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7/30/2019 How Emu Break-up Can Be Avoided
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November 2012 0
Mark CliffeChief Economist ING Group
Presentation to the Peterson Institute for International Economics
Washington D.C.
13th November 2012
Roads to Survival
How EMU Break-up can be avoided
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Outline
1. Unfinished business Double dip driven by fiscal squeeze and weak credit growth
Core vs. periphery divergence is politically and economically unsustainable
2. Sovereign and bank solvency intertwined
Tougher capitalisation requirements are also hurting growth Banks remain reliant on ECB funding, exposed to government debt
3. There areRoads to Survival
It is not just about fiscal discipline, or even external indebtedness
growth(especially in the periphery) is crucial too for now, its up to the ECB More resources will have to be transferred to the periphery
Banking and funding union involve covert transfersbut fiscal union is thedestination
Will politicians secure popular support to trade sovereignty for solidarity?
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November 2012 2
Italy
Spain
Eurozone debt crisis unfinished business
Greece
Ireland
Germany
Portugal
NL
10Y government bond yield (%)
0
5
10
15
20
25
30
35
40
07 08 09 10 11 12
0
5
10
15
20
25
30
35
40
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d e b t =
Pr i m a r y d e f ici t + ( I n t e r e st r a t e GD P- g r o w t h ) x Ex i st i n g d e b t
Four ways to bring down debt-to-GDP ratio
Austerity / higher taxes
1
Lower interest rates Faster real growth orhigher inflation
Sell-off assets orrestructure/default
2 3 4
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Diverging fiscal policy
Fiscal tightening*
Source: OECD, ING
* % of potential GDP; annual change in underlying primary balance
-1
0
1
2
3
4
5
6
SP PT GR IT IR FR NL EA17 UK US DE
2012 2013
Periphery led by Spain is tightening more than the core
Domestic Demand
86
88
90
92
94
96
98
100
102
104
08 09 10 11 12
86
88
90
92
94
96
98
100
102
104
GermanyUS
NetherlandsItaly
UK
Spain
1Q08 = 100 1Q08 = 100
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1
2
3
4
5
6
7
07 08 09 10 11 12
Greece Portugal Spain Italy NL
(%)
Diverging interest rates
Corporate lending rates*
* Loans over 1m at floating rate and up to 1 year initial rate fixation
Source: ECB
Markets are penalising, not rewarding, the peripherals for their fiscal austerity
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Bank regulation strongly pro-cyclical
Policy-makers are keen make the financialsector more robust.
A key idea is for banks to increase capital,including counter-cyclical buffers
But the effect is strongly pro-cyclical, addingto the weakness of growth
1.Higher bank funding costs banks seen asuninvestable, with regulatory uncertainty
2.Pressure to increase holdings of governmentdebt for liquidity buffers
3.Volume of lending is being squeezed
4. Capital markets are filling the gap but doesthis make the systemsafer? Asset pricevolatility the source of crises - could evenbe greater
Bank funding costs rise (Asset Swap Spreads)
0
50
100
150
200
250
300
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
ASW (bp)
0
50
100
150
200
250
300
Covered Senior
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Draghis pledge the euro is irreversible
There is no going
back to the Lira or the
Drachma or any other
precursor currency
ECB OMT:
To repair the effective working of monetary policy
the ECB may undertake outright open market
operations
of unlimited size
focused on the short end of the yield curve (
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NL
Portugal
Spain
Italy
Germany
Greece
Ireland
France
Real gross domestic product (GDP level)
Eurozone: widening economic divergences
UK
82
84
86
88
90
92
94
96
98
100
102
2008 2009 2010 2011 2012
1Q 2008 = 100
Greek experience is ominous
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-15%
-10%
-5%
0%
5%
'00 '02 '04 '06 '08 '10
ES DE IE
Crisis not solely caused by fiscal indisciplineSpain and Ireland ran budget surpluses on the eve of the crisis
Budget balance as % GDP
Ireland
Spain
Germany
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Source:IMF, Eurostat
Debt/deficit Eurozone lower than in US & JP
Netgovernment debt (% GDP)
Budgetdeficit
(% GDP)
U S
D E
F R
GR
ES
I E
PT
U K
JP
N L
A T
BE
I TEZ
-11
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
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Sovereign and bank debt solvency intertwined
The sovereign debt crisis is more a symptomthana cause: it stemmed from the financial crisis.
