INTERNATIONAL FINANCIAL MARKETS

Instructor: Professor Helmut Schuster

CAN EURO SURVIVE? SHOULD IT SURVIVE?
Bryukhanov Yegor K1156418 e-mail: yegor.bryukhanov@aalto.fi

Date: 26th November 2011

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Preface In the very beginning of the new millennium global economy has already experienced severe crises stemming from growing indebtedness in both private and public sectors. Starting with 9/11 terrorist attacks on the World Trade Center in 2001, interest rates in the United States were kept at very low levels, leading to increased debt burden, due to the access to the cheap resource by the organizations and individuals. Simultaneously, European Union has adopted a common currency and implemented a set of policies, which were aimed at unifying the region’s economic landscape and increasing the competitiveness of developing economies. While the idea of convergence in the European Union, seemed feasible and attractive to policy makers, global macroeconomic situation has led to several bubbles being formed in the financial markets, both in the US and the EU. These have subsequently led to a contraction in the EU and loss of confidence in the financial markets. This paper aims to address an issue, which has been fuelling heated discussions about whether or not current fiscal, social and economic policies are sustainable enough to ensure positive direction of the European Economy as a generic entity. The question of whether the Euro is able to survive in its current state or it should be abandoned became centric to various stakeholders of this crisis. In order to properly address, it a background on current crisis and its causes will be provided. Followed by a discussion of the options available to the policy makers and their potential implications for global economy and financial markets, the paper will conclude with an author’s opinion on the matter. Given that the discussion of the present situation depends on constantly evolving flow of the information that appears daily and can adjust the likelihood of an adoption of particular policy, it is necessary to remember that concluding arguments are based exclusively on an up-to-date information and academic research available.

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Background & Current Situation An initial purpose of establishing the euro was to adopt a common currency that would provide unified resource for businesses and governments to facilitate the trade, thus, lowering vulnerability to potential exchange rate fluctuations and economic crises in the member countries. In order to ensure that no members of the common-currency zone would become an anchor pushing down the rest of the countries into a potentially harmful state of the economy, specific convergence criteria were adopted (Lewis, 2011). More specifically, any country willing to join had to maintain 3% of GDP for the yearly deficit, while fines of up to 2% of GDP (Article 121, European Community Treaty) were to be imposed on the member-states 10 CARNEGIE ENDOWMENT FOR INTERNATIONAL PEACE violating this condition. As a result, Eurozone, now was perceived as a coherent entity, where initially weak economies, were backed upwouldthe strongthose of the GIIPS, con dencethe increased confidence with respect to by prevail over ones, contributing to in the GIIPS frameworks public debts of the weaker countries. Initially planned convergence in the Eurozone took place. A good 1
1990 that are comparable to those of Ghana today, the GIIPS (excluding Greece ) saw their in ation and interest rates converge with those of the EUN during the 1990s. Long-term government bond yield spreads of the GIIPS vis-à-vis the EUN, fell from 550 basis points in 1980–1990 to just 10 in 1999. surged. After averaging in ation levels and public borrowing costs from 1980 to throughout its periphery and that the EUN’s stronger institutional and economic

example to illustrate this effect is to compare the initial and subsequent differences of long-term
EUN, government bond yieldswhich inflation rates betweenlending to – the weaker economies and EUN – the stronger and indicate the perceived risk of GIIPS the GIIPS instead of the

ones. GIIPS corresponds to Greece, Ireland, Italy, Portugal and Spain, while EUN to Europe’s northern members, they are: Austria, Belgium, France, Germany and the Netherlands.

Annual In ation Rates and Long–Term Government Bond Yields
Average aggregate rate, percent 25 20 15 10 5 0
Bond Yield: In ation: GIIPS GIIPS EUN EUN

Source: IMF

1980

1985

1990

1995

2000

2005

1 The figure above clearly illustratestothat GIIPSoccurred slightly later in Greece, whichcosts ofnal approval The process of convergence EUN fundamentals have enjoyed their did not win borrowing declining after initial

to join the Euro area until 2000; bond yield spreads fell from 750 basis points in 1980-1990 to about 30 in 2001.

