Roads to Survival

How EMU Break-up can be avoided

Mark Cliffe
Chief Economist ING Group

Presentation to the Peterson Institute for International Economics

Washington D.C.
13th November 2012
November 2012 0
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 are Roads to Survival
 It is not just about fiscal discipline, or even external indebtedness…
…growth (especially in the periphery) is crucial too – for now, it’s up to the ECB
 More resources will have to be transferred to the periphery
 Banking and funding union involve covert transfers…but fiscal union is the
destination
 Will politicians secure popular support to trade sovereignty for solidarity?

November 2012 1
Eurozone debt crisis – unfinished business

10Y government bond yield (%)

40 40

35 35

30 30

25 25

20 20 Greece

15 15 Portugal
Spain
10 10 Ireland
Italy
5 5
NL
0 0 Germany
07 08 09 10 11 12

November 2012 2
Four ways to bring down debt-to-GDP ratio

Δdebt =
Primary deficit + ( Interest rate – GDP-growth ) x Existing debt

1 2 3 4

Austerity / higher taxes Lower interest rates Faster real growth or Sell-off assets or
higher inflation restructure/default

November 2012 3
 Diverging fiscal policy
Periphery – led by Spain – is tightening more than the core

1Q08 = 100 1Q08 = 100

Domestic Demand
104 104
Fiscal tightening*
102 102

6
100 100
2012 2013
5
98 98
4
96 96
3
94 94
2

1 92 92
Germany
US
0 90
Netherlands
90
Italy
-1 88 UK 88
SP PT GR IT IR FR NL EA17 UK US DE Spain

86 86
08 09 10 11 12

Source: OECD, ING

* % of potential GDP; annual change in underlying primary balance

November 2012 4
 Diverging interest rates
Markets are penalising, not rewarding, the peripherals for their fiscal austerity

Corporate lending rates*

7
(%)
6

1
07 08 09 10 11 12

Greece Portugal Spain Italy NL

* Loans over € 1m at floating rate and up to 1 year initial rate fixation

Source: ECB

November 2012 5
 13/11/2012

Bank regulation – strongly pro-cyclical

Bank funding costs rise (Asset Swap Spreads)
 Policy-makers are keen make the financial
ASW (bp) sector more robust.
300 300
 A key idea is for banks to increase capital,
including counter-cyclical buffers…
250 250
 But the effect is strongly pro-cyclical, adding
to the weakness of growth
200 200
1. Higher bank funding costs – banks seen as
‘uninvestable’, with regulatory uncertainty
150 150 2. Pressure to increase holdings of government
debt for liquidity buffers
100 100 3. Volume of lending is being squeezed

Covered Senior
4. Capital markets are filling the gap – but does
50 50
this make the system safer? Asset price
volatility – the source of crises - could even
be greater…
0 0
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

September 2012 6
Draghi’s pledge – “the euro is irreversible”

“There is no going
ECB OMT: back to the Lira or the
Drachma or any other
To repair the effective working of monetary policy… precursor currency”
…the ECB may undertake outright open market
operations…
…of unlimited size
…focused on the short end of the yield curve (<3Y)…
No yield cap
ECB holdings no longer senior
 BUT…with strict conditionality attached
So first, Spain has to ask for a bail-out…

November 2012 7
Eurozone: widening economic divergences
Greek experience is ominous…

Real gross domestic product (GDP level)

102 Germany
1Q 2008 = 100
100 France

98 NL

UK
96
Spain
94
Portugal
92
Italy
90 Ireland
88
86
84
82 Greece
2008 2009 2010 2011 2012

November 2012 8
Crisis not solely caused by fiscal indiscipline
Spain and Ireland ran budget surpluses on the eve of the crisis

