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Current state of the sovereign g debt crisis University of Saint Andrews, February 2012 Seppo Honkapohja Suomen Pankki Views expressed are my own and do not necessarily represent views of the Bank of Finland SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND I. Introduction SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND General government deficit 10 Spain Ireland Italy Greece Portugal Germany France Finland % of GDP 5 0 -5 -10 -15 -20 -25 30 -30 -35 1999 2004 Sources: Eurostat ja European Commission. Commission 2009 24297@Alijäämät(en) 16.2.2012 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 3 General government debt 250 Spain Ireland Italy Greece Portugal Germany France Finland % of GDP 200 150 100 50 0 1999 2004 2009 Sources: Eurostat and European Commission Commission. 24297@Velat(en) 16.2.2012 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 4 General government debt United States 250 Japan United Kingdom % of GDP 200 150 100 50 0 1999 2004 S Source: European E Commission. C i i 2009 24204@Chart1 (en) SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND General government deficit United States 6 Japan United Kingdom % of GDP 4 2 0 -2 2 -4 -6 -8 -10 -12 12 -14 1999 2004 S Source: E European C Commission. i i 2009 24204@Chart2 (en) SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Euro area sovereign CDS prices 45 Percentage points Greece 40 Portugal 35 30 Irland 25 Italy 20 15 Spain 10 Germany 5 0 Jan - 10 Jul - 10 Jan - 11 Jul - 11 Jan - 12 Finland Source: Bloomberg. g 5-year y CDS p prices. Quotations for Greece are no longer regularly available. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 7 Euro area bank CDS prices 28 % Alpha p 24 Banco Comercial Bank of Ireland 20 Unicredit 16 Banco Santander Raiffeisen 12 RBS 8 Rahoitussektori (Eurooppa) Deutsche Bank 4 0 Jan - 10 Nordea Jul - 10 Jan - 11 Jul - 11 Jan - 12 Source: Bloomberg. 5-year CDS prices. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 8 Sovereign yield spreads vis-à-vis Germany (10 y) 35 Percentage points Greece 30 Portugal 25 Ireland 20 15 Italy 10 Spain 5 Finland 0 01/10 04/10 07/10 10/10 01/11 04/11 07/11 10/11 01/12 Source: Bloomberg Bloomberg. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 9 GDP, GIIPS Euro area 115 Spain Ireland Italy Greece 2008 2009 2010 Portugal 2005 = 100 110 105 100 95 90 2005 2006 Source: Eurostat Eurostat. 2007 2011 23586@Chart40(en) 16.2.2012 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 10 Inflation,, GIIPS 7 Spain Ireland Greece Portugal % change from previous year Italy Euro area 6 5 4 3 2 1 0 -1 -2 3 -3 -4 2005 2007 2009 2011 S Source: Eurostat. E t t 23586@Chart1(en) SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Current account,, GIIPS Spain Greece 5 Ireland Portugal Italy Euro area % of GDP 0 -5 5 -10 -15 -20 1999 2004 2009 S Source: European E Commission C i i fforecast, t Autumn A t 2011. 2011 23586@Chart4(en) SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND II. Design g faults? SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Current account and public deficits in Greece, Ireland, Portugal and Spain in 2003-2009 Spain Ireland Public deficit P Portugal Greece Eurostat C Current t accountt SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 14 Assessments on Greece 2006-2007 IMF (Article IV report, report Dec 2006): – ” Significant fiscal consolidation was put in place in 2005–06, but further deficit cuts are needed.” – “Vulnerabilities Vulnerabilities have developed in the form of very high credit growth, persistent inflationary pressures, eroding competitiveness, and an unsustainably large current account deficit.” OECD (Country report, report May 2007): – “There has been substantial [fiscal] consolidation since 2004.“ – “Losses in competitiveness may ultimately undermine growth p performance.” – “The clearest sign of macroeconomic tension is an increase in the current account deficit.” Broad p picture in 2006-2007: – Fiscal situation seen to be on the mend. – External deficit seen as a vulnerability. – But no alarm bells, no perceived need for drastic action. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Assessments on Ireland 2006-2007 IMF (Article IV report, report June 2006): – ”Economic policies have been in line with Fund policy advice.” – ”Financial system continues to perform well, but rapid credit growth is a vulnerability.” y – “concentration of lending in property-related sectors… banks’ reliance on wholesale funding…” – “Regulatory and supervisory framework has been strengthened in line with the recommendations of the 2000 FSAP FSAP.” OECD (Economic survey, March 2006) – “The fiscal position is healthy.” – “House House prices may have overshot fundamentals to some extent, extent although this does not imply that they will fall significantly.” Broad picture in 2006: – Growth performance based on genuine productivity miracle, strong public finances. – Well-supervised financial sector, but property sector risks recognized. – Again, no alarms sounding! SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Current account – the missing link Before the crisis, crisis – Current accounts within a monetary union were seen as largely unimportant. – Balance-of-payments Balance of payments crises were seen as largely impossible: • BOP crises traditionally involve run on a currency, forcing interest rates up. • But monetary union shares a common currency and interest rate, so there is no risk of speculative attack. Now we know that: – Sovereigns within a currency union are leveraged entities and can be subject to a run, • … and once a sovereign is targeted, the financial sector goes down with it. – As long as solvency is defined along national borders, the monetary union alone does not shield from a BOP crisis. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND A regulatory failure? Stability and growth pact focuses only on public finances. – More generally, generally national imbalances and competitiveness were not included. – The 2003 revision of the Stability and Growth Pact clearly unfortunate. • The new Pact was not necessarily much worse than the old, but revision had wrong motivations. motivations – Signalled lack of political will for macroeconomic coordination. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND The ”No No bail out out” –clause clause had no real bite. bite – No enforcement mechanism. Integration of euro countries had not not progressed sufficiently far. – In particular, regulation and supervision of financial markets had remained entirely national. – Financial markets did not impose sufficient discipline on member countries. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND III. EU and euro area reforms SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND TREATY ON STABILITY, COORDINATION AND GOVERNANCE IN THE ECONOMIC AND MONETARY UNION To foster budgetary discipline through a fiscal compact To strengthen the coordination of economic policies To improve the governance of the euro area (“Six Pact”) – Fiscal surveillance and enforcement – Macroeconomic imbalances and enforcement – More automatic sanctions The treaty shall enter into force on 1 January 2013 if ratified by 12 euro area countries. The aim is to incorporate this treaty into the legal framework of the European Union within five years. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Fiscal compact The budgetary position of the general government should be balanced or in surplus. Medium-term M di t objective: bj ti structural t t l budget b d t deficit d fi it nott to t exceed 0.5 % of GDP. Structural deficit of at most 1 % of GDP allowed if the ratio of government debt is significantly below 60 % and risks s s in terms e so of long-term o g e sus sustainability a ab y a are e low. o Contracting parties may temporarily deviate from their medium-term objective j or the adjustment j p path towards it only in exceptional circumstances as defined in Stability and Growth Pact. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Fiscal compact (II) The rules should be incorporated in the national law of the contracting parties at the latest one year after the entry into force of the treaty treaty. The provisions in the national law should be binding, permanent and preferably constitutional or otherwise guaranteed to be respected throughout the national budgetary processes. – Compliance ultimately judged by European Court of Justice. A correction mechanism to be triggered automatically in the event of significant deviations as specified in the revised Stability and Growth Pact. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Excessive Deficit Procedure (EDP) and European Stability Mechanism (ESM) European Commission may initiate an excessive deficit procedure which includes deficit targets over several years. years Automatic sanctions on euro area countries with excessively high budget deficits; can be avoided only with a reversed qualified majority. The e pe permanent a e European u opea S Stability ab y Mechanism ec a s ((ESM) S ) to o replace the temporary EFSF should be operational in mid-2012. The lending capacity of ESM will be 500 billion euros. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND The objective of the reforms is to move toward a ”Maastrict plus” type system, not a complete fiscal union. – Each country has responsibility of its economy. – The aim is to strictly apply the commonly accepted rules. Eurobonds? – Several proposals, perhaps best known is the idea of blue bonds and red bonds. – Would move Europe (excluding UK?) strongly toward federalist direction • It seems that th t there th i nott very much is h support, t exceptt in i th the problem countries. – Would p probably y require q changing g g a change g in the EU Treaty. y • Not a tool to resolve the current crisis? SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND IV. Policies in the crisis countries SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Necessary to achieve a turnaround in the public debt to GDP ratio and then p proceed with reduction of indebtedness. – This will take 10-20 years. Consolidation of public finances – To convince the markets and the creditors – Negative N ti impact i t on economic i growth th in i th the short h t run. Structural policies – To improve economic growth in the medium to long run – Improving the legitimacy of government and administration • Achieving g the p positive effects will take time. 15.11.2011 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 27 Greece vs. vs Italy Greece Italy 74,5 60,5 18,2 21,1 Investments 16 6 16,6 19 7 19,7 Export 21,5 26,7 Import 30,4 28,6 Current Account (92 – 10) ‐8,3 ‐0,1 % of GDP, 2010 Private consumption expenditure Government consumption expenditure Source: European Commission. 15.11.2011 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 28 Challenges for Greece 2012 will be the 5th year with falling GDP. Debt-GDP G ratio will be nearly 200 % at the end off the year unless something is done. Major changes in the economy: – Private consumption must go down a long time.. – Massive need to move productive resources from public and closed private sector to export production. – Where are the new industries for exports? Major program for public sector consolidation and reform. reform ------------ A second aid package under negotiation. negotiation Voluntary restructuring of public debts held by the private sector under negotation. 15.11.2011 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 29 Challenges for Italy There are some strong private sectors and private sector financing is working so far. But: Liquidity Li idit crisis i i because b off high hi h public bli debt. d bt Too big to fail? – Country’s Co ntr ’s own o n actions decisive. decisi e – The new government has had a good start? Balancing of public finances is necessary (and should be achievable), But weak growth performance necessitates structural reforms to improve long-term sustainability. 15.11.2011 SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 30 Challenges for Portugal External adjustment gathered pace lately and structural adjustment program started off fairly well. But: B t – Weak growth and structural problems deep rooted. – Debt flows have helped to avoid adjustment in domestic demand, debt servicing burden has become problematic. – Needs for relative price changes to improve competitiveness, but probably b bl smaller ll than h eg Greece. G – Refinancing of public and private debt remains extremely challenging. g g SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Reprioritisation of resources towards tradable sector has seemingly started Portugal Greece Poland Export of goods and services, as % of GDP 50 40 30 20 10 2000 2002 2004 2006 2008 Source: national authorities SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 2010 External adjustment speeding up, but large debt burden keeps debt servicing still high Current account (6 m average) Net trade (goods and services, 6m average) mio EUR 0 -500 -1000 -1500 -2000 2000 2000 2002 2004 2006 2008 Lähde: national statistics SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 2010 V. Examples p of succesful ((?)) adjustment j SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND GDP: Estonia Estonia, Latvia Latvia, Ireland and Iceland E t i Estonia 200 L t i Latvia I l d Ireland I l d Iceland Index, 2000 Q1 = 100 180 160 140 120 100 80 2000 2002 2004 2006 2008 Sorces: Eurostat, National authorities. SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND 2010 Government debt: Estonia, Latvia, Ireland and Iceland Ireland 120 Estonia Latvia Iceland % of GDP 100 80 60 40 20 0 2000 2002 2004 2006 2008 2010 Sorces: Eurostat (Q3 for 2011), Iceland (for 2000-2004) national authorities and for 2011 IMF forecast. forecast SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND Thank you! y SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND