The Euro Area Crisis - 99 Q & A, March 2012

The Euro Area Crisis
99 Q & A

March 27, 2012

The Euro Area Crisis
99 Q & A
INFORMATION MATERIAL ON THE CRISIS IN THE EURO AREA AND THE
MACRO ECONOMIC EFFECTS ON OUR HOME MARKETS

The crisis in the euro area has several dimensions, ranging from the many
causes of the crisis, to the consequences for the global economy and Europe,
including Sweden and the Baltic countries.

There have been numerous uncertainties discussed lately, such as a break-up
of the currency union, and a Greek default and exit from the euro area. There
are also many different views on the best response from politicians and central
bank policy makers to alleviate the crisis.

To support Swedbank’s clients and staff, the Group Economic Research
Department has prepared a material with 99 questions and answers (Q & A)
on the euro area crisis.

The material can be accessed on a topic by topic basis, using the hyper links
in the document. It will be updated on a quarterly basis. Comments and
suggestions for changes will be most appreciated.

Cecilia Hermansson
Group Chief Economist

2 The Euro Area Crisis - 99 Q & A • March 27, 2012

A. The cause and starting point of the euro area crisis ............................................................ 8
1. When did the crisis in the EMU start and what role did the global financial crisis and
recession play? .......................................................................................................................... 8
2. Why was the Stability and Growth Pact not adhered to?.......................................................... 8
3. In what way is the crisis a sovereign debt crisis, and why? ...................................................... 9
4. Why did yields on sovereign debt, which had been closely correlated despite country
differences, start to diverge, especially in 2010? .................................................................... 10
5. In what way is the crisis a trade and competitiveness crisis, and why?.................................. 10
6. In what way is the crisis an issue of confidence for politicians and other policymakers? ..... 11

B. The economic, political and social impact of the crisis ........................................................ 12
7. How much must the euro area consolidate in fiscal terms and what is the impact on .growth?
12
8. Will the crisis cause a recession in the euro area? .................................................................. 12
9. Will the euro area have a long period of no or low growth, i.e., stagnation and deflation, like
Japan? ...................................................................................................................................... 12
10. What is needed to create a recovery? ...................................................................................... 13
11. How are the labour markets affected by the crisis? ................................................................ 14
12. Will the euro area crisis cause unrest, strikes, and riots in the short term, and what will be the
impact on the EU social model in the longer run? .................................................................. 14
13. What are the longer-term effects on democracy of the euro area crisis, not least since many
feel alienated from the newly created technocratic governments? ......................................... 14
14. How is the crisis in the euro area affecting the global economy at large? .............................. 15

C. The effect of the euro area crisis on the financial sector ..................................................... 16
15. Why are banks affected by the sovereign debt crisis in the euro area? .................................. 16
16. In which countries have banks the largest exposure to the crisis-struck countries, and how
large are these exposures? ....................................................................................................... 16
17. How are banks affected by the private sector involvement (PSI) in Greece, and in what way
could it affect interest rate premiums for other countries? ..................................................... 17
18. How large is the credit default swap market in the euro area, and what impact does this have
on the crisis? ........................................................................................................................... 18
19. What are the Basel rules and how will they be affected by the euro area crisis? ................... 19
20. Capital requirements have been raised before the new Basel III rules take effect – how much
is needed and when must banks have Fulfiled these? ............................................................. 20
21. How are stress tests carried out in the EMU? ......................................................................... 21
22. Banks will shrink their balance sheets to meet the new rules, causing a credit squeeze or a
credit crunch – how will companies and households be affected? ......................................... 23