attempts to fit the convergence criteria and saw even steeper decline, when in 1999 Euro was adopted. On 3

the other hand, northern economies reaped the benefits of escalating demand in the new markets and decreasing competition due to the broader geography of demand for their products. Germany, as the strongest member-state saw its exports rising, because the adoption of the Euro made its exports cheaper. The Euro now reflected not only German’s competitiveness, but also the competitiveness of the whole Eurozone, which, generically was lower than the one of Germany alone, hence, the Euro was cheaper for German exports than was the Deutsche mark before (Dadush et al., 2010). Surge in confidence of the Eurozone periphery and low interest rates combined with significantly lowered cost of borrowing have fueled internal demand in GIIPS. Escalated demand has led to a growth in prices and wages, heating up inflationary expectations, while GIIPS’ demand have largely switched from manufacturing into services and housing. Unit labor cost rose 32% from 1997 to 2007, indicating rise in wages that were not matched by increase in productivity. Over the same period prices of services in GIIPS rose 1,5% more than those of goods, compared with only 0,5% difference in EUN, indicating a severe increase in prices of non-tradables against tradables (Dadush et al., 2010). On the other hand, governments enjoyed growing tax revenues from industries, where the profit steeply rose amid increased demand. However, governments failed to realize that this growth was short-term and the proceeds had to be saved in order to be able to compensate for the possible URI DADUSH AND BENNETT STANCIL contraction in GDP growth and rise in borrowing costs. Instead, GIIPS governments increased public spending, which, over the period between 1997 and 2007 amounted to 76% increase per person, while in EUN this figure was only 34% (Akram et al., 2011). Ireland, Spain, Portugal and Greece are the leaders among Eurozone countries in terms of the levels of government spending increase. Essentially, government speeding’s GDP
Annual Growth of Government Expenditure
Percent average, 1997–2007 12 10 8 6 4 2
Source: Eurostat

15

Portugal

Italy

Netherlands

contribution escalated as well, making it more vulnerable to the possible deterioration in bubbles in Ireland and tax revenues. For the expanded state sector was una ordable. e housing countries, such as Greece, where tax system is highly inefficient and only allows collecting around 30% of to rescue its hugely expanded nancial sector at an estimated cost of 13.9 percent
of GDP, greatly increasing its di culties. As their domestic recessions deepened, the GIIPS’ loss of competitiveness made resorting to export markets extremely of 20 percent of GDP from 2007 to 2009—further restricted public spending Spain burst, putting additional strain on government budgets. Ireland was forced

Germany

Ireland

Spain

Greece

France

Belgium

Austria

0

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challenging. Rising borrowing costs and ballooning public debt—up by an average

all the possible tax revenues, reliance on such assumption has put the country under the threat. In Ireland and Spain, lowered costs of borrowing have fuelled the real estate bubble and Portugal and Italy started seeing deterioration in export revenues already in the beginning of 2000s. In Portugal this happened particularly during to the emergence of China and India as alternative low-cost producers, while low-cost was previously Portugal’s competitive advantage (CIA Factbook, 2011). Large labor costs, vigorous government spending and low interests rate have led to a decrease of competitiveness in these countries. Following a blowup in the housing market in the US, the collapse in Irish and Spanish housing markets was triggered, while Greece’s borrowing costs surged as confidence in the sustainability of the Eurozone’s growth model began to be questioned. Ireland had to rescue its financial system, which was largely exposed to the housing market, at an estimated cost of 13% of GDP with an assistance of IMF, restraining its growth prospects for the following several years. From 2007 to 2009 borrowing costs for GIIPS surged at a rate of about 20% of GDP, imposing further cuts on public spending, when it was needed to resort the competitiveness and gain momentum on the export markets (Dadush et al., 2010). Standard & Poor’s and other rating agencies have cut sovereign credit rating, a measure of how safe a particular bond issued by a country is, several times over the course of the last 6 months. According to Standard & Poor’s sovereign ratings list (2011), prospect for GIIPS looks gloomy at best. The data is presented below and is available on the 26th of November 2011. Name of the country Greece Portugal Ireland Italy Spain Long-term credit rating Outlook

CC (In default with little prospect Negative for recovery) BBB- (lower medium grade) BBB+ (lower medium grade) A (upper medium grade) AA- (high grade) Negative Negative Negative Stable

Note: This is a selected sovereign rating for S&P data only, for example, Portugal has been already downgraded by Fitch and Moody’s, this is mentioned below. 5

