Aperiodic - n 3 - December 2011

Greece vs. Argentina: looks can be decieving

Since the beginning of the Greek crisis in late 2009, it has become increasingly common to compare Greece today with Argentina's situation ten years ago. Given Argentina's post-crisis economic recovery, some go as far as to predict, or even recommend, that Greeks opt for an identical shock therapy by exiting from the euro zone, reintroducing a severely devalued national currency and going into a unilateral default. Nevertheless, comparisons are often misleading. We see several major differences that make the Greek situation unique and that require extreme caution when considering the best remedy to be used to end the crisis. In Greece's case, devaluating does not seem to be a magic formula that would justify the country's exit from the euro zone, even if staying entails a temporary social crisis. Given the regional positioning and sector specialisation of Greek exports, we are very sceptical about the chances that Greece's export sector would benefit from devaluating. To the contrary, this scenario risks creating a major upheaval, not only for Greece but also for the European Monetary Union as a whole.

I- Argentina in 2001, Greece in 2011: striking similarities

i. The success and setbacks of Argentina's Currency Board
In April 1991, Argentina decided to set up a currency board - known locally as the Convertibility Law - which is similar to a quasi-monetary union. This monetary regime set a peg with a fixed one-to-one parity between the US dollar and Argentine peso (an irrevocable commitment), implying that all local currency issues were backed by dollar-denominated assets. This bimonetary regime required dual accounting of bank balance sheets and a high dollarization of the economy, which resulted in the quasi-replacement of the national currency. By ruling out devaluation, corseting monetary creation and eliminating a lender of last resort for banks and the government (except the Fed), the abandonment of monetary sovereignty aimed to bring an end to years of hyperinflation, anaemic GDP growth and public deficits. 1992-97: the successful years As of late 1992, the monetary corset helped to reign in inflation below 10% and to restore investor confidence. With nominal price stability and a notable increase in direct investment flows (as the country launched a privatisation programme), combined with a weaker dollar that favoured Argentine exports (+15% a year between 1994 and 1998), the country managed to swing back into robust growth, with GDP growth rates averaging 5.5% between 1992 and 1997. In the light of these convincing results, the IMF lifted Argentina into the ranks of the "good students", which bolstered confidence

in Argentina's economic fundamentals and triggered a virtuous circle between foreign capital inflows, growth in money supply and lending, and economic growth. 1998-2000: the downfall A series of external shocks revealed the weaknesses of this model. A string of financial crises, including Asia in 1997 and Russia in 1998, shook the emerging market universe and triggered a widespread surge in risk premiums, which strained Argentina's fiscal equilibrium by increasing the cost of debt. The dollar's appreciation against most of the emerging market currencies as of 1995, followed by the devaluation of the Brazilian real in 1999, created a massive foreign exchange shock. In 2001, just before the outbreak of the crisis, the Argentine peso was estimated to be overvalued by about 50%. Faced with this loss of competitiveness, a slowdown in exports (which averaged only +2.1% over the period, resulting in a slowdown in hard currency inflows), surging imports (symmetrical effect) and the evaporation of foreign direct investment flows, Argentina had no choice but to adjust through internal devaluation and deflation (i.e. lower wages and prices). Money supply contracted, a credit crunch arose, as well as a severe recession (a cumulative 8.7% for the three years), but Argentina was still required to maintain a primary deficit of about 1.3% of GDP in order to clean up public finances. The efforts undertaken in the late 1990s proved to be too small to offset the increase in interest charges, which triggered the debt crisis: the stock of debt doubled from 34% to more than 60% during the 1990s. Under the guidance of the IMF, three austerity plans were launched one after the other (March 2000, January 2001 and September 2001) to try to control the deficits and

