Eurozone Crisis:

Policy Responses & Solutions

Lalith Samarakoon

Department of Finance

University of St. Thomas

Presentation atFreeman Center for International Economic Policy

Humphrey School of Public Affairs, University of Minnesota

Nov 20, 2012

Three Inter-related Crises

2

Debt Crisis

Fiscal

Crisis

Banking

Crisis

Banking Crisis: Sources

• Credit freeze

• U.S. Subprime crisis froze international money markets, dried up

liquidity and low-cost short-term foreign borrowings.

• Exposure to U.S. Subprime assets

• Banks had invested in sub-prime assets.

• Exposure to domestic real estate bubble

• Excessive exposure to domestic property bubbles.

• Exposure to euro-zone government debt

• Exposure to sovereign debt of other eurozone countries.

• Capital flight (from Greece, Spain, Italy) to other countries.

3

Banking Crisis: Irish and Spanish Property Bubbles

4

Capital Bonanza

(Short-term, Foreign)

Excessive Property Lending

Speculative Demand &

Property Bubble

Credit Freeze (2008 U.S. Subprime)

Property Bubble Burst

Loan Losses & NPLs

Bank Runs , Withdrawals,

Capital Flight,

Liquidity Crisis

Banking Crisis: Eurozone Property Bubbles

5

Country % Increase from 1997 to

peak

% Decline from peak to

2011

Ireland 268 -34

Spain 192 -16

Greece 148 -17

Eurozone 78 -1

Italy 72 0.4

Portugal 49 -0.2

PIIGS 146 -13

• Property prices rose by an average of 146% in PIIGS.

Sources: ECB

Banking Crisis: Loss of Credibility of Greece

• Sudden loss of credibility: Greece announced that its budget deficit had

been under-reported and made significant an upward revision to 2008

and 2009 data. (October 2009)

• Sudden collapse of funding sources: Greece was cut off from Euro

interbank market and international bond markets.

• Rating agencies downgrade Greek debt

• Sovereign spread increased rapidly.

• Bank liquidity problems

• Banks faced deposit withdrawals and raised deposit rates (mainly

time deposits) to counter deposit leakages.

• Lending rates increased due to higher borrowing and deposit rates.

• Lending declined.

• Bank capital problems

• Banks faced increasing loan losses, particularly consumer loans. 20%

or €48b non-performing loans as of Aug 2012.

• Bank’s suffered losses in Greek government bonds due to loss of

market value and then pubic debt restructuring.

6

Fiscal Crisis: Output Plummeted

7

• Output plunged by more than

8% over 4 years.

Country Pre-crisisAverage Growth

(1999-2007)

Post-crisisCumulative

Drop(2008--2012)

Greece 4.0 -18.6

Ireland 6.4 -6.5

Italy 1.5 -6.7

Portugal 1.8 -6.1

Spain 3.7 -4.3

Eurozone 2.3 -1.0

PIIGS 3.5 -8.4

Fiscal Crisis: Budget Balances Deteriorated

8

• Ireland and Spain ran

surpluses before the

crisis.

• Italy had a primary

surplus but overall

deficit.

• Greece and Portugal had

persistent deficits.

Primary & Overall Balances Worsened

9

Country Pre-crisisOverall Balance

2007

Post-crisisOverall Balance

2012

Pre-crisisPrimaryBalance

2007

Post-crisisPrimary Balance

2012

Spain 1.9 -7.0 3.0 -4.5

Ireland 0.1 -8.3 -1.0 -4.4

Eurozone -1.0 -3.0

Italy -1.6 -2.7 3.1 4.0

Portugal -3.2 -5.0 -0.6 -0.7

Greece -6.8 -7.5 -2.0 -1.7

PIIGS -1.9 -6.1 0.5 -1.5

• Overall deficit increased

by 8 percentage points.

• Primary balance declined

by 2 percentage points.

• Factors

• Lower revenue due to

recessions & cyclical

taxes

• Higher spending due

to automatic

stabilizers

• Higher interest costs

due to more debt

Debt Crisis: Public Debt Increased

10

• Decline in growth, rise in

budget deficits, banks rescues

& recapitalizations & bailouts

increased debt by 47%.

Country Pre-crisis Debt (%)

(2007)

2012 Debt (%) & Increase (%)(2007--2012)

Greece 107 144 (34)

Italy 103 126 (22)

Portugal 68 118 (72)

Eurozone 66 92 (38)

Spain 36 76 (109)

Ireland 25 112 (348)

PIIGS 68 115 (47)

Sovereign Bond Yields Increased

11

Country Yield % (Dec

2008)

Yield %(Nov 2012)

Greece 5.08 17.61

Ireland 4.57 4.72

Italy 4.47 4.93

Portugal 4.00 8.79

Spain 3.86 5.83

Germany 3.05 1.30

• Yields rose. But have

declined significantly

since the peak except for

Greece & Portugal.

