CAN THE EURZONE SURVIVE?

GROUP 6 ARUSHEE | DINESH | SHOMRITA | SONALI | RUPALI

What is the Eurozone Crisis?
Eurozone Crisis, in short, is a sovereign debt crisis of peripheral
nations arising as a consequence of growing Current Account
imbalances
There were a series of mistakes which led to this outcome
Mistake 1: Failure to factor in default risk in the pricing of bonds of
peripheral countries

Comparison of 10-year Government Bond yields of various countries

25

20

15

10

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Germany Spain Italy Greece

Source: OECD Economic Outlook November 2012, Annex Table

What is the Eurozone Crisis?
Risk in pricing of bonds = Inflation risk + Exchange Rate risk +
Default risk
Type of Risk Why not considered
Inflation Risk Price converge in the long run according to PPP

Exchange Rate Risk A single currency, Euro, so, no exchange rate risk

Default Risk 1. Euphoria

2. Assumption that all member countries will
adhere to membership criteria

Mistake 2: Violation of membership criteria related to debt and

deficit limits
Debt and Deficit Limit Criteria
1. Maintaining fiscal deficit under 3% of GDP
2. Limiting Government debt to 60% of GDP

What actually happened?

3. Six of the eleven original Eurozone members did not meet the debt
limits
4. No action taken because of the political dominance of Germany and
France
What is the Eurozone Crisis?
Consequences of Mistake 1 & 2
Excessive Lending by German banks and excessive borrowing by
peripheral countries
Secondary Effect of higher banking leverage

CAD/CAS as a percentage of GDP

10

-5

-10

-15

-20

Germany Greece Itlay Spain

Source: OECD Economic Outlook November 2012, Annex

What is the Eurozone Crisis?
Mistake 3: Inappropriate use of borrowing by peripheral countries

Greece Spain Italy

Excessive Massive private In Italy, there was

Government sector borrowing neither excessive
borrowing leading drove current- government
to CAD account deficit spending nor
Increase in G Increase in I private spending
Too much But investment But growth was
Government was poor
spending predominantly on Rate of increase
Excessive real estate in Y was less than
borrowing to fulfill Led to housing the rate of
their bubble which increase in
consumption resulted in a lot external
Failure to invest of bad loans borrowing
in productive Y decreased as a
assets, thus no result and CAD
increase future increased
earnings
What is the Eurozone Crisis?
Consequence of inappropriate usage of external borrowing
Stagnant Low
Rising wages
productivity competitiveness
Single currency Poor labour relations High unit labour cost
Rising borrowing to system increase in periphery
compensate for Average Labour countries
wage hike productivity growth in Loss of
Spain and Italy from competitiveness
2000 to 2008= 0.7% & hinders current
0.1% p.a account reversal
Unit Labour Cost Index (Rebasing 2002 Index to 100)
135
130
125
120
115
110
105
100
95
90
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Germany Greece Italy Spain

Source: Eurostat
What is Eurozone Crisis?
A Graphical Interpretation

Eurozone Crisis: Growing Current Account Imbalance

300

200

100

0
Current Account Balance (in $ billion) -100

-200

-300

-400
2000 2008 2014
Germany France Greece Spain Italy Ireland

Germany A few peripheral

Germany in
having a large countries have moved
deficit
surplus from deficit to surplus
France in
All peripheral Germanys CAS
Surplus
countries in continues to be very
deficit high
Source: OECD Economic Outlook November 2012, Annex
Euro-zone & You Why should you worry?
Homes and Banks not willing to lend funds easily
Mortgages Tougher conditions for first-time home buyers
Fewer first-time buyers mean more tenants and rising rents

The interest paid by banks to savers record at low levels. Any further
Safety of euro-zone trouble means those rates would rise more slower.
Savings Faced with a "slow and silent run on banks in Italy, Spain and Greece",
there has been an acceleration in attempts to create a Eurozone-wide
deposit protection scheme.

A euro-wide banking crisis would squeeze the credit available to firms

Outlook for
to expand and create new job opportunities. Small businesses: hard hit
jobs
If the eurozone survives the crisis, austerity measures are still likely to
affect employment, especially in the public sector.

Investments Splitting money into different investment pots and taking a long-term
view may be the safest approach for investors amid volatility in the
markets.

Holidays in It is highly unlikely holidaymakers will be left stranded in Greece with

Europe unusable euros because Greeces exit from the euro would be
huge admin task
 What
Measures
has been done so far..
taken Economic Implications
Financial assistance to Eurozone states in difficulty. Backed by guarantee commitments from
Member States for a total of 780 billion. Lending capacity of 440 billion.
Creation
of EFSF Contribution: Ireland 17.7 billion/ 67.5 billion, Portugal 26/ 78 billion, Spain 100 billion
In the second bailout for Greece, the loan was shifted to the EFSF, amounting to 164 billion.

An emergency funding programme reliant upon funds raised in financial markets.