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

restore the markets' confidence. These plans were combined with financial aid that was constantly revised upwards from $7.2bn initially to $22bn in 2001. Even so, Argentina was incapable of meeting the budget targets imposed by the IMF. Doubts about the government's solvency plunged the country into an austerity trap (a vicious circle in which higher risk premiums and deficits asphyxiated both public finances and growth). Under the zero deficit law adopted in July 2001, for example, the government was supposed to reach a fiscal equilibrium by the end of the year. Instead of bolstering confidence, the announcement of the balanced budget law immediately triggered a higher risk premium that compromised the target right from the start (political credibility was also extremely low). Budget restrictions thus aggravated the economic recession: GDP contracted 4.5% over the year, whereas the plan called for 3.5% growth. In an attempt to get public debt back on a sustainable trajectory, Argentina also proposed a debt swap initially limited to residential bondholders (the Megacanje, in June 2001) and then to all creditors (November 2001) which resulted in the downgrading of its sovereign credit rating to junk status. 2001: the crisis Numerous pressures combined to trigger the end crisis. In November 2001, there was a fierce acceleration in the flight of deposits, foreign reserves began to erode at the rate of $2bn a day, and there was no lender of last resort capable of supplying the banks with liquidity. To counter the bank runs, the government imposed foreign exchange controls and restricted withdrawals from demand deposits (corralito), which was later expanded to term deposits as well (coralon). On the 5th of December, the IMF refused to unblock a new tranche of aid, which only amplified the confidence crisis. Unable to recover their savings, the people of Argentina took to the streets in a series of massive, violent demonstrations. The social upheaval led to the resignation of the La Rua government. Mr. Duhalde was appointed president on 1 January 2002 and declared the country in default of payment. He orchestrated the end of the Currency Board, resulting in the devaluation of the peso, effective in February 2002, with a new official exchange rate of 1.40 pesos for USD1. Thereafter, the country sank into a major economic and social crisis with a 15% drop in output in just six months, a surge in the unemployment rate to over 20% in 2002 and a very high poverty index (the number of people living below the poverty threshold exceeded 50%).

%
12 6 0 -6

... but GDP growth fell far more in Argentina

(t = entry into monetary union/peg)

GR: Q3 2011
-12 -18

Default Arg.
t t+2 t+4 t+6 t+8 t+10 t+12 t+14 t+16 t+18 t+20 t+22 t+24 t+26 t+28 t+30 t+32 t+34 t+36 t+38 t+40 t+42 t+44 t+46

Argentina (1991-2001)

Greece (2001-2011)

Source: non-seasonally adjusted data, national statistics institute, CA S.A.

However, the boom in commodities and the growing importance of emerging markets, allowed the Argentine economy, an agricultural powerhouse, to return to strong growth. Furthermore, the strong increase in soy prices, one of Argentinas key exports, helped restore the financial health of Argentina's government and enabled it to be relatively generous in terms of social welfare.

ii. Greece, caught in the midst of the crisis

In 2001, Greece joined the European Economic and Monetary Union (EMU) and thus abandoned its monetary sovereignty to the European Central Bank (ECB), replacing the drachma with the euro. Like Argentina, Greece gave up the possibility of devaluing its currency to counter a foreign currency shock. However, unlike Argentina, Greece retained access to a lender of last resort, the ECB. This differentiates the Greek situation from that of Argentina, whose central bank was restricted by the Currency Board and could not (re)finance residential agents. 2001-2008: the economic boom years Like Argentina, the first years were marked by a certain success. By joining the euro, Greece was able to benefit from advantageous financing conditions (lower risk premiums) to take on low-cost debt. At the same time, it received transfers from European structural funds and foreign direct investment (FDI). These funds fuelled the economic catch-up process in an environment of low, steady inflation.
bps 3500 3000 2500

Greek interest rate spread vs. Bund 10Y

2000
1500 1000

500
1996 1999 2002 German Bund Source: Datastream, Crdit Agricole S.A. 0 1993 2005 2008 2011 Risk premium Greece

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

2008 and beyond: outbreak of the crisis Much like in Argentina, where a series of adverse shocks highlighted the limits of the currency board, the 2008 financial crisis revealed the shortcomings of the Greek growth model with its swollen and ineffective public sector, excessive accumulation of public debt and chronic loss of competitiveness. At the same time, wage increases far surpassed productivity gains and unbridled consumption ended up swelling the trade deficit.
Greece : GDP growth forecasts continually revised downward
0,2