News, highlighting constant downgrades of the Eurozone countries, have significantly contributed to the volatility of financial markets and, as a result, to rising bond yields and rumors on the market that any of the affected sovereign borrowers may default on its debt at any time. On the 23rd of November, after Germany’s sovereign bond auction was 35% undersubscribed, Markit iTraxx SovX Western Europe Index of creditdefault swaps on 15 governments rose to an all-time high, indicating that markets perceive the probability of default in the countries of the Eurozone as an all-time high (Nazareth, 2011). Stock markets all over the world are sliding; erasing billions of wealth accumulated over the past two years amid concerns that Euro zone debt crisis is going to throw global economy into the recession. Financial sector is especially hampered by the debt contagion, because a lot of European banks, including UniCredit, BNP Paribas and Societe Generale all have direct exposure to the sovereign debt, which, with every further downgrade becomes less liquid and more risky to hold on the books. MF Global, large US brokerage, led by former Goldman Sachs co-CEO had to file bankruptcy, because of large losses on European sovereign debt just in a matter of days. European policy makers have already forced some of the Greece’s lenders to incur a 50% haircut on the bonds by replacing previous bonds with new ones containing longer maturities and lower yields. However, even this 50% is not actually a 50%, but rather the figure is close to 30%, because out of Greece’s 350 billion Euros of outstanding debt, approximately 150 is held by European Central Bank, IMF and Troika, while the remaining 200 billion belong to private investors (Becker, 2011). Although, the restructuring was not binding, the possible write-down amounted to only 100 billion of Athens’ liabilities and did not restore confidence in the markets. Greece’s default is widely considered to be manageable, however, where’s the guarantee that eroded confidence and rising yields would not trigger default at countries with much larger economies such as Spain and Italy? 7% bond spread relative to German Bund was the borderline after crossing which Portugal, Ireland and Greece were to seek for bailouts from the EU and now the Rubicon is crossed by Italy, whose default would be disastrous for the global economy, given that the country is placed 8th by the nominal GDP, according to the data compiled by IMF (2011). Even though, Italy has not yet asked for a rescue package and wants to resolve existing problems by introducing austerity measures that would enable the country’s economy to regain competitiveness and increase growth from the current 0,75% average over the past 15 years, which is 6

much less than the interest it has to pay on its debt (Knight, 2011). Unless Italy is able to reduce its 156% of debt to GDP ratio or trigger the growth in its economy, it can become the most likely receiver of European rescue fund. The government of the new Prime Minister, Mario Monti is expected to introduce a series of credible measures to tackle Italy’s economic incompetence. Regarding the remaining GIIPS members, two days ago Fitch decided to downgrade Portugal from BBB- to BB- or “junk” grade, which is below investment level (Bloomberg, 2011). Portuguese economy is expected to contract 3% in the following year threatening government’s deficit reduction plan. Situation with Spain and Ireland currently remain relatively stable (Bloomberg, 2011). Possible Solutions & Policy Suggestions In this section, several possible options to tackle the crisis will be discussed in a country specific manner. In the end, consolidation of the universal measures applicable on a broader scale will be provided. Relying on the information outlined in the above section of the paper, the emphasis will be put on the countries with largest risk of default, namely Greece, Portugal and Italy. Greece. Recently, former Prime Minister George Papandreou was forced to leave the office in response to his announcement of a referendum for Greek people to vote for the rescue plan proposed by the EU. Crisis in Greece has become largely political, rather than economic issue. European leaders have been saying may times that it is their responsibility to keep Greece afloat. However, does Greece want to impose tight austerity measures, such as extended taxes, pension cuts above 1200 euro threshold, public wages cut, VAT hike and privatization of national lottery, two airports and 2004 Olympic venues (Inman, 2011)? One of the main problems of Greece is the macroeconomic prospects that look very gloomy. Lack of confidence in the market towards Greece, which stems largely from the actions of the previous government, does not allow Greece to lower the costs of its borrowing and to concentrate on addressing structural issues in the economy. Therefore, Europe only buys time for Greece and nothing more, while Greece needs to restore its competitiveness, balance out its budget and widen its tax net. The latter, given the scales of shadowy economy, might trigger massive windfall of tax revenues that might somewhat help the country in the short run to bare its debt burden. If this does not work, one of the likely scenarios will be to abandon the 7

Euro, while still remaining in the EU. However, significant problem arises if Greece is to do that. Abandoning Euro currency and going back to Drahma will solve Greece issues only under the condition of the existence of strong export industries in the economy. Under Drahma, Greece will have to bare interest on euro-denominated debt, which, after imminent Drahma devaluation will become very expensive, because currency devaluation in this case does not translate to credit ease, like it happened in Russia in 1998 . Therefore, the option of abandoning Euro does not seem very plausible, just because, Greece, just like every other severely infected Euro zone country is on the two-edged sword: lost competitiveness and large indebtedness. Final option might be to follow austerity measures required by the European union, or even impose more severe ones, even at the cost of the citizens' well-being. Such scenarios, even though are harsh, might prove feasible and they actually work. However, decisions regarding the policies are still to be made. Italy. While Italy does not have such severe fiscal problems as compared to Greece, Portugal or Spain, the main issue with this country is the loss of competitiveness and essential stagnation of the economy. Italy's labor unit cost rose 32% over 1997-2007 periods, which is comparable to the 34% rate experienced by Greece (Dadush, 2011). Also, Italy lacks competitiveness in some of its main industries, such as: telecommunications, energy and transport. Italy's exports grew at the slowest pace out of any other, country lacks big firms and over 15% of young people, especially in the south are jobless, while the population is ageing. One of the options, which is now being pursued by the ECB is to try weaken the Euro and increase the inflation, which will not likely lead to an increase in real interest rates in the short-term, however, it might contribute to the overall export growth of the Italian economy. However, before that, it is essential to lower unit labor cost and to introduce legislation that will ensure competitiveness in the backbone industries. This action might not have an immediate effect, but will likely send a signal to the markets that Italy is on the right way. Portugal. Having barely experienced euroboom, Portugal has slid into the recession without being able to build up budget surpluses and move into higher-value added industries, where its comparative advantage 8