Social Costs: Unemployment Increased

12

Country Pre-crisis (2007) Rate

(%)(2007)

Post-crisis (2012)

Rate (%) &Increase(Points)

Greece 8 24 (16)

Spain 8 25 (17)

Portugal 8 15 (7)

Eurozone 7 12 (5)

Italy 6 11 (5)

Ireland 5 15 (10)

PIIGS 7 18 (10)

• Jumped by 11 percentage

points over 4 years.

Sources: Eurostat, ECB & IMF

Reponses

13

Bank Liability

Guarantee

Bank Recapitaliza-

tion &

Nationalization

Asset Support Schemes

Liquidity

Support

Bailout Programs

Debt Restructuring

Structural Reforms

Bank Liability Guarantees

• Purpose: State guarantee of liabilities of banks to restore confidence in

banks and prevent bank runs and a liquidity crisis.

• Irish blanket liability guarantee: guaranteed all deposits and debts of the

six largest in Sep 2008 (€485b, about 319% of GDP).

• Policy discussion

• Helped stabilize the banking system

• Socialized private debt

• Increased sovereign debt burden

14

Bank Recapitalizations & Nationalization

• Purpose: Prevent bank solvency crisis.

• Instruments: common shares, preferred shares and other hybrid

instruments

• Examples:

• Ireland: Anglo Irish, Nationwide Building Society, Allied Irish

(AIB), BOI, EBS Building Society

• Spain: Savings banks (Cajas); Bankia

• Policy discussion

• Restored bank solvency.

• Potential losses to tax payers.

• Increase public debt load.

15

Asset Support Schemes

• Purpose: ensure financial stability of banks by either removing impaired

assets to a bad bank or insuring against losses

• Asset removal schemes (Bad banks)

• Ireland: National Asset Management Agency (NAMA) acquired bad

assets worth €74b at an average haircut of 57% through bond for loan

swap.

• Spain: bad bank being set-up with part funding by bailout fund.

• Policy discussion

• Stabilized bank balance sheets

• Difficult to value, overpayment to buy bad assets

• Socialized private debt, taxpayers bear losses

• Increased public debt

16

Liquidity Support

• Purpose: Improve market liquidity in public and private debt securities market.

• Instruments• Covered Bond Purchase Program (CBPP) - June 2009 – Oct 2012

• Buy eligible covered bonds from banks in the primary and secondary markets. • Securities Market Program (SMP) – May 2010 – Sep 2012

• Buy eligible bonds issued by eurozone• governments and public entities (secondary market) and private entities

(primary and secondary markets). • Long-term Refinancing Operations (LTRO) – Dec 2011 & Feb 2012

• Long-term credit (up to 3 years) on the basis of collateral. €1,047b• Emergency Liquidity Assistance (ELA) – Life Support – Since 2008

• Credit line to NCBs to provide emergency funds to banks that cannot put up acceptable collateral to ECB for regular refinancing (Greece, Ireland, Germany, Belgium). €233b

• Policy discussion• Helped lower & stabilize sovereign bond yields• Provided liquidity for banks to continue to lend• Helped finance budgetary and debt repayment needs (via ELA)• Risks of ELA borne by the NCBs and hence the government.

17

Bailout Programs

18

• Purpose: Provide loans by EU & IMF to help finance the budget deficit,

debt repayments and bank recapitalizations.

•€110b

•May 2010

Greece

•€85b

•Nov 2010

Ireland

•€78b

•May 2011

•€130b

•Mar 2012

Greece

• Bailouts are conditional on implementation of large austerity programs.

• Policy discussion

• Helped fund governments via budgetary support.

• Helped avert sovereign debt defaults & insolvency.

• Added to debt stock increasing the sovereign risk.

• Large budgetary adjustments in a short time span is infeasible.

• Austerity causing less growth, social unrest and political instability.

Portugal

Debt Restructuring

• Purpose: reduce Greek’s debt burden through debt reduction and

restructuring (March 2012, part of the second bailout) of privately-held

debt.

• Mechanism• Debt swap: exchange old bonds for new Greek bonds worth 31.5% and

eurozone bailout fund (EFSF) notes worth 15% of face value of old bonds.

• Haircut: resulted in a 53.5% haircut and reduction of Greek debt from €350b to

€250b.

• Favorable terms: lower coupon: 2% (2012-2015), 3% (2015-2021) and then

4.3%, and longer maturity.

• Policy discussion

• Reduced the debt burden.

• Private investors, not the tax payers, took losses.

• Losses reduced capital base of Greek banks requiring recapitalization.

• Not adequate given the enormity of debt stock.

• Public investors were spared giving a bad signal to the market.

19

Structural Reforms

• Purpose: remove impediments to long-term growth by creating a more

efficient, competitive, flexible, market-oriented economy.