The massive bank runs that triggered the Argentinian crisis have not occurred in Greece yet, although there has been a rampant flight of deposits. Nevertheless, unlike the situation in Argentina, Greek banks can always count on ECB interventions as the lender of last resort to refinance their borrowing needs. Since 2010, repurchasing agreements have reached an average of 90bn (40% of Greek GDP and about 20% of total bank assets). From this rapid overview, it seems rather easy to draw parallels between the events in Argentina and Greece. Both were hit first and foremost by competitiveness problems ; excessive public debt continued to swell with the increase in borrowing costs in a self-fulfilling and self-sustaining scheme; adverse shocks revealed the weaknesses of their economic models; and painful real adjustments had to be made despite the emergence of austerity traps. Some analysts are quick to point out these similarities, and given Argentina's postcrisis economic recovery, some go as far as to predict, and even recommend, that Greek opt for identical shock therapy by exiting from the euro zone, reintroducing a severely devalued national currency and going into default. Georges Papandreou's announcement of a referendum (an idea that was quickly reversed) rekindled the debate on whether or not Greece should exit from the euro zone. Comparisons can be misleading, we see several major differences that make the Greek situation unique and that require extreme caution when considering the best remedy to be used to pull the country out of the crisis.

% 2,5 1,0 -0,5 -2,0 -3,5 -5,0

-2,0 -3,5
-4,5 -6,0
2009 IMF (AUG-09) IMF (APR 2011) 2010 2011 IMF (APR-2010) EMP/CA (SEPT 2011) 2012 2013 IMF (JUL 2010) EMP/CA (NOV 2011)

-6,5

Source: IMF, Crdit Agricole S.A.

Faced with a double deficit, large financing needs and limited, costly access to financial markets, Greece was forced to call upon the euro zone and international institutions for financial aid in May 2010. Like Argentina, the country was subjected to a series of budget consolidation plans that aimed to reduce the public deficit from 15.4% of GDP in 2009 to less than 3% in 2014. So far, all of these adjustment programmes have ended in failure. They were not only hard to implement in the midst of fierce social turmoil, but triggered a downward spiral between austerity and economic activity. The 110bn in emergency loans approved in May 2010 quickly proved to be insufficient to cover the country's financing needs beyond H1 2012. On 21 July 2011, Europe granted a new 109bn extension over three years on condition that the private sector was implicated in the Greek bailout. Private creditors were offered a debt swap programme with a 20% haircut. Still this failed to lift doubts on the solvency of Greek public finances with the public debt trajectory remaining explosive, and aggravated by the recession. In October, faced with renewed market tensions and an increasingly deteriorated Greek economy, the haircut was increased to 50% and the emergency bailout package was raised to 130bn.
Greek public debt trajectory
Scenario July 2011 (haircut of 20%) vs. same scenario with recently unpdated data 2011-13
200 190 180 170 160 150 140 130 120 110 100
% GDP

II- A comparison of Argentina in 2001 and Greece in 2011: comparisons can be misleading
i. Greece's problems are on a totally different scale
In terms of their external and internal imbalances, Argentina's problems were by no means comparable to those of Greece. One of the effects of Greece's entry into the euro zone, which was beneficial at first, but then adverse, was the convergence of interest rates. Greece was able to take on debt at an artificially low cost, allowing it to finance its growing trade deficits relatively easily. It was as if by joining the euro, risks simply disappeared. The market's lack of discernment was partially justified by the nominal convergence observed during the preparatory phase before Greece joined the euro. Yet, Greece's public debt held at a very high level in absolute terms, above 100% of GDP. This is much higher than in Argentina, where debt peaked at 54% of GDP in 2001. In addition to misleading accounting presentations that masked the real state of public finances, the endemic problems of tax collection and ballooning public sector employment (the fruits of political cronyism) had already put Greek's fiscal deficit on an upward trajectory before the ultimate budget overruns of 2008-09. Consequently, Greece's public deficits were on average three times higher than Argentina's in the five years preceding the crisis, despite relatively similar growth conditions. These internal imbalances were reflected in the external accounts with a structural current account

143.5

120.8

2010

2012

2014

2016

2018

2020

scenario IIFJuly 2011 with recently updated data (growth, deficit, privat.)
Source: IIF, Crdit Agricole S.A.

