once again that international financial integration will not automatically lead to an efficient allocation of capital and that it can contribute to the development of unsustainable imbalances

• The Stability and Growth Pact’s belief in the power of free markets to

discipline governments was not warranted (under-/overpricing of risk)

• International (including regional) financial integration increases

contagion risk

– Greek crisis triggered a full-blown European crisis

• Financial institutions engaging in cross-border activities increase

systemic risk and pose a regulatory challenge

• East Asian countries should be careful with liberalising financial markets

too fast

Lesson 2: Rethink costs&benefits of int’l fin. integration


§ Regulatory architecture needs to keep pace with financial

integration

• Close cooperation of national regulators needed

• From a certain level of regional financial integration a regional

regulatory body is needed

• Macroprudential regulation to deal with capital inflows (especially in a

monetary union where interest rate and exchange rate cannot be used)

Lesson 2: Rethink costs&benefits of int’l fin. integration


§ Crisis prevention and resolution mechanism needs to be in place before the next crisis

• ASEAN+3 should increase efforts to improve regional financial architecture

now

• There is no time for complacency in East Asia

– Risks are looming

– Capital inflows can reverse quickly

– Liquidity crisis can occur even if fundamentals are ok (e.g., Korea 2008)

§ Make Chiang Mai Initiative Multilateralisation (CMIM) process fully functional asap

• Work out details of cooperation with the IMF – if a big crisis hits, IMF

support will be needed

• US$240bn. may not suffice

Lesson 3: Bolster crisis resolution mech. before crisis hits


§ Strengthen surveillance and monitoring of regional financial

markets

• Crisis can spread quickly among closely integrated economies

(remember the Asian crisis!)

• Effective surveillance and monitoring is the best crisis prevention

§ Strengthen ASEAN+3 Macroeconomic Research Office (AMRO)

• More resources need to be devoted to regional financial surveillance

§ Risks of capital inflows need to be managed

• Regional approach (in addition to global efforts) to volatile capital flows

is needed

• In an integrated region (world) no country can do it alone

§ Consider Asian Financial Stability Dialogue

Lesson 4: Strengthen reg. surveillance and monitoring


§ Respond swiftly to banking crisis with swift recapitalisation of

banks

• Undercapitalised banks need to be recapitalised quickly, otherwise they

will hold back economic growth and increase risk of new crisis outbreak

• Europe has set negative example in this respect

§ Negative Japanese experience with too slow clean-up after banking crisis should have been a warning

• Europe seems to be following Japan

Lesson 5: Recapitalise banks swiftly after crisis


Overview

1. Introduction



4. Conclusions


§ European crisis highlights what can go wrong in terms of regional financial and monetary integration

§ It is wrong to conclude that European monetary union was a flawed idea, but the vulnerabilities have become obvious now andought to be addressed

§ The crisis holds important lessons for East Asia and these should be taken seriously

§ East Asia needs more regional monetary and financial cooperation, not less!

• Regional financial and monetary cooperation need to keep pace with integration of the real economies of East Asia

• Cooperation on the regional level as complement to global cooperation

§ As seen also during the Asian crisis, crises can spread quickly

• The region needs to have adequate response mechanisms in place

• The time to strengthen crisis response mechanisms is now!

Conclusions


MIT Press book & ADBI Working Paper


[email protected]

Thank you for your attention!

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LESSONS OF THE EUROPEAN CRISIS FOR REGIONAL MONETARY … · 2015. 1. 30. · §There is still a strong case for monetary and exchange rate cooperation in East Asia (e.g., Volz 2011)