D. European politicians’ response to the euro area crisis ......................................................... 25
23. How have politicians in the euro area responded to the crisis, i.e., what are the major policy
measures? ................................................................................................................................ 25
24. The process of politicians addressing the crisis has been described as “kicking the can down
the road” – what does this mean? .................................................................................................. 25
25. To what extent has the EMU turned into a “transfer union” despite the EU Treaty? ............. 26
26. What characterises the most important support mechanism of the transfer union, the
European Financial Stability Facility (EFSF), and in what way will the next measure, the
European Stability Mechanism (ESM), be different? ............................................................. 27
27. What is included in the Six Pack EU budget rules?................................................................ 28
28. What are the rules of the new Fiscal Pact and which countries belong to the new pact? ....... 30
29. How will the sanctions system work? ..................................................................................... 30
30. In what ways have politicians focussed on other aspects than budget consolidation, i.e. e.g.,
growth, labour markets, and competitiveness, to solve the crisis? .........................................31

E. The roles of the European Central Bank (ECB) and national central banks .................... 32
31. What is the ECB allowed to do and not allowed to do in order to support EMU member
countries, according to the EU Treaty? ...................................................................................32
32. How has the ECB conducted monetary policy throughout the crisis?.................................... 32
33. What responsibilities does the ECB have for the functioning of the financial market and
banks, and how does the ECB support the market with liquidity, i.e., what are its facilities?33
34. What role do the LTROs play in bank capitalisation and credit austerity (direct role), and in
the sovereign debt crisis (indirect role)? .................................................................................34
35. What is the difference between ECB support and some other central banks’ quantitative
easing?..................................................................................................................................... 34
36. Will the ECB policies increase inflation? ............................................................................... 35
37. Should the ECB follow the private sector and write off its Greek debt? ................................ 35
38. What is the role of national central banks, how can they alleviate the crisis, and how are they
related to the ECB? ................................................................................................................. 36

F. The involvement of the International Monetary Fund (IMF) in the euro area crisis….... 38
39. How does the IMF get its resources, and how much can it lend to countries in crisis? ......... 38
40. What role has the IMF played in the euro area crisis? ............................................................ 38
41. How is the IMF, as part of the EC/ECB/IMF (the “Troika”), supporting the crisis-struck
countries in the euro area? ...................................................................................................... 39
42. Which countries have so far received loans from the IMF, in what ways, for how much, and
under what conditions? ........................................................................................................... 40
43. How does the IMF calculate debt sustainability, and, according to the IMF, how does the
euro area fare in this respect compared with the US and Japan? ............................................ 41
44. There has been criticism that the IMF treats the euro area differently, i.e., compared with the
Asian, Latin American, and African countries. Is the criticism valid? ................................... 42


45. Does the IMF have the resources necessary to continue its support if the euro area crisis
escalates, and, if not, how can resources be found?................................................................ 42
46. What will be the impact on the IMF as a worldwide organization from the euro area crisis
(and debt crises in other parts of the advanced world)?.......................................................... 43

G. Greece, Ireland, and Portugal – experiences of the first crisis-struck countries .............. 45
47. Why has Greece been hit the hardest by the crisis? ................................................................ 45
48. In what way has Greece received support? .............................................................................45
49. What are the reforms needed to get Greece out of the crisis? ................................................ 46
50. What has happened politically in Greece since the crisis started?.......................................... 46
51. Will and should Greece default, and should Greece leave the EMU? .................................... 47
52. Why did Ireland get into a sovereign debt crisis? ...................................................................48
53. How has the reform programme proceeded in Ireland, and why are risk premiums coming
down? ...................................................................................................................................... 49
54. What have been the political consequences of the crisis in Ireland? ......................................49
55. Why did Portugal have to apply for a support programme? ................................................... 49
56. How will Portugal get out of the crisis economically and politically? ................................... 50
57. Will Portugal need a new rescue package? ............................................................................. 50

H. The spread of the crisis from periphery to core ............................................................... …52
58. Spain’s sovereign debt is not very high; why did financial markets lose confidence in the
country?................................................................................................................................... 52
59. How has the crisis affected politics in Spain? ........................................................................ 52
60. What reforms is Spain planning to get out of the crisis? ........................................................ 53
61. Italy has had a high sovereign debt for a long time; why did the crisis only recently become
acute? ...................................................................................................................................... 53
62. What have been the political consequences in Italy of the crisis? ..........................................54
63. What reforms will solve Italy's problems? ............................................................................. 54
64. How have credit rating institutions rated creditworthiness in the euro area, including
countries like Germany and France, and support mechanisms like the EFSF? ...................... 55
65. What is the risk that even countries such as France and Belgium could be hit by a sovereign
debt crisis? .............................................................................................................................. 55
66. Will the support mechanisms be sufficient if the crisis spreads to the core? .......................... 56

I. The possible breakup of the EMU – how it would come about and how likely is it? …….58
67. Is there currently a legal way of leaving the EMU? ............................................................... 58
68. Does a country defaulting on sovereign debt have to leave the EMU? .................................. 59
69. Why would a country or several countries want to leave the EMU?...................................... 59
70. What would happen if a weak country, like Greece, left the EMU? ...................................... 59


71. What would happen if a strong country, like Germany, left the EMU? .................................. 60
72. What are the pros and cons of breaking up the EMU? ........................................................... 61
73. What would happen to the EU if the EMU broke up? ............................................................61
74. How likely is the breakup of the EMU? ................................................................................. 62

J. The EMU in the longer term: how to fix it and why is this important? ............................. 63
75. What institutions are needed to make a currency union function well? ................................. 63
76. Is there an alternative to creating a fiscal union, financial union, and a central bank as lender
of last resort, e.g., rescue funds, and how sustainable is this alternative? .............................. 64
77. What are the pros and cons of a Eurobond market? ............................................................... 64
78. What structural reforms are needed to boost competitiveness in the crisis-struck countries? 65
79. Is internal devaluation the only cure for Greece, and will it be successful, perhaps resembling
the experiences of the Baltic countries?.................................................................................. 66
80. Must Germany become weaker in order for southern Europe to become stronger, and if
countries in the euro area continue to maintain different living standards and levels of
competitiveness, as well as cultural and social values, can the EMU have a future? ............. 67
81. How will the EMU crisis affect euro area enlargement? ........................................................ 68
82. Why is it important from a longer-term perspective to save the EMU? ................................. 68

K. The EMU crisis – implications for Sweden and the Baltic countries ................................. 69
83. How important is foreign trade with the euro area for Sweden and the Baltic countries? ..... 69
84. Should companies in Sweden and the Baltic countries try to change the direction of trade
away from the euro area if the crisis worsens and remains for a long time? .......................... 69
85. How is Estonia, as an EMU member country, affected differently by the crisis than Latvia,
Lithuania, and Sweden? .......................................................................................................... 70
86. How likely is that Latvia and Lithuania join the EMU in 2014 as planned, and what are the
challenges? ..................................................................................................................................... 71
87. In what way has the EMU crisis changed the likelihood of Sweden's joining the EMU? ...... 72
88. How would Sweden and the Baltic countries be affected if the EMU crisis worsened and the
currency union broke up?........................................................................................................ 72
89. What are the implications of the crisis for companies in countries outside the EMU, in
relation to hedging foreign exchange risk? .............................................................................73
90. How are households in Sweden and the Baltic countries affected by the EMU crisis? ......... 73
91. Is the euro at risk and should therefore euro savings be avoided?.......................................... 74

L. The history and characteristics of the EMU ......................................................................... 76
92. Why and when was the EMU created? ................................................................................... 76
93. Which countries are members of the EMU and when did they adopt the euro? .................... 77
94. What are the conditions for membership? .............................................................................. 77


95. What elements of the EU Treaty have the strongest impact on the EMU and have also
influenced the handling of the current euro area crisis? ......................................................... 78
96. What characterises an optimum currency area in general, and what institutions were built up
in the beginning to ensure the EMU would meet the criteria? ............................................... 79
97. How does the euro area differ from the US as a currency area? ............................................. 80
98. How has the euro developed since it was created? ................................................................. 81
99. How has the creation and use of the euro affected trade and investments within the euro area
and with countries outside the euro area? ............................................................................... 81
Acronyms ...................................................................................................................................... 83