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

deficit. For years, Greece has accumulated enormous trade deficits, which averaged 16% of GDP between 2005 and 2009. This illustrates the chronic weakness of the country's productive system, a problem amplified by the regular loss of competitiveness. The country is not only incapable of exporting; it also fails to cover domestic demand, resulting in disproportionally high imports to exports. Part of this shortfall was fuelled by excessive consumption during the economic boom years and is now in the process of being absorbed, with a concomitant drop off in private demand and imports. To erase the deficit, however, would require an even more drastic adjustment of private consumption, which is synonymous with a severe recession. Tourism, the country's hard currency engine, will not suffice on its own to offset the balance of payments deficit, swollen by the weight of interest charges paid on the debt. Consequently, the current account deficit is still high at between 8% and 10%. Even in the case of default (including halting interest payments on public debt held by nonresidents, i.e. 4% to 5% of GDP), a severe and abrupt correction of domestic demand would still be needed to balance the external accounts, which would become essential with the drying up of external sources of financing. The necessary correction in domestic demand is estimated at about 30%, which would be unbearable. Argentina was not faced with such a relentless mechanism due to its trade surplus (+2.7% of GDP in 2001) and the quasi-immediate turnaround in its current accounts in the midst of a severe recession, and just after it suspended payments on its external debt. This brings us to another argument, that it would be in Greece's best interest to trigger a radical (and temporarily devastating) purge in the hopes of sparking a strong rebound thereafter. This contrasts with the alternative solution proposed today of suffering less but over a longer period of time, via a long-term adjustment scenario combining austerity, recession and an internal devaluation via wage and price deflation. Argentina with its remarkable recovery provides a good example. However, for this to be the case in Greece, we would have to assume the latter would benefit from the same catching-up potential when faced with a strong currency devaluation. . We are not convinced that the Greek export sector is likely to benefit from such a leverage.
Greece vs. Argentina: economic fundamentals before, during and after the crisis
Argentina 1996-2000 average Greece 2005-2009 average Argentina 2001 Greece 2011 Argentina 2003-2009

ii. Argentinas rebound capacity, most likely out of reach for Greece
In Argentina, the abandoned Currency Board and resulting sharp devaluation of the peso sparked a robust export rebound (+16% as of 2003, followed by an average growth rate of 8-10% a year). Dynamic exports drove Argentina's economic recovery with an average GDP growth rate of nearly 8%. Although part of this remarkable performance can be attributed to the renewed competitiveness of Argentine products thanks to its devalued currency, we must not overlook the fact that this agricultural powerhouse also benefited from a combination of favourable factors at the time, notably the economic boom in big emerging markets, which came about from changes in consumer behaviour that were eminently favourable for Argentine exports. Take for example, the robust pace of trade with China, with export growth rates of nearly 10%. Although volumes increased strongly, the high level of demand also pushed up farm prices, notably for soya, resulting in a surge in export revenues converted into pesos. These revenues helped boost employment and consumption, while their taxation gave the welfare state some room to manoeuvre. Moreover, as prospects improved, assets that had been sheltered abroad (the fruit of massive tax evasion before the crisis) were repatriated to purchase depreciated Argentine assets at discount prices. Some predict that Greece, by analogy, will be just as fortunate with a rebound in exports fuelling a dynamic recovery. Yet we advise caution given the regional positioning and sector specialisation of Greek exports. Greece mainly exports to mature markets, essentially in Europe, where growth potential is limited. As to its sector specialisation, the graph below illustrates the potential and weaknesses of the Greek export sector. We have identified four different areas of export performance: 1 Export growth (green area): sectors in which world demand is growing and Greece's market share is also on the rise. Export potential (blue area): sectors with growing world demand, but in which Greece's market share is declining. Lack of world demand (grey area): poor choice of specialisation in which demand has been declining since 2006, but Greece's market share is on the rise. Slowing exports (orange area): World demand has been slowing since 2006, and Greece's market share is also in decline.

GDP growth (%) Public debt (% of GDP) Public deficit (% of GDP) Current account (% of GDP)

2.7%

2.1%

-4.4%

-5,5%*

7.6%

40.1% -2.9% -3.7%

110.0% -8.7% -11.7%

53.7% 6.1% -1.4%

165.4% -8,5%* -8.2%

82.9% -2.2% 3.2%

* Government forecast at October 2011

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

Greece: identification of potential export sectors

Size of bubbles: ratio of exports in the 'X ' sector to total Greek exports (%)
Change in global demand for products from sector X in total global demand between 2006-10 (%)
1,5

Sectors with global demand potential

energy
1

Developing sectors in demand

pharma.
agriculture chemical pord. food metal prod.
0 -0,8 -0,6 -0,4 -0,2 0 0,5

plastics non-metal mineral prod. wood prod. 0,2

0,4

machinery & appliances

-0,5

textile & clothing

base metals
-1

transport equip.