could become the driving force of growth for the whole economy. Instead, Portugal decided to concentrate on traditional sectors, such as low-tech manufacturing, where low cost producers were gaining increasing share of the market. The country has lost 10% in the export market over the period between 1995-2000, largely before even joining the euro. Unlike for Greece, Spain and Ireland, European monetary policy was too tight for Portugal and even growing levels of debt, stemming from low convergence-related interest rates, could not fuel real estate growth. Combined with slowing labor productivity and high unit labor costs, the economy began stagnating, showing a contraction of 2,7% of GDP. Portugal, just like every indebted country will have to reduce debt burden, because under current market conditions it only slows growth and worsens the prospects for the long-term economic outlook (Rogoff and Reinhart, 2010) . A country might impose a series of tax policies that would discourage service consumption and investment into-non tradable. Also, given that large amount of growth in the EU is contributed to the small and medium-sized businesses, essentially start-ups and more mature start-ups, the country might improve its performance along business indicators, such as: ease of doing business, transparency and providing a credit to the business owners. This way, Portugal might be able to fight its current account deficits and attract investments into sectors, which would contribute to the overall competitiveness to the Portuguese economy. Concluding Remarks Having briefly addressed and analyzed current EU crisis, I now can provide the answer to the question located on the titel page of this paper. Should the Euro stay? I think it should and it will stay. I think so, primarily because the initiated convergence has greatly contributed to the peripheral economies by having created welath and encouraged people's consumption. Moreover, Euro itself has led to the stabilization of the trade relations and to reduced uncertainty between the bilateral partners. However, prevailing socialist model of the government proved to be not suitable for navigating through this growth, because the surpluses were direct into public spending and not into the infrastructural development. In my opinion, the heart of the problem is the way the socialist model has treated the proceeds of this growth. Convergence in European Union has led to unification of bond spreads between the countries but it has not led to the unification of the retirement ages. It has not changed the people's attitude to work and it has not created infrastructures that would enable long-term development, instead it has created consumer excesses that has ballooned asset 9

bubbles all over the continent and all over the world. However, the consequences of abandoning the euro by weak economies can be horrible for them and it would only contribute to the global imbalances generated by the current crisis. Adoption of the Euro has led to more prosperous countries prospering and less prosperous worsening their state of the economy; however, abandoning the Euro is not a solution. Having examined a lot of research papers and articles while preparing this paper, my certainty has grown that the Euro will remain in place and it should do so, however, the ways of treating the advantage of the common currency and those proceeds it brings should be changed fundamentally. References: Andreas Becker . (2011). Greek haircut: When 50 percent is not half. Available: http://www.dwworld.de/dw/article/0,,15508757,00.html. Last accessed 26th November 2011. Carmen M. Reinhart and Kenneth S. Rogoff. (2010). Growth in a Time of Debt. American Economic Review: Papers & Proceedings. 2 (3), 1-9 EU. (2006). TREATY ON EUROPEAN UNION AND OF THE TREATY ESTABLISHING THE EUROPEAN COMMUNITY. Official Journal of the European Union. 1 (1), 1-331. Muhammad Akram. (2011). Contagious Effects of Greece Crisis on Euro-Zone States. International Journal of Business and Social Science. 2 (12), 120-129. Nathan Lewis. (2011). What is the purpose of the Euro. Available: http://www.forbes.com/2011/05/12/eurocurrency-purpose_3.html. Last accessed 26th November 2011. Philipp Inman. (2011). Greece's austerity measures . Available: http://www.guardian.co.uk/business/2011/nov/01/greece-austerity-measures. Last accessed 26th November 2011. Rita Nazareth . (2011). U.S. Stocks Decline as European Bond Risk Increases to Record. Available: http://mobile.bloomberg.com/news/2011-11-23/u-s-stock-index-futures-decline-on-germany. Last accessed 26th November 2011.

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Unknown. (2011). CIA - the world factbook. Available: https://www.cia.gov/library/publications/the-worldfactbook/geos/po.html. Last accessed 26th November 2011. URI DADUSH. (2010). Paradigm Lost. Carnegie Endowment for International Peace. 1 (1), 1-159.

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