Creation of
EFSM Guaranteed by European Commission using the budget of the European Union as collateral.
Capital markets bond issue of 5 billion for financial support package for Ireland

Increase in bail-out funds upto 1 trillion in EFSF

Brussels
Agreement
50% write-off of Greek sovereign debt held by banks
Increased mandatory level of 9% for bank capitalisation within the EU
EU set up new supervisory authorities in 2011 (European Securities and Markets Authority)
Supervision
A banking union- EU-level banking supervision & resolution system-has been created.

Fiscal It focuses on raising national saving through decreasing Govt. spending and increasing taxes
Austerity Cut budgets to limit deficit projections to raise market confidence & lower interest rates.

Outright In 2012, ECB offered additional financial support in form of some yield-lowering bond
Transaction purchases
 What has been done so far
Measure
taken Economic Implication
Began open market operations buying government and private debt securities in 2010 (to
create demand) though it lead to increase in inflation too.
European Cut its bank rates reaching a historic low of 0.25% in Nov 2013. The lowered borrowing rates
Central Bank caused euro to fall in relation to other currencies, which is hoped will boost exports from euro-
zone and further aid recovery.
Set deposit rate at -0.10% in June 2014 to prevent holding of money due to high deflation

LT ECB started this biggest infusion of credit into banking system in the euro's 13-year history.
Refinancing Loaned 489 billion to 523 banks for an exceptionally long period of 3 years at a rate of 1%.

The ESM is an intergovernmental organisation acting as a permanent rescue funding

European programme which serves as a "financial firewall."
Stability
Mechanism Prevent contagion; the firewall mechanism can ensure that downstream nations and banking
systems are protected by guaranteeing some or all of their obligations.

In March 2011 a new reform of Stability and Growth Pact was initiated.
European
Fiscal It aimed at straightening the rules by adopting an automatic procedure for imposing of
Compact penalties in case of breaches of either the 3% deficit or the 60% debt rules.

In 2012, EU adopted a Compact for Growth and Jobs, aimed at re-launching growth,
Growth and investment and employment and making the EU more competitive.
jobs
In June 2013, European Council launched EU youth employment initiative. to boost youth
employment
Current Scenario - Economic Stagnation
Decreasing Unable to Falling
productivity devalue exports

Economic Austerity Internal

Recession measures devaluation

8 GDP Growth Rate

6
4
2
0
-2
-4
-6
-8
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Germany Greece Italy Spain

The Deflationary Spiral
Cause Effect
Weak
Prices expect to
Demand fall tomorrow
Internal Fear of
Devaluatio Inflation in
n Germany Fall in
consumption/dem
and today
High Deflatio Falling
Unemployme
nt n Exports
Loan defaults rise

6 CPI Inflation
4
2
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-2
-4

Germany Greece Italy Spain

Can the Eurozone survive?
It must! Else
Repercussions will be high as there will be a capital
flight from the exiting nation

Imminent devaluation of currency in the member

nations will lead investors to immediately withdraw
funds from a nation that is already plagued with
economic crisis

High transaction costs of converting cash and

savings to member currency

Domino effect on other nations banks holding the

exiting nations bonds leading to credit crunch

The associated administrative upheaval will help

disintegrate an already weak economy
What should be done?

Increase
Competitivene
ss

Increase Devalue your

Productivity currency

Monetary and Quantitative

Leave the Euro
Fiscal Union Easing
Quantitative Easing (QE)
Germanys fear of inflation appears to be one of the reasons why the ECB
has waited so long for unconventional monetary policy
QE wont work unless the banking crisis is resolved. Banks remain awashed
with bad debts and private lending has contracted since 2012
Since ECB is not lender of last resort, an implicit default risk continues to
haunt investors of real assets
QE leads to asset bubbles as money flows into stocks and other financial
assets instead of households and companies
ECB should insist on debt-write downs and debt restructuring for the banks
instead of panic driven money printing
Monetary and Fiscal Union
CA = Y C I - G
Measures taken Impact on BOP Outcome expected
Equation
Liquidity infusion into CA decreases Money lent is invested
periphery countries (Borrowing increases) in productive assets
(Current I increases)
which leads to future
increase in Y
Austerity measures C and G decreases Money lent not used in
demanded non-productive
spending
But there is no mechanism to ensure that the money lent is
invested in productive assets to increase competitiveness
without further increase in expenditure, which is the mandate
of sovereign government
The lending entity should also be the one responsible for
controlling the purpose for which it is used, for quicker
achievement of the above objective
But this union may not be possible to achieve in the
In the meanwhile
ECB should be granted more authority to review budgets of member countries

Greater cooperation is needed among the member countries for long-term

benefit

Germany should focus on increasing domestic demand to improve the

European imbalance

Germanys past fear of hyper-inflation should not impediment ECBs policy

decisions

Better responsiveness from all fronts as delayed implementation mutes the

intended impact

Thus gradually move towards monetary and fiscal union