Budget balance as % GDP

5%

0%

Germany

-5%

Spain
-10%

Ireland
-15%
'00 '02 '04 '06 '08 '10
ES DE IE

November 2012 9
Debt/deficit Eurozone lower than in US & JP

-11

-10 IE GR
JP
-9 US

-8 UK
ES
Budget -7
deficit
(% GDP) -6

-5
FR PT
NL
-4 BE

EZ IT
-3

-2
AT
DE
-1
20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170

Source:IMF, Eurostat
Net government debt (% GDP)
November 2012 10
 13/11/2012

Sovereign and bank debt solvency intertwined

Solvency is threatened by falling asset prices and growth

 The sovereign debt crisis is more a symptom than

The Deleveraging ‘Doom Loop’
a cause: it stemmed from the financial crisis.
ASSET  Excessive private borrowing (leverage)
PRICES exacerbated the downturn…

 BUT it’s not just about debt, since asset prices …

1.fuelled debt, just as debt fuelled asset prices
2.precipitated the bust
BANK FISCAL
3.may drive a deleveraging doom loop if they fall further
SOLVENCY SOLVENCY
 Bank and fiscal solvency are intertwined: banks
still depend on ECB/state support, weak bank
lending may hurt economic growth and public
ECONOMIC finances, banks are big buyers of public debt…
GROWTH  Financial stability, fiscal and monetary policy are all
intertwined…
 Central banks are now targeting asset prices

September 2012 11
Peripheral countries are large net debtors…

-10%
GR
-8%

-6%
PT
IT
-4% US

FR ES
Current -2%
Account UK
(% GDP) 0%
BE FI
IE
2%
JP AT
4%

6%
DE
8% NL

10%
-100% -50% 0% 50% 100%

Net external debt (% GDP)

Source: Eurostat; external debt 2010; current account 2011

November 2012 12
 13/11/2012

And it’s not just about external balance…

 In principle, external balance can be

External
surplus achieved through squeezing domestic
Tight
Competitive demand – fiscal restraint can deliver this...
policy
currency
Higher
Foreign boom BUT if this is at the expense of growth
saving
and employment, it will ultimately be
Recession Growth economically and politically unsustainable

 As Jan Tinbergen pointed out, each

policy objective needs a policy
Uncompetitive currency Loose policy instrument…
Foreign slump lower saving
External  Without the exchange rate, regaining
deficit
competitiveness is tough

September 2012 13
 Eurozone debt crisis – reality check
The Paradox of Merkelism – attempts to limit the costs
to the core countries have served to increase them!

1. Debt restructuring – core 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

Politics will decide how losses are divided between bond holders and tax payers…

September 2012 14
 Capital flight – financed by the ECB
Markets are penalising, not rewarding, the peripherals for their fiscal austerity

Peripheral* Eurozone Balance of Payments: Private Capital Takes Flight

500 EUR bn 500

400 400
300 300
200 200
100 100
0 0
-100 -100
-200 -200
-300 -300
-400 -400
-500 -500
2006 2007 2008 2009 2010 2011 1H
2012***
Target 2 financing Program financing
Net private inflows** C/A deficit 25% of the
periphery’s
GDP
* Sum of Greece, Portugal, Ireland, Spain and Italy ** Calculated as residual *** Non-annualised
Source: National central banks, IMF, European Commission, ING estimates
November 2012 15
EMU – Roads to Survival

Fiscal austerity alone will not ensure the

survival of EMU. So what to do?
Reform – structural, or supply-side reform
could stimulate economic growth. this is the
road 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 .

