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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 5 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. 6 Convergence Criteria • The purpose of setting the criteria is to maintain the price stability within the Eurozone. 7 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 8 Convergence Criteria • Fiscal criteria –National budget deficit less than 3% GDP –National debt less than 60% of GDP – or heading in the right direction 9 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 10 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 11 €/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 12 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. 13 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? 14 Sweden and Denmark • Referenda defeat pushed membership back • Some more positive attitudes to membership emerging but: – Politicians wary of further defeats – Difficult to justify 15 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 16 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 17 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 18 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 19 Exhibit 5.10 European Sovereign Debt in 2011 20 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 21 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 22 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 23 Exhibit 5.11 European Sovereign Debt and Interest Rates 24 Example 5.12 Holders of Sovereign Debt 25 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 26 Exhibit 5.13 Selective Eurozone Financing Needs 27 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 28 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 29 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. 30