Decling sectors, with weak global demand

-1,5

Developing sectors, but with weak global demand potential

Evolution of the Greek global market share in sector X between 2006-10 (%)

What is most striking is that Greece is almost completely absent of sectors in demand (green area). With the exception of energy (notably refining products), between 2006 and 2010, there is not a goods sector in Greece that benefited from both growing world demand and growth in market share. Some sectors, however, do show export potential, notably pharmaceuticals and metals. Yet since these exports have a high content of intermediate goods (notably in the energy sector), devaluation risks having only a very small impact on the price competitiveness of these products, since the higher cost of inputs would probably be carried over to end prices. Exports of food products alone (22% of total exports in 2010) will not suffice to create sufficient momentum, even though we can imagine that the country could destabilise its southern European competitors like Spain, in the case of a sharp drop in prices.

As for the services sector, since the shipping is mostly an offshore activity that is not very sensitive to Greek pricing conditions, the main hopes are essentially concentrated on the tourism sector. With devaluation making prices more attractive, Greece could hope to capture once more the clientele that has stayed away in recent years in favour of less expensive destinations like Turkey, Morocco or Tunisia. However, price is not everything. Tourist structures would surely need to be adapted (size, quality, specifications) to expand the tourist season and capacity, as well as to target the sought after retirement age customer segment. Unfortunately, this kind of adaptation requires time and financial resources, a luxury that Greece cannot afford at a time when its rebound potential is hampered.

Argentina (2001)

Export destinations for Argentina (2001) and Greece (2010) 5 biggest export Total share of exports Average GDP growth in the 5 destinations years following the crisis (2001-2005) Brazil 23.3% 2.8% EU 17.7% 2.0% USA 10.9% 2.4% Middle East 5.1% 5.0% China 4.2% 9.8% (2011-2015) 1.7% 0.7% 1.7% 3.4% 4.0%

Greece (2010)

Germany Italy Cyprus Bulgaria Turkey

11.1% 11.0% 7.3% 6.5% 5.3%

* IMF data & forecasts

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

In Greece's case, devaluation does not seem to be a magic formula that would justify the country's exit from the euro zone, even at the cost of a temporary social crisis. To the contrary, this scenario risks creating a major upheaval, not only for Greece but also for the European Monetary Union as a whole. It is worth recalling that the imminent end of the Currency Board in Argentina triggered a series of bank runs and the quasi-collapse of the financial system. Widespread insolvency was aggravated by different post-devaluation conversion systems for assets and debt that was extremely costly for creditors. The recession was fed above all by an abrupt, severe evaporation of credit, followed by a string of bankruptcies in the private sector. Greece is unlikely to escape a similar fate in the case of an imminent exit from the euro zone. The banking sector r would be extremely hard-hit by bank runs and a surge in liabilities denominated in the new currency. Faced with this threat, the government would have to resort to nationalisations. As the lender of last resort, the Bank of Greece would have no alternative but to begin printing money to enable banks and the government to make ends meet at the end of the month. This precarious balancing act could rapidly deteriorate if it leads the country into a hyperinflationary spiral, with self-sustaining price-wage loops and uncontrolled exchange rates. It would spell a return to the chronic financial and economic instability that Greece was all too familiar with in the past1. The simple possibility that this catastrophic scenario could occur is enough for the Greek people to reject this solution. Faced with the option of exiting the euro and the European Union, the Greeks know all too well that there is no magic formula. Devaluation would be poisonous. Moreover, instability could spread well beyond Greece's borders.

Official loans: Greece vs. Argentina

IMF loans Argentina (2001) Greece (2010) $22bn 30bn 8% of GDP 13% of GDP Official loans (total) $48bn 110bn 17% of GDP 48% of GDP

Although the Greek problem is relatively small in size (3.5% of the euro zone's GDP and 4% of the aggregated debt of the EU), it has huge implications. This is the lesson to be drawn from the latent sovereign debt crisis that is now shaking all of Europe. Seeing how powerless European officials have been at managing the Greek situation, investors have become extremely wary of any European countries with shaky finances. In addition to the risk/return trade off, investors must now face the risk of capital loss in case of default and/or debt restructuring. Initially, these sovereign debt runs forced Europe to bail out some of the other small peripheral countries (first Ireland, then Portugal) which could no longer access capital markets. Once the contagion spread to the heavyweights of the euro zone (especially Italy, but also Spain), the ECB had no alternative but to act as the buyer of last resort, in order to lower the pressure on the yields of the governments under attack. Yet the ECB unwillingly took on this role of lender of last resort and administered only homeopathic doses that were too small to be effective circuit breakers. This led to October's decision to beef up the firepower of the European bailout fund - the European Financial Stability Facility (EFSF) - to try to set up a line of defence against the risks of a systemic chain of events. Contagion effects between countries are a self-sustaining vicious circle in which the higher probability of default drives up the cost of debt, which in turn strains the fiscal equilibrium and increases the probability of default. The pro-cyclical nature of the rating agencies only amplifies this self-fulfilling cycle by automatically triggering selling in case of rating downgrades.
billions,