Excessive privateborrowing (leverage)
exacerbated the downturn
BUT its not just about debt, since asset prices
1.fuelled debt, just as debt fuelled asset prices
2.precipitated the bust
3.may drive a deleveraging doom loop if they fall further
Bank and fiscal solvency are intertwined: banks
still depend on ECB/state support, weak bank
lending may hurt economic growth and publicfinances, banks are big buyers of public debt
Financial stability, fiscal and monetary policy are all
intertwined
Central banks are now targeting asset prices
BANK
SOLVENCY
FI SCAL
SOLVENCY
ECONOMI C
GROWTH
ASSET
PRI CES
The Deleveraging Doom Loop
Solvency is threatened by falling asset prices and growth
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CurrentAccount(% GDP)
Net external debt (% GDP)
Peripheral countries are large net debtors
BE
DE
IE
GR
ESFR
IT
NL
AT
PT
FI
US
UK
JP
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%-100% -50% 0% 50% 100%
Source: Eurostat; external debt 2010; current account 2011
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And its not just about external balance
In principle, external balance can be
achieved through squeezing domestic
demand fiscal restraint can deliver this...
BUT if this is at the expense of growth
and employment, it will ultimately beeconomically and politically unsustainable
As Jan Tinbergen pointed out, each
policy objective needs a policy
instrument
Without the exchange rate, regaining
competitiveness is tough
Tightpolicy
Highersaving
Uncompetitive currency
Foreign slump Externaldeficit
Externalsurplus
Competitivecurrency
Foreign boom
Recession Growth
Loose policylower saving
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Eurozone debt crisis reality check
Politics will decide how losses are divided between bond holders and tax payers
1. Debt restructuringcore country creditors have
already taken losses: there could be more to come...
2. Transfer Union much bigger fiscal transfers from
the rich to the poor
ECB funding (covert)
Common bond issuance (covert) European taxes/transfers
The Paradox of Merkelism attempts to limit the costs
to the core countries have served to increase them!
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Capital flight financed by the ECB
Peripheral* Eurozone Balance of Payments: Private Capital Takes Flight
* Sum of Greece, Portugal, Ireland, Spain and Italy ** Calculated as residual *** Non-annualised
Source: National central banks, IMF, European Commission, ING estimates
-500-400
-300
-200
-100
0
100200
300
400
500
-500-400
-300
-200
-100
0
100200
300
400
500
2006 2007 2008 2009 2010 2011 1H2012***
Target 2 financing Program financingNet private inf lows** C/A deficit
EUR bn
25% of theperipherys
GDP
Markets are penalising, not rewarding, the peripherals for their fiscal austerity
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EMU Roads to Survival
Fiscal austerity alone will not ensure the
survival of EMU. So what to do?
Reform structural, or supply-sidereform
could stimulate economic growth. this is theroad favoured by Germany and NL.
Reflation loosen macro policy to boost
demand.
Redistribution boost the periphery with
resource transfers from the core, either covert
or contingent (e.g. ECB funding or bail-out
loans) or explicit fiscal transfers .
