The Future of the Eurozone Right and Wrong

The Future of the Eurozone: Right and Wrong Turns On the Way Ahead Gabriel Glöckler Deputy Head of the EU Institutions Division European Central Bank Central European University, Budapest, 24 March 2011 1

Outline What future for the Eurozone? • The Untenable Status Quo – Succession of crises – Market and policy failure • The Right Turns – Make fiscal consolidation a priority – Be serious about reinforcing governance • The Wrong Turns – Default/restructuring are not the easy options they may seem – What to do instead 2 • The Way Ahead

Outline • The Untenable Status Quo • The Right Turns • The Wrong Turns • The Way Ahead 3

The crisis unfolds 4

Dramatic impact on growth and employment Source: Eurostat, European Commission Autumn 2010 forecast 5

Public interventions in the banking sector 6

Situation is difficult worldwide 7

…though the crisis is only partially responsible… 8

May 2010: the sovereign debt crisis escalates 9

Non-linear market reactions & contagion effects Spread over 10 -year German government bond yield, in basis points 10

… a sudden stop in certain bond markets… Sources: Bank of Greece. Notes: Volumes traded on Secondary Market Platform run by the Bank of Greece (HDAT). 11

… leading to widespread market dysfunction Daily changes in bond prices, in percentages 12

Systemic risk at all time high Percentages, probability of default Notes: Probability of simultaneous default of two euro area LCGBs, Source: Bloomberg, ECB calculations 13

Problematic feedback loops of politics markets Government bond spreads against German Bund in basis points – based on Carmassi & Micossi (2010) on voxeu. org 9. April 22: Moody’s downgrades Greece for 2 nd time in 2010. German MP Schaeffler says Greece should be prepared to leave the euro if it can’t push through enough austerity measures. 10. April 23: Greece requests activation of euro area/IMF support – EU says terms of aid may be agreed in a matter of days, Merkel says Greeks must satisfy stringent conditions. 11. April 26 -27: Merkel says no agreement to support until Greece shows credible plan for a sustainable deficit reduction - “Germany will help when the correspondent conditions are fulfilled”. Standard & Poor’s downgrades Greece’s long-term credit rating to junk. 12. April 29 -30: Loan programme for Greece announced to be concluded within days. Greece adopts € 24 billion austerity package; Merkel confident it will keep the euro stable. 13. May 1: Merkel says EU should be able to temporarily revoke voting rights from member states who violate deficit rules. 14. May 2 -3: € 110 billion euro area-IMF support package for Greece adopted. ECB relaxes collateral policy for Greek sovereign debt. 15. May 7: German Parliament approves law to release funds (€ 22. 4 billion) to Greece. 16. May 10: EU stabilisation mechanism adopted (€ 500 billion from euro area and EU; € 250 from the IMF). ECB adopts Securities Markets Programme and reactivates US dollar swap lines with the Federal Reserve. German Constitutional Court refuses to block support package for Greece. 17. May 15 -16: Merkel: “if euro fails, more fails”. Germany calls for more stringent euro area fiscal framework based on German model. 18. May 18: Germany adopts ban on short-selling. 19. June 7: Euro area ministers establish the € 440 billion SPV (the European Financial Stability Facility) envisaged in the May 10 package. 14 20. June 14: Moody’s downgrades Greek sovereign debt to junk.

New monetary policy decisions (€ billions, daily data) Latest observations: 25 July 2010. Source: ECB. 15

European financial assistance for Greece 16

A financial stability safety net in Europe ECOFIN/Eurogroup decisions of 9 May 2010 European Financial Stabilisation Mechanism (EFSM – € 60 bn) European Financial Stability Facility (EFSF - € 440 bn. ) Complementary IMF financing (2: 1 basis) 17

The EU economic crisis – what went wrong? 1. Failure of market discipline – Presumption of rational behaviour – Expectation of enforcement of rules in a rule-based system – Solidarity vs. ‘no bail-out’ clause 2. Failure of fiscal policy framework – Principle of “non-interference” – Reluctance to give warnings and follow-up on recommendations – Weak enforcement by Commission, Eurogroup and EU Council 3. Lack of a competitiveness framework – Lisbon Strategy did not deal with divergences – Eurogroup processes informal – Lack of overall coherence 18

Poor compliance with SGP targets 19

Slow correction of excessive deficits 20

Resulting in an increase in public debt… Public Debt in % of GDP Source: EC and 2010 Stability Programmes targets for Government debt. For IT available up to 2012, for IE up to 2014 and for the remaining countries up to 2013. For GR EC/ECB/IMF programme 21

Diverging competitiveness developments… 22

… and widening economic imbalances 23

Sovereign risk – an alternative explanation 24

Outline • The Untenable Status Quo • The Right Turns • The Wrong Turns • The Way Ahead 25

Finding a way back should be priority… Source: European Commission Autumn Forecast 2009 26

No consolidation is not an option… Source: European Commission Autumn Forecast 2009 27

… carrying a large debt burden… Interest expenditures as % of GDP Source: European Commission, Morgan Stanley 28

… with increasing age-related spending over the next 40 -50 years… 29

… raising questions about debt sustainability Sample of 32 high-grade sovereigns. Source: What A Change A Year Makes: Standard & Poor's 2007 Global Graying Progress Report 30

Inflating away the debt mountain is no option Inflation expectations are well anchored Five-year forward break even inflation rate five years ahead Sources: Reuters, ECB, Federal Reserve Board staff calculations, Bank of England 31

Inflation expectations based on surveys ECB policy and commitment credible 32

Be serious about stronger governance ECB Opinion on all 6 legislative acts (21 February 2011) 1. Greater automaticity § Non-compliance must have predictable consequences; Council to have less room for manoeuvre to halt or suspend procedures 2. Strict deadlines § to avoid lengthy procedures; deletion of “escape clauses” 3. Focus – asymmetrically – on problematic countries § i. e. those with current account deficits, competitiveness losses, high levels of public and private debt. 33

Be serious about stronger governance (II) 4. Political and reputational incentives § Increased reporting obligations; escalation to European Council; Commission/ECB surveillance missions. 5. Earlier and graduated sanctions (in macro-surveillance) § interest-bearing deposit after the first instance of non‑compliance in EIP, fine after repeated non-compliance 6. Ambitious benchmarks for establishing excessive deficit § Reduce scope of “relevant factors” 34

Be serious about stronger governance (III) 7. Ambitious medium-term budgetary objective § Improvement of structural balance to be significantly higher than 0. 5% of GDP for high debt countries. 8. Quality and independence of economic analysis § Body of wise (wo)men to perform ex post assessment of surveillance 9. Strong national fiscal frameworks § Swift and uniform implementation of directive 10. Improved statistics 35

Important steps taken … more to come In less than one year: § March 2010: financial support to Greece (€ 10 bn) § May 2010: creation of EFSF (€ 440 bn) and EFSM (€ 60 bn) § September 2010: launch of economic governance reform § November 2010: EFSF/EFSM activated for Ireland (€ 85 bn) § December 2010: Agreement to change Treaty § March 2010: “Pact for the Euro” § March 2011: Comprehensive package + ESM 36

Outline • The Untenable Status Quo • The Right Turns • The Wrong Turns • The Way Ahead 37

A challenging environment: Sovereign redemptions and refinancing needs 2011 38

What it takes to stabilise debt 39

What if adjustment is beyond Greece’s & Ireland’s capacity? Greece: primary balance to adjust by 14. 6% over 6 years (2009 -2015) Ireland: primary balance to adjust by 13. 8% over 6 years (2009 -2015) 40

Such large adjustments in the primary balance are not unprecedented – e. g. Italy, Canada General Government Primary Balance (as a percentage of GDP) Source: OECD 41

Markets have their doubts 5 -yr Sovereign CDS Spreads (basis points) Source: CMA Data. Vision via Datastream 42

Stop scaring the markets 23/11/10: Merkel: “We are facing an exceptionally serious situation. ” 12/11/10: G-20 Joint F/D/IT/ES/UK statement “Any new [bail-out] mechanism only after mid-2013; no impact on current 28 -29/10/10 : arrangements. ’’ European Council endorses the Van Rompuy report but divided on sanctions. 18/10/10: Deauville Summit declaration: private creditors to be involved in the crisis resolution mechanism Government bond spreads against German Bund in basis points (10 yr) 28/11/10 : ECOFIN approves € 85 bn Irish package 16 -17/12/10 : European Council confirms private creditors’ involvement in the ESM 10/01/11: After China, Japan announces bond buys to boost confidence in EFSF. 25/01/11: EFSF first bond issue. 43

Allegedly easy options are not easy (I) • Inconceivable expulsion from the euro area – not compatible with political foundations of the euro – inconsistent with crisis response so far – economic and political “suicide” for countries concerned 44

Allegedly easy options are not easy (II) • Default or sovereign debt restructuring – No recent precedents in advanced economies – not really a significant relief – Costly and traumatic economic and social experience – “Orderly” restructuring in monetary union a myth – contagion effects in monetary union 45

Past experience with defaults/restructuring Experience so far only from emerging markets Reputational/penalty costs • Loss of market access • Higher future borrowing costs • Trade sanctions by creditor countries Broader costs to the domestic economy • Output losses 46

Past experience with defaults/restructuring Over the last 20 years, 19 countries out of 120 IMF programmes had debt restructuring: • • • 1998 Ukraine, Russia, Pakistan, Venezuela 1999 Gabon, Indonesia, Pakistan, Ecuador 2000 Ukraine, Peru 2001 Argentina, Cote d'Ivoire 2002 Moldova, Seychelles, Gabon 2003 Dominican Republic, Paraguay, Uruguay 2004 Grenada 2005 Dominican Republic 2006 Belize 47

Defaults/restructuring nearly always associated with sharp output losses - but worse in case of default Evolution of GDP growth around crisis episodes Pre-emptive restructuring cases (in percent) Default cases Source: IMF WEO. 48

Default/restructuring associated with higher borrowing cost and contagion Evolution of the EMBIG spreads around crisis episodes (in basis points) Argentine crisis (2001 -02) Source: Haver Analytics. 49

… although some solutions tend to be less costly • Extensive prior consultations with investors • Inclusion of collective action clauses (CACs) • Accompanying IMF programmes with strong conditionality 50

Restructuring would have major impact on domestic financial wealth… 51

… and the banking system Strong correlation between sovereign and banks’ CDS Banks Sovereigns Latest observation: 25 Jan. 11. Note: Five-year CDS; basis points. Sources: CMA Data. Visiosn via Datastream 52

Industrialised countries differ from emerging markets • Advanced economies have higher debt tolerance • Stronger institutions • More favourable composition of debt • More stable revenue basis • Advanced economies have highly integrated financial markets, especially inside a monetary union • No government of an advanced economy has defaulted/ restructured since World War II 53

If no restructuring – then what? • Seek new sources of growth • structural reform • regain competitiveness • confidence effects • Identify other measures to reduce debt burden • privatisation • improved tax collection • debt buybacks 54

The Greek government ‘under supervision’ Structural reforms demanded by EU/IMF: – Pension reform – Labour market and welfare system reform – Health system – Public administration reform – Public procurement – Opening up closed professions (transport, energy, retail sectors, pharmacists, notaries, etc. ) – Tackling tax evasion and the informal economy – Privatisation (€ 50 bn programme) 55

Need to improve growth prospects via structural reforms in Greece Competition and productivity • • Deregulation of transport and energy sectors Opening up of closed professions Implementation of Services Directive Restructuring of state-owned enterprises and bringing in of private management Labour market flexibility and labour supply • • • Reduction of employment protection Facilitating use of part-time work/flexible work arrangements Reform of the arbitration system Pension reform • • • Extensive reform to improving long-run sustainability, simplify system and increase participation New accrual rates with same profile for all workers Increase in retirement age to 65 and contributory period for full pension from 35 to 40 years 56

Greece – good progress but with pains HICP inflation Annual % change Source: Eurostat and ECB. Last observations: December 2010 for HICP and October 2010 for HICP at constant tax rates. Unemployment % of the labour force Source: Greek LFS for monthly, Eurostat for quarterly, green triangles give EC/ECB/IMF projection Last observations: October 2010 for monthly series, 2010 Q 3 for quarterly. 57

Initial impact on competitiveness 58

Create a credible financial safety net European Stability Mechanism • Effective lending capacity of € 500 bn; subscribed capital of € 700 bn (€ 80 bn paid-in capital; € 620 bn guarantees) • Interest rates: financing costs + 2%; further +1% for longer-term loans • Link to adjustment programme (EU/IMF) – conditionality • Instruments: (1) loans; (2) primary market purchases of government bonds • To be ready by 2013 (Treaty change procedure underway) • Private sector involvement: debt sustainability analysis; collective action clauses, preferred creditor status 59

Outline • The Untenable Status Quo • The Right Turns • The Wrong Turns • The Way Ahead 60

Temporary decrease in market pressure should not lull sense of urgency Government bond spreads against German Bund in basis points (10 yr) 15 -Feb-11: Finland to dissolve parliament by 15/03; last chance to agree on comprehensive package is the 11 March summit. 15 -Feb-11: Comprehensive package: EU officials announce that extra meetings are needed; Olli Rehn admitted that ‘’there is work still to be done’’. 4 -Feb-11: France and Germany introduce a joint proposal for a ‘’’competitiveness pact’’ at the European Council, facing reluctance from the other members. 25 -Feb-11: German coalition MPs rule out bond buying by ESM. 61

Way ahead • Commission proposals + • EP ambition • Franco-German Competitiveness Pact • “Comprehensive Package”+ agreement on ESM • Demonstration effect of Spanish reforms Make it work! Markets will not forget & forgive 62

Debt burden not only relevant for euro area Source: OECD, Eurostat, Morgan Stanley (estimates) 63

The euro area is ahead of others 64

Thank you! For further questions or enquiries: Email: gabriel. glockler@ecb. europa. eu Or visit: www. ecb. europa. eu 65