What’s wrong with the Euro? What does it mean

for Croatia?Ben Slay

Senior EconomistUNDP Regional Bureau for Europe and CIS

Zagreb9 December 2011

Empowered lives.

Resilient nations.

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 the global financial crisis in 2008-2009

CIS SEE/NMS Euro zone USA Japan Other Asia

9.0%

5.5%

2.9% 2.7% 2.4%

11.4%

-6.4%

-3.6% -4.1%-3.4%

-6.3%

7.2%

2007 2009

IMF data

Regional GDP growth

Recovery in 2010—relatively weak

Other Asia Latin America

Africa CIS SEE/NMS Japan USA Eurozone

9.5%

6.1%

5.0%4.6% 4.2% 4.1%

3.0%

1.9%

IMF data

Regional GDP growth trends

Crisis impact on Europe, Central Asia: Five groups of economies

Group EconomiesA: Crisis had minimal impact Central Asia, Azerbaijan,

Albania, Kosovo, PolandB: Recession in 2009, strong bounce in 2010-2011

Germany, Sweden, Finland, Baltics, Slovakia, Turkey,

Armenia, Georgia, Moldova

C: Recession in 2009, weaker bounce in 2010-2011

Most other EU countries, Russia, Ukraine, other Western Balkans

D: No recovery in sight “PIIGS”, Romania, Croatia

E: 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

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

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

How has the Euro fared? Not so badly . . .

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

$1.07

$0.92$0.90

$0.95

$1.13

$1.24$1.26

$1.37

$1.47

$1.39

$1.33

$1.39

** Despite the “Euro crisis”, the Euro is still quite strong against the dollar.** The British pound, Russian rouble, and other currencies have been weaker against the dollar than the Euro.** A weaker Euro would not be such a bad thing . . .

Average annual exchange rates, $/€

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, financial 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

Greece Italy Belgium Ireland Portugal EU-27

99%106%

90%

44%

66% 62%

143%

119%

97% 96% 93%

80%

2008 2010 Stability and growth pact limit (60%)

Gross public debt as share of GDP. Eurostat data.

Competitiveness trends

-19%-14%

-2%0%

6% 8%

22%

31% 32%

42%

68%Cumulative changes in industrial unit labour costs, 1999-2010

Improvement

Deterioration

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?

Social implications: EU-27 unemployment rate isn’t falling

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q32008 2009 2010 2011

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

“Double dip” recession?

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, tourism, 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