iii. The Greek crisis, the first in a new generation of crises

Argentina's default did not have major financial repercussions since it was the last link in a contagion chain that had rocked the emerging economies over the previous decade (Mexico in 1995, Asia in 1997 and Russia in 1998). The financial community largely anticipated Argentina's default, which was absorbed by numerous investors, mostly non-residents from outside of Latin America. Overlooking differences in size, the dispersal of Argentine risk contrasts with the high concentration of Greek public debt. A large share of Greece's public debt is held by the Greek banking system (about 15% of debt) and the rest is mostly in the hands of European financial institutions (banks, insurance companies, asset managers), not to mention the growing share held by official institutions (IMF, euro zone member states and the ECB). The Economic and Monetary Union (EMU) naturally strengthened the financial links within the zone through the internalisation of sovereign risks and cross exposure.

2000
1600 1200 800

Public debt (2011 forecasts)

GR
400

0
Italy France Spain

PT IR
Smaller periphery countries

Source: Crdit Agricole S.A.

Greece experienced several episodes of hyperinflation before joining the euro zone. Since its independence in 1929, the country has defaulted five times, and spent over half of this period in default. The country has a highly debatable track record in terms of fiscal and monetary discipline.

Contagion has also spread towards the European banking system, which carries sovereign risk. There are numerous transmission channels (direct exposure, concomitant downgrades of credit ratings on sovereign debt and banks as well as the valuation of collateral eligible for the ECB or for other secured operations), but the end result is same with higher (re)financing costs for banks. The ECB's deployment of crisis management tools, such

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

as auctions at fixed rate with full allotment and increasingly longer maturities, has helped contain pressures on short-term liquidity (albeit without eliminating them). The higher cost of longer-term refinancing is however likely to have implications on the intermediation activities of banks, ultimately resulting in tighter restrictions on loan distribution. This is especially true since banks will have to raise more capital on financial markets to meet: the new Basel III prudential requirements, the 106bn in recapitalisation (decided in October) and the major flow of debt maturing in 2012. By beating down confidence levels and increasing the cost of financing these harmful interactions between sovereign and banking risks threaten GDP growth, the last link in the contagion chain. In the very short term, there is an increasingly important recession risk in the euro zone, which would only worsen the debt crisis. As Greece lies at the epicentre of the crisis, it could be appealing to get rid of this weak link so that the rest of the euro zone can regain its strength. Yet if Greece were to exit the euro zone, it is unlikely to eliminate the contagion effect. To the contrary, contagion is likely to increase tenfold. The markets would be prone to test the extreme scenarios of a cascade of sovereign defaults (whether or not the countries end up exiting the euro zone), followed by the collapse of the European banking sector, incapable of absorbing such massive losses. This systemic threat should not be taken lightly given the risk of a pure and simple breakup of the euro zone, with unknown but surely devastating consequences. Therefore, maintaining Greece within the euro zone would not only help the country, it would help all members of the European Union.