November 2012 16
Six Survival Scenarios – the policy mixes
The scenarios involve different combinations of policies:

Scenarios

Austeria Draghia Bondia Europhilia Inflationia Krugmania

Policy measures
Reform - Product/labour market
- Finance/ funding

Reflation - monetary policy: QE

- monetary policy: rate cuts

- € depreciation

- fiscal loosening

Redistribution - fiscal transfer

=not applicable =applicable =partly applicable =applicable in reverse

September 2012 17
EMU Survival: Reflation vs. Redistribution
High
Inflationia
Krugmania

America

Switzerland
Reflation Europhilia
Draghia
Bondia

Austeria
Low

High
Low Redistribution

18
September 2012 18
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 (aka Outer Draghia)     

Krugmania     

Note: Arrows show direction of impact in years 1-2 -> years 3-5 (● = no change)

November 2012 19
 Growth benefits, except in Austeria

YoY% Core YoY% Peripheral  The Austeria scenario

3.5 3 depresses activity in the short
term. The others boost GDP,
2.5 2 with the biggest gains in
Krugmania and Inflationia
1.5 1 Reflation and euro depreciation
lift activity generally, while
0.5 0
transfers benefit the periphery
 Sustained stimulus is required
-0.5 to maintain the growth advantage
-1
of the more reflationary
-1.5
scenarios in the long term
-2
 The initially adverse effects of
-2.5
labour and product market
-3 reform are turned in sustained
gains to output growth in the
-3.5
-4 longer term…
…nevertheless, the Austeria
-4.5
-5 scenario fails to make up for lost
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 ground relative to other
Base Austeria Draghia
Base Austeria Draghia
Bondia Europhilia Inflationia
scenarios
Bondia Europhilia Inflationia
Krugmania Krugmania

November 2012 20
 Public Debt-to-GDP – Draghia wins…

Periphery
 Bondia and Draghia s result in the
Core
85 120 largest falls in debt to GDP profiles, to
115 c.75% after 5 years: for the core
countries, the ratio falls close to 60%
80 110
 Fiscal transfers in Europhilia-,
105 Inflationia and Krugmania result in
75
100 relative deterioration in the debt profiles
for the core, with ratios staying above
95
70 80%, while the periphery sees falls
90 below 100%

85  Debt the periphery in Austeria

65
scenario shows no significant decline as
80
weak nominal GDP growth offsets
60 75 budget cuts, implying that debt
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 relief/default would be likely
Base Austeria Draghia Base Austeria Draghia
Bondia Europhilia Inflationia Bondia Europhilia Inflationia
Krugmania Krugmania

November 2012 21
 13/11/2012

Banking Union – breaking the sovereign link

Mutualising risk via Eurozone-wide…
Share of Eurozone deposit base
 Regulation and Supervision

 Deposit Guarantee
Rest, 13.5%
 Recapitalisation BE, 4.7%
DE, 29.6%
 Resolution funds NL, 6.3 %

ES, 12%

 lower bank risk = lower spreads FR, 19.5%

IT, 14.4%
 more, and cheaper, credit

 lower sovereign risk = lower spreads

bank funded? Core government back-stop?

September 2012 22
Common Bonds = massive yield convergence

% Eurozone 10year Government Bond yields  The German government does not rule out
7 7
non AAA ex GR,PT,IE common bonds on principle, but sees them as
EZ
AAA ex German
German
a long term option, once fiscal union is agreed.
6 6
Crucially, the SPD is supportive…
The implied mutualisation of risk is a massive
5 5
contingent transfer, and there is an implicit
transfer arising from yield convergence…
4 4
] …peripheral yields would plunge, while the
core yields would rise…
3 3
…BUT this would be a ‘positive sum game’ as
weighted average yields would likely fall…
2 2

Common
…so long as moral hazard – fiscal ill-discipline
Eurobond – is addressed with binding commitments
1 1
08 09 10 11 12 13 14

November 2012 23
A possible route? Discipline before Solidarity

High
Transfer union

Banking union Euro bonds

Slower ECB Quantitative Easing

austerity
Euro bills/European
Redemption Fund
Economic
impact
ECB /ESM Larger bailout
bond buying fund
Investment
support
ECB rate cut

Low

Low Political resistance High

November 2012 24
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. EMU’s 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 transfers…but fiscal union is the
destination. The challenge is to secure popular support…
 The ‘Grand Bargain’ = transfers from the core if the periphery shows discipline

November 2012 25