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Six Survival Scenarios the policy mixes
The scenarios involve different combinations of policies:
Scenarios
Policy measuresReform - Product/labour market
- Finance/ funding
Reflation - monetary policy: QE
- monetary policy: rate cuts
- depreciation
- fiscal loosening
Austeria Draghia Bondia Europhilia Inflationia Krugmania
=not applicable =applicable =partly applicable =applicable in reverse
Redistribution - fiscal transfer
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18
EMU Survival: Reflation vs. Redistribution
Krugmania
America
Austeria
Europhilia
HighLow
High
Low
Reflation
Redistribution
Switzerland
Inflationia
Draghia
Bondia
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Scenario impact scoreboard
Scenario Output Yields Spreads
Core Periphery
Greek exit
Austeria
Draghia (banking union)
Bondia (funding union)
Europhilia (from transfer union to fiscal union)
Inflationia (akaOuter Draghia)
Krugmania
Note: Arrows show direction of impact in years 1-2->years 3-5 (= no change)
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Growth benefits, except in Austeria
The Austeriascenariodepresses activity in the short
term. The others boost GDP,with the biggest gains inKrugmaniaand Inflationia
Reflation and euro depreciationlift activity generally, whiletransfers benefit the periphery
Sustained stimulus is requiredto maintain the growth advantage
of the more reflationary
scenarios in the long term
The initially adverse effects oflabour and product market
reform are turned in sustained
gains to output growth in thelonger term
nevertheless, the Austeriascenario fails to make up for lostground relative to other
scenarios
Core
-4.5
-3.5
-2.5
-1.5
-0.5
0.5
1.5
2.5
3.5
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
YoY%
Base Austeria Draghia
Bondia Europhilia Inflationia
Krugmania
Peripheral
-5
-4
-3
-2
-1
0
1
2
3
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
YoY%
Base Austeria Draghia
Bondia Europhilia Inflationia
Krugmania
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Public Debt-to-GDP Draghiawins
Core
60
65
70
75
80
85
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Base Austeria Draghia
Bondia Europhilia InflationiaKrugmania
Periphery
75
80
85
90
95
100
105
110
115
120
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Base Austeria DraghiaBondia Europhilia InflationiaKrugmania
Bondiaand Draghias result in thelargest falls in debt to GDP profiles, to
c.75% after 5 years: for the core
countries, the ratio falls close to 60%
Fiscal transfers in Europhilia-,
Inflationiaand Krugmaniaresult in
relative deterioration in the debt profiles
for the core, with ratios staying above
80%, while the periphery sees falls
below 100%
Debt the periphery in Austeria
scenario shows no significant decline as
weak nominal GDP growth offsets
budget cuts, implying that debt
relief/default would be likely
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Banking Union breaking the sovereign link
Share of Eurozone deposit base
Rest, 13.5%
BE, 4.7%
NL, 6.3 %
ES, 12%
IT, 14.4%
DE, 29.6%
FR, 19.5%
Mutualising risk via Eurozone-wide
Regulation and Supervision
Deposit Guarantee
Recapitalisation
Resolution funds
lower bank risk = lower spreads
more, and cheaper, credit
lower sovereign risk = lower spreads
bank funded? Core government back-stop?
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Common Bonds = massive yield convergence
The German government does not rule out
common bonds on principle, but sees them as
a long term option, once fiscal union is agreed.
Crucially, the SPD is supportive
The implied mutualisation of risk is a massive
contingent transfer, and there is an implicit
transfer arising from yield convergence
peripheral yields would plunge, while the
core yields would rise
BUT this would be a positive sum game as
weighted average yields would likely fall
so long as moral hazard fiscal ill-discipline
is addressed with binding commitments1
2
3
4
5
6
7
08 09 10 11 12 13 14
1
2
3
4
5
6
7
non AAA ex GR,PT,IEEZAAA ex GermanGerman
%
Common
Eurobond
Eurozone 10year Government Bond yields
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Political resistanceLow High
Low
High
Larger bailoutfund
Banking union Euro bonds
Euro bills/EuropeanRedemption Fund
ECB /ESMbond buying
Slowerausterity
Investment
support
ECB Quantitative Easing
ECB rate cut
Economicimpact
A possible route? Discipline before Solidarity
Transfer union
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Summary
1. Macro-policy is tight = pro-cyclical
Fiscal policy is tight and credit creation dysfunctional
2. Economic growth is weakening and diverging
This politically and economically unsustainable
3. EMUs Road to Survival solidarity in return for discipline
It is not just about fiscal discipline, or even external indebtedness
Growth, especially in the periphery, is crucial too
Monetary policy to be loosened further and austerity scaled back?
More resources will have to be transferred to the periphery
Banking and funding union involve covert transfersbut fiscal union is thedestination. The challenge is to secure popular support
The Grand Bargain = transfers from the core ifthe periphery shows discipline