resort for governments, as it is already doing for the banks. It is certainly difficult for a central bank with an exclusive mandate of "maintaining nominal price stability" to embark on such a strategy of monetizing public deficits, even indirectly (interventions could be carried out in the secondary market). Yet in times of crisis, pragmatism should win the upper hand over dogmatism, especially when the integrity of the euro zone is at stake. The United States and the UK have no qualms about printing money. As a result, faced with similar budget challenges, both countries are now refinancing at negative real interest rates, with 10-year government bond yields at about -2% after deducting inflation, a painless way to clean up their financial imbalances. The reverse side of this policy is that it weakens their currencies, resulting in an appreciable increase in competitiveness at a time when the whole world is looking to foreign trade as a growth engine. Moreover, an excessively strong euro is an additional handicap for the southern countries undergoing adjustments, who are being asked to restore competitiveness lost during the economic boom years via lower wages and prices. Depriving the euro zone of this adjustment tool is harmful at two levels, since costly financing conditions and a strong euro inhibit growth, which further weakens fiscal imbalances. The purchasing of public debt is also perceived as endangering the equilibrium of the ECB's balance sheet, since it would have to absorb any losses in case of default. This is a valid point if we assume that the countries currently targeted by the markets are actually insolvent and, like Greece, will sooner or later need a debt haircut (although in this case, the ECB's losses would not necessarily be very big since it purchases securities on the market at a very big discount). However, if these countries are only experiencing a liquidity crunch, then theoretically, the ECB does not run any risk by holding these securities until they are paid back at maturity. The ECB's reticence to act as the lender of last resort for governments kindles doubts about the intrinsic quality of these assets and the solvency of its issuers, which only fuels further speculation and contagion. A formal commitment by the ECB to ensure the liquidity of ailing, but fundamentally solvent sovereign states, whatever the cost, is just as important as the act itself, not only to reassure the markets, but to dissuade them from speculating against governments. Only then can we hope to trigger a virtuous circle in which the easing of risk premiums reduces pressure on governments and raises new hopes for GDP growth, the only real guarantee of debt sustainability in the long term. But it cannot stop there. Intra-zone financial imbalances cannot be absorbed by simply erasing public deficits: the excessive debt in the southern countries and the surplus savings in the northern ones mainly reflect diametrically opposed competitive positions. Convergence will be a very long process requiring major sacrifices from the southern countries, but with recurrent financing needs that will have to be covered by revenue transfers from the northern countries. This ultimately raises the question of the optimum degree of fiscal federalism. Undoubtedly, fiscal discipline must be established as the rule, but structural reforms are just as important and must be embedded in the adjustment plans that are currently being set up. To integrate Greece (or one of the other

III- If Greece's exit is not the solution, then which way out of the crisis?
For its own good and for that of the euro zone member countries, Greece must remain within the European Union. Nevertheless, this does not mean that the strategy adopted so far has been the right one. Budget discipline and monetary orthodoxy are two sides of the same strategy, which is bound to fail because it ignores growth. Without growth, the debt burden will inexorably swell unless socially inacceptable austerity measures are driven through. If we must retain only one lesson from Argentina's crisis, it is the failure of adjustment plans that combine austerity, internal devaluation via nominal wage and price cuts and a severe, drawn out recession. This fundamentally unstable equilibrium risks leading to the development of chronic instability between the financial, economic and political spheres. An alternative strategy does exist: reflation at the European level. Budget targets would have to be lowered (notably by linking them to growth conditions) so that adjustments in the southern countries could be smoothed out over time. This would have to be accompanied by more stimulation for the core countries (with credible commitments to adjust public finances in the medium to long term). To cut short speculation and contagion, the ECB must play its role as lender of last

No. 3 December 2011

Bndicte KUKLA
benedicte.kukla@credit-agricole-sa.fr

Isabelle JOB
isabelle.job@credit-agricole-sa.fr

Robin MOURIER
robin.mourier@credit-agricole-sa.fr

vulnerable southern countries) into the global valueadded chain will require reflection on the euro zone's industrial fabric. That is on the development of a quality, pan-European infrastructure and on capital and labour flows to spread knowledge and innovation. What is currently being undertaken at the country level to develop regions must now be carried out at the euro zone level as well. This calls for a different economic and political

governing system built around federalism and equalisation. Although Greece and the other ailing countries clearly need financial support, they also have an even bigger need for a vision and a project for the future to create new momentum.

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This publication reflects the opinion of Crdit Agricole S.A. on the date of publication, unless otherwise specified (in the case of outside contributors). Such opinion is subject to change without notice. This publication is provided for informational purposes only. The information and analyses contained herein are not to be construed as an offer to sell or as a solicitation whatsoever. Crdit Agricole S.A. and its affiliates shall not be responsible in any manner for direct, indirect, special or consequential damages, however caused, arising therefrom. Crdit Agricole does not warrant the accuracy or completeness of such opinions, nor of the sources of information upon which they are based, although such sources of information are considered reliable. Crdit Agricole S.A. or its affiliates therefore shall not be responsible in any manner for direct, indirect, special or consequential damages, however caused, arising from the disclosure or use of the information contained in this publication.

No. 3 December 2011