A. The cause and starting point of the euro area crisis

1. When did the crisis in the EMU start and what role did the global financial
crisis and recession play?

The euro area debt crisis is not a direct consequence of the global financial crisis
and subsequent global recession; however, it was triggered and exacerbated by
those events. Contracting global demand nudged central banks to cut interest rates
and increase liquidity, whereas governments, resorting to “good old” Keynesian
economic policies, tried to stimulate their economies through more spending and
larger deficits. In addition, the handling of some banks’ solvency problems
burdened public finances. At the same time, economies were contracting, as was
tax income. All these factors caused budget deficits in Portugal, Ireland, Greece,
and Spain to exceed 10% of GDP in 2009 and gave birth to a demeaning acronym
– PIGS. These countries, along with Italy, remain at the heart of the euro area debt
crisis.

Although imbalances in the euro area (caused by cheap credit and diverging
competitiveness) were building up gradually, the main trigger for loss of confidence
in EMU cohesion and its foundations was the chronic problems in the Greek
economy. Throughout 2009, despite contracting EMU economies and the raging
global financial crisis, confidence in euro area countries remained high – the
difference between Greek and German 10-year government bond yields was only
around 1 percentage point. However, at the end of 2009, investors started to doubt
whether Greece would be able to repay its debt and whether other EMU countries
would be willing to bail it out – i.e., in one way or another to take over part of its
debt. In a matter of a few months, Greek government bond yields exceeded 10
percent, the price at which it no longer made sense to borrow in financial markets.

2. Why was the Stability and Growth Pact not adhered to?

Strict Maastricht convergence criteria are designed to ensure that all countries
entering the EMU are able to sustain stable prices and exchange rates, as well as
low budget deficits and debt, and are trusted by financial markets. The Stability and
Growth Pact (SGP) was supposed to ensure that EMU members continued on a
sustainable path by requiring that budget deficits not exceed 3% of GDP and public
debt not exceed 60% of GDP, nor approach those levels. Initially, the SGP was
supposed to set much stricter limits than those in the Maastricht treaty, e.g., by
restricting the deficit to 1% of GDP and using automatic monetary sanctions.
However, before the pact was signed, the requirements were watered down, e.g., a
majority of two-thirds of the finance ministers was necessary to establish the
sanctions. 1 The absence of automatic monetary sanctions for breaching the
requirements caused many countries, including France and Germany, to continually
violate them. The pact was violated more than 60 times. Peer pressure was weak,
and “sinners” were somehow supposed to decide for themselves if they should be
punished; since there were always so many sinners, the system never worked. A

1
http://mises.org/books/bagus_tragedy_of_euro.pdf


new fiscal compact, signed on March 2012, is supposed to fix the major flaws – the
structural budget deficit (adjusted to the economic cycle) will be targeted and semi-
automatic monetary sanctions will apply for breaching it, unless a supermajority
(85%) votes against.

3. In what way is the crisis a sovereign debt crisis, and why?

Although this crisis has substantially increased the tension in the banking sector
and lowered the confidence of all market participants, at the heart of it lies a
mistrust in governments and their ability to repay the massive debt. Part of the
mistrust arises from the fact that individual EMU countries have no power to print
money and inflate or monetarise their debt. At the onset of the sovereign debt crisis,
there were no institutions that could help the countries facing liquidity problems.

As the economic situation in Greece worsened in 2009 – its GDP contracted by
3.3%, after a 0.2% contraction in 2008 – so did the markets’ view about the
sustainability of its debt, which jumped to 129.3% in 2009 from 113% in the
previous year. Although the debt level in itself was not a disaster – Japan, e.g., has
a public debt above 200% of its GDP – the contracting economy and the
government's inability and unwillingness to rapidly cut the budget deficit and initiate
other badly needed reforms indicated that the debt was about to become
unsustainable, i.e., Greece would never be able to repay it.