• Policy instruments• Financial sector reforms (bank recapitalization, deleveraging, prudential capital

requirements, reorganization and downsizing of the banking sector, bank resolution

regime, strengthen banking regulations and supervision)

• Entitlement reforms (curtail entitlement and selected social security benefits)

• Labor market reforms (reduce minimum wage, reform unemployment benefit

system)

• Pension reforms ( increase in state pension age, curtail early retirement)

• Public administration reforms (modernize public administration & reduce

inefficiency)

• Increase competition in the non-tradables sector (electricity, transportation, and

telecommunications) & sheltered sectors (legal, medical and pharmacy )

• Privatization of government-owned enterprises.

• Policy discussion• Needed reforms to address root causes of fiscal crisis.

• Needed reforms to increase competitiveness and growth .

• Takes a long-term to yield results.

20

21

Solutions

Permanent Bailout Fund (ESM)• Purpose: A permanent bailout fund with more capital to provide funds to

member states with financial instability.

• European Stability Mechanism (ESM) – Oct 2012• Subscribed capital €700 b (€80b paid-in and €620b guarantees)

• Maximum lending capacity €500b. with a 40% cushion.

• Combined lending capacity of EFSF/ESM €700b.

• Issue bonds and other instruments in the market to fund its programs.

• Instruments of support• Loans to a euro area member states in financial difficulties.

• Intervene in the debt primary and secondary markets.

• Act on the basis of a precautionary program.

• Provide loans to governments for bank recapitalizations.

• Policy discussion

• A more robust backstop to insolvency.

• Provide confidence to the investors.

22

ECB Bond Buying Program (OMT)“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me,

it will be enough“ ECB President Mario Draghi (July 26, 2012).

• Purpose: Buy sovereign bonds in secondary market to lower yields and thereby

long-term interest rates.

• Mechanism• Outright Monetary Transactions: buy short-dated (1-3 year) bonds. Unlimited.

• Condition: Must ask aid from bailout fund and agree to conditions.

• Creditor treatment: ECB parri-passu with others.

• Sterilization: liquidity to be fully sterilized (OMT is not QE).

• Policy discussion• Help lower bond yields and funding costs

• Lower interest rates might boost investment and consumption.

• Gives the option of rollover or restructuring.

• Limited effect due to high unemployment, weak consumer confidence and growth.

• Does not address budget deficit and debt

23

Banking Union

• Goal: Establish unified banking supervisory, deposit guarantee and resolution system

to minimize systemic risks and create a stable banking system.

• Ingredients

• Single Supervisory Mechanism (SSM)

• ECB to supervise all banks based on a single rulebook

• Banks receiving public support – Jan 01, 2013; Systemically important banks

July 01, 2013; All other banks – Jan 01, 2014

• Standardized Deposit Guarantee Schemes (DGS): Harmonization and

simplification of deposit guarantee systems, funded by banks.

• Recovery and resolution of banks: A common framework funded by banks.

• Policy discussion

• Reduce the occurrence and magnitude of bank failures

• Protection of deposits provides confidence and stability

• Resolution framework will make bank restructuring more efficient and less

burdensome to the state

• Reduce the exposure of states to bank bailout costs.

• Delink the bank insolvency from sovereign insolvency,

• Need to unify different national regulations and system (implementation issues) 24

Fiscal Union“ If we want to re-establish trust in the eurozone, countries must pass a part of their sovereignty

to the European level,“ Mario Draghi, Oct 28,2012, Der Spiegel

• Goal: create an effective mechanism for budgetary control and supervision

and debt management

• Ingredients• Common fiscal authority: Super-commissioner to supervise budgets and have

veto power over national budgets (German Finance Minister Wolfgang

Schaeuble).

• Central Eurozone budget (Rompuy, the president of the European Council

proposal, Oct 2012) to fund national operating deficits with binding contracts

with member states (fiscal transfer scheme to deal with asymmetric shocks).

• Fiscal solidarity instruments (Rompuy): Jointly issued Treasury bills, Eurozone

bonds.

• Policy discussion• Need effective control of budget deficits and debt.

• Practical mechanism is the key – 3%/60% rule did not work.

• Need to establish comprehensive fiscal management and supervision25

Debt Relief Proposals

• Debt forgiveness or reduction (IMF)

• Euro-zone governments to forgive or take a haircut on their Greek debt

(Official-Sector Involvement - OSI).

• Debt rollover (ECB)

• Rollover the debt held by public creditors such as ECB (ECB)

• Does not reduce debt level.

• Debt redemption fund (Rompuy)

• State debt in excess of the 60% to be pooled and paid off over a 20-

years.

• Debt buyback (Euro-zone Finance Ministers)

• Buyback debt held by private investors (€63b) and NCBs (€12b) at a

discount.

• What is the funding mechanism?

26

Debt Sustainability Analysis

• Government budget constraint

• Budget constraint in terms of GDP ratios

• Debt accumulation (change in debt)

27

11 tttt iBPBBB

ttt PBiBB )1(1

ttt

tt pbb

g

ib

1

1

1

ttt

ttt pbb

g

gib

1

1

Definitions:

Bt = debt at time t

Bt -1 = debt at t-1

PBt = primary balance (-surplus/+deficit)

it = nominal interest rate

bt = debt-to-GDP ratio at time t

bt -1 = debt-to-GDP ratio at time t-1

pbt = primary balance-to-GDP ratio at t

(-surplus/+deficit)

it = nominal interest rate

gt = nominal GDP growth rate

Baseline: IMF Growth and Primary Balance Forecast

28

Baseline Debt Dynamics

• Baseline scenario:

• Debt will continue to

increase

• Unsustainable

except for Spain.

29

Negative Scenario: Baseline – 1% Growth, -0.5% Primary Balance

• Negative scenario:

• Debt will continue to

rise

• Unsustainable except for

Spain.

30

• Positive scenario:

• Debt will be lower

• But still high for Greece

and Portugal

31

Positive Scenario: Baseline + 1% Growth, + 0.5% Primary Balance

Debt Path: Reduce Debt Load to 100% of GDP

32

Debt Path: Reduce Debt Load to 80% of GDP

33

Debt Reduction Amounts

34

Country Current Debt (€b)

Reduction Needed (€b)

To 100%

GDP

To 80%

GDP

Greece 301 133 193

Ireland 180 21 57

Italy 1,982 517 914

Portugal 198 35 74

Spain 805 - -

Total 3,466 706 1,238

Summary

• Crisis of Credibility: need a credible plan rather than the reactive and gradualist approach.

• Core vs. Periphery: core must lead with a comprehensive solution.

• Banking union: needed to create a stable banking system.

• Fiscal union: needed with a new set of fiscal rules and monitoring mechanism. Fiscal Transfer Scheme is needed to absorb asymmetric shocks.

• Austerity vs. Growth: need to balance. Pace of fiscal adjustment needs to take a medium term approach rather than “front-loaded” adjustments.

• Debt sustainability: necessary to reduce the debt load to reasonable levels to ensure fiscal sustainability. Need to balance economic and social risks with moral hazard.

• Political and social instability: the biggest risk to success.

“It's not over until the fat lady sings,” Christine Lagarde, IMF Managing Director, Nov 16, 2012

35

Appendix

36

External Imbalance: Current Account

37

Competitiveness Indicators: Price

38

Competitiveness Indicators: Cost

39

Credit Ratings

40

US Dollar vs. Euro

41

Credit Default Spreads

42

Country 5-yr CDS(Basis

Points)11/19/12

5-yr CPD %(Sep-2012)

Greece 7186 90-99

Ireland 308

Italy 200

Portugal 618 36.5

Spain 350 29.5

Germany 31

• 5-year Credit Default

Spreads and Cumulative

Probability of Default

(CPD).

Country Bailout Programs

43

Country Date Amount

€ bn.

Features Fiscal Adjustments (Austerity): Revenue

increases and spending cuts

Greece May 2010 110 3-year

(2010-2013)

Deficit targets:

7.5% in 2011 (actual 9.1%)

5.2% in 2013

3% by 2014 (-7.5% actual in 2012)

Mar 2012 130 2-year

(2012-14)

Extended to

2016

Reduce debt

Debt swap (PSI)

120% by 2020 (actual 171% in 2012)

Ireland Nov 2010 85 3-year

(2011-2013)

Deficit targets:

8.6% in 2012 (actual 8.3%)

7.5% in 2013

3% in 2015.

Portugal May 2011 78 3-year

(2011-2013)

Deficit targets:

5.9% in 2011 (actual 4.2%)

5.0% in 2012 (actual 5.0%)

4.5% in 2013

2.5% in 2014

Total 403

44

Fund Date Capacity (€b) Sources and Uses of Funds

EFSM May

2010

60b

(Backed by EU budget

and implicit member

guarantees)

Funding:

-Issue bonds and other instruments

in the market to fund its programs

Uses:

-Macroeconomic adjustment

programs (Greece, Ireland, and

Portugal, Ireland)

-Bank recapitalizations (Spain).

-Precautionary programs (credit line

to a non-program country to

overcome external temporary

shocks)

-Primary and secondary market

interventions.

EFSF June

2010

440b

(over-guarantee up to

165% or €720b)

ESM

(Permanent

bailout

fund)

Oct

2012

700b

(€80b paid-in and €620b

callable; Maximum

lending capacity €500b

with a 40% cushion.)

Eurozone Rescue Funds

45

Governments and Elections