Transcript Document

Convergence Criteria
and European financial crisis
ECONOMIC AND MONETARY UNION
(EMU)
Optimal Currency Area
The Optimal Currency Area theory was behind
the European Single Currency argument. It
requires:
1. An absence of asymmetric shocks
2. A high degree of labour mobility and wage
flexibility
3. Centralised fiscal policy
Thus, to meet conditions above, there is a
convergence criteria for establishing Eurozone.
2
Economic benefits of EMU
• Removes exchange rate uncertainty on intraEMU trade
• Avoids competitive devaluations
• Eliminates transaction costs
• Increases price transparency
• Low and stable inflation and interest rates
• Promotes international specialisation and
improves EU competitiveness
• Boosts the EU’s international economic profile
3
Economic risks of EMU
• Short term deflation
• ‘Can one monetary policy fit all’?
• Loss of economic sovereignty and self
determination in monetary policy
• Asymmetric shocks? – especially if EMU lead to
specialisation.
• Lack of real economic convergence
• Burden of adjustment on wages and prices –
internal devaluation needed
4
The path to Euro
•
•
•
•
Werner Report – proposes EMU by 1980
1979 European Monetary System - ERM, ECU
1989 Delors Report – 3 stage approach to EMU
1993 Maastricht Treaty – EMU framework and
timetable
• 1992-3 ERM (Exchange Rate Mechanism) crises
• 1.1.99 - fixing of exchange rates
• 1.1.02 – notes and coins in circulation
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Convergence Criteria
(Maastricht criteria)
• For European Union member states to enter
the third stage of European Economic and
Monetary Union (EMU) and adopt the euro as
their currency
• The 4 main criteria are based on Article 121(1)
of the European Community Treaty.
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Convergence Criteria
• The purpose of setting the criteria is to
maintain the price stability within the
Eurozone.
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Convergence Criteria
• Monetary criteria
– Inflation no more than 1.5 percentage points
above the average of the 3 countries with the
lowest rates
– Long term interest rates no more than 2
percentage points above the average of the 3
countries with the lowest rates Exchange rate
– has joined ERM II (Exchange Rate Mechanism) for
previous 2 years and not devalued its currency
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Convergence Criteria
• Fiscal criteria
–National budget deficit less than
3% GDP
–National debt less than 60% of GDP
– or heading in the right direction
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Convergence Criteria
• 12 member states form the Eurozone – all pre-2004 member states
• UK and Denmark ‘opt-out’
–Danish referendum: February 2000
– 53% against
–Sweden remains out: September
2003 ‘no’ vote
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European Central Bank (ECB)
• Independent and supranational
• Primary objective is price stability
• Responsibility for monetary policy – i.e.
interest and exchange rate policy.
• Fiscal policy – remains national – but Growth
and Stability Pact to stop member states
undermining ECB
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€/S Exchange
rate:Rates;Jan
1999
May
2012
Frequency: Daily; Currency: US dollar;
Currency denominator: Euro
1.8
1.6
1.4
1.2
1
0.8
0.6
Dataset name: Exchange
Rates; Frequency: Daily;
Currency: US dollar;
Currency denominator:
Euro; Exchange rate
type: Spot; Series
variation - EXR context:
Average or…
0.4
0.2
0
Source: European Central Bank
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March 2005 –
Stability and Growth Pact reforms
• 3% budget deficit/60% debt thresholds
remain
• ‘relevant factors’ to enable member
states to avoid ‘excessive deficit’
procedures
– e.g. economic cycle, structural reform, research
and development, public investment, etc
• Countries have longer time to correct
‘excessive deficit’ – 2 years. Can be extended
further.
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UK - not on the agenda in short or
medium term
• Political parties
– Labour in favour ‘in principle’ but some dissenters
– Conservatives – mostly Eurosceptic – some pro
– Liberal Democrats – the most ‘pro’
• Businesses – divided
– Foreign investors – more pro
– Big companies – more pro than anti
– Small companies – more anti than pro
• Public opinion
– Heavily anti – how deeply held?
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Sweden and Denmark
• Referenda defeat pushed membership back
• Some more positive attitudes to membership
emerging but:
– Politicians wary of further defeats
– Difficult to justify
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Convergence criteria - 2003
Inflation
(%)
Budget
Debt/GDP Interest
deficit/GDP
(%)
Cyprus
4.3
-5.2
60.3
4.6
Czech
0.0
-8.0
30.7
4.1
Estonia
1.6
0.0
5.4
6.4
Hungary
4.6
-5.4
57.9
6.5
Latvia
2.5
-2.7
16.7
5.1
Lithuania
-0.9
-2.6
23.3
5.1
Malta
1.3
-7.6
66.4
5.8
Poland
0.7
-4.3
45.1
5.9
Slovakia
8.5
-5.1
45.1
4.9
Slovenia
5.9
-2.2
27.4
5.5
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Convergence criteria - 2004
Inflation
(%)
Budget
Debt/GDP Interest
deficit/GDP
(%)
Cyprus
2.4
-5.2
72.6
5.8
Czech
2.8
-4.8
37.8
5.0
Estonia
3.4
0.5
4.8
4.5
Hungary
6.9
-5.5
59.7
8.4
Latvia
6.8
-2.0
14.6
5.0
Lithuania
1.2
-2.6
21.1
4.6
Malta
3.7
-5.1
72.4
4.7
Poland
3.5
-5.6
47.7
7.2
Slovakia
7.7
-3.9
44.2
5.1
Slovenia
3.9
-2.3
30.9
4.8
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Convergence criteria - 2005
Inflation
(%)
Budget
deficit/GDP
Debt/GDP
Interest (%)
Cyprus
2.0
-2.4
70.3 X
5.16
Czech
1.6
-2.6
30.5
3.51
Estonia
4.1x
1.6
4.8
3.98
Hungary
3.5X
-6.1 X
58.4
6.60X
Latvia
6.9X
0.2
11.9
3.88
Lithuania
2.7X
-0.5
18.7
3.70
Malta
2.5
-3.3
74.7X
4.56
Poland
2.2
-2.5
42.5
5.22
Slovakia
2.8X
-2.9
34.5
3.52
Slovenia
2.5
-1.8
29.1
3.18
Source: national governments and Eurostat:
X = above threshold value
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Sovereign Debt
• Government (sovereign) debt typically considered to be of the
highest quality due to ability to manage fiscal (tax) policy and
monetary policy
• Eurozone members control fiscal policy for their own countries
but not monetary policy
• Different levels of debt are incurred by each of the eurozone
countries as seen in Exhibit 5.10
• Greece with a debt/GDP ratio of 166% is the highest
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Exhibit 5.10 European Sovereign Debt
in 2011
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The European Debt Crisis of 2009-2012
• October 2009 the newly elected Greek government discovers
the previous administration has systematically under-reported
the government debt
• Greek financial instruments are down graded
• Financial markets fear Greek default and financial contagion to
other financially weak eurozone countries
• March 2010 the IMF helps establish a plan to stabilize the
Greek economy
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The European Financial Stability
Facility (EFSF)
• EFSF designed to raise €500 billion to extend
credit to distressed member states
• Ireland:
– Unlike Greece, their problems are similar to those
in the U.S., a property bubble and the failure of
the banking system
• Portugal
– Problems may actually be contagion as their
financial problems did not appear to be as serious
as Greece or Ireland
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Transmission
• Greek, Irish, and Portuguese government debt was held by
many European banks
• These banks were considered too big to fail
• The risky sovereign debt was trading at deep discounts and
with high yields
• Further bailouts of Greece and others were becoming
necessary
• Exhibit 5.11 illustrates what happened to interest rates
• Who would buy such risky debt? See Exhibit 5.12
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Exhibit 5.11 European Sovereign Debt
and Interest Rates
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Example 5.12 Holders of Sovereign
Debt
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Moving Ahead in Europe
• How much money is needed in the coming
years for eurozone countries? Exhibit 5.13
• Solutions to the debt crisis
– Greece needed immediate capital to manage debt
obligations and run their government
– European banks needed to be protected from the
plunging value of the sovereign debt of Greece,
Ireland, Portugal and the like
– Address the long-term fundamental issues of
government deficits with ...in some cases austerity
measures
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Exhibit 5.13 Selective Eurozone
Financing Needs
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Alternative Solution to the Eurozone
Debt Crisis
• The Brussels Agreement - a failed attempt to write down
sovereign debt values, increase funds in the EFSF, and increase
required bank equity capital – contingent upon Greek
acceptance of new austerity measures, but the Greeks
hesitated
• Debt-to-Equity Swaps – these come at a cost as the debt value
is trimmed before conversion to equity
• Stability Bonds – Issued with the full backing of every
eurozone country rather than individual sovereign debt –
resisted by the stronger countries
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Currency Confusion
• Has the sovereign debt crisis put the euro at risk?
• YES
– Too much euro-denominated sovereign debt could
raise significantly the cost of financing as could the
failure of eurozone countries to meet convergence
standards
• No
– Bad sovereign debt should affect each country more
than the group of euro nations
– Very little empirical evidence thus far that the crisis
has really devalued the currency
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Sovereign Default
• Exhibit 5.14 provides a brief history of sovereign
defaults since 1983, and their relative outcomes.
• U.S. response to the 2008-2009 credit crisis was:
write-offs by holders of bad debt, government
purchase of debt securities, and government
capital injections to support liquidity
• Europe has chosen a similar path as the last
technique.
• banks are not participating to the same extent as
in the U.S.
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