In 2010, other EMU countries continued implementing highly expansionary fiscal
policies – none of them (bar Finland and Luxembourg) met the Maastricht criteria of
a budget deficit below 3% of GDP. The bailout of Greece in May 2010 was not the
only one – later that year, Ireland asked for help from the IMF and EU and received
a EUR 67.5 billion loan. In May 2011, Portugal received from those two institutions
an official loan of EUR 78 billion. A few months after that bailout, confidence in
bigger EMU countries – Spain and Italy – started to wither. The ECB reactivated its
Securities Markets Programme (SMP), under which it bought government bonds in
a secondary market. Although there was no official bailout, from the reactivation of
the SMP until the end of 2011 the ECB bought Italian and Spanish bonds worth
more than EUR 130 billion. Meanwhile, Italian public debt, which had hovered
above 100 percent of GDP for many years, in 2011 exceeded 120 percent of GDP;
this is the second-highest level in the EU, below only the 160% of Greece. A big
part of the mistrust in Italy was related to its lack of competitiveness, slow growth,
and inactive government.

Ireland is an exception in that it has been brought to its knees not by its reckless
public finances – its debt was only 24.7% of GDP before the crisis – but by the
government's decision to guarantee the liabilities of six Irish banks that had
recklessly financed a huge real estate bubble. In a sense, the Irish government,
wanting to avert a banking crisis, transferred part of the burden from the private to
the public sector.


4. Why did yields on sovereign debt, which had been closely correlated despite
country differences, start to diverge, especially in 2010?

Until the eve of 2010, markets had implicitly assumed that, if any EMU country were
to experience temporary funding problems, other countries would bail it out –
despite EU Treaty Article 125, which states that bailouts are not allowed. For that
reason, investors eagerly lent to all EMU countries at a very similar price –
borrowing costs throughout most of the last decade did not diverge more than half a
percentage point. However, the Greek economy was hit particularly hard by the
global recession due to its high dependence on the volatile tourism and shipping
sectors. Only at the end of 2009, with a rapidly deteriorating economic situation in
Greece, did the new and more transparent government reveal that the public deficit
was going to exceed 15% of GDP, which was much higher than previously
expected. This raised investors’ concerns about Greece's ability to repay its debt.
But the level of debt was not the only problem – the US and UK have higher debt-
to-GDP ratios than the euro area on average. However, individual countries in the
EMU are unable to influence monetary policy, and there was an expectation that the
ECB would not resort to quantitative easing measures (buying bonds with newly
printed money)--policies that have been used by the Federal Reserve and the Bank
of England. At the same time, investors started to acknowledge the previously
ignored fact that the Greek economy was uncompetitive, due to rigid labour
markets and an oversized and inefficient public sector. Even still, this would have
been less of a problem if the country could have devalued its currency, but this was
not the case.

5. In what way is the crisis a trade and competitiveness crisis, and why?

It can be argued that the current EMU is by far not an optimal currency area (see
question 96), and that the countries in it are by far too different to share the same
currency and monetary policy. One of the reasons for this is the divergent levels of
real labour productivity, which is around two times lower in Greece and Portugal
than in the EMU on average. Even accounting for price differences, Greece's
productivity is only 87% of the EU-15 average. The differences in competitiveness
are also reflected in the huge imbalances in foreign trade – in 2008, Greece's
foreign trade deficit exceeded 20% of GDP. Portugal and Spain have also suffered
from constant chronic trade deficits, which in both countries started to narrow
somewhat only last year.

At the same time, Germany, due to its higher household savings rate and
productivity, was able to sustain large trade surpluses. In contrast, peripheral euro
zone countries were able to sustain huge external imbalances due to cheap
external credit, which caused a rapid accumulation of external debt by both public
and private sectors.

Productivity alone is not a very significant issue – Estonia, e.g., has the lowest
productivity in the euro area but was the fastest-growing economy in the EU in
2011. Bigger problems in Greece, Italy, Portugal, and Spain are the rigidity of the
labour market and the artificially constrained competition in many manufacturing
and services sectors. Laws that overprotected the rights of employees and gave
excessive powers to interest groups created a situation in which wages, rising


faster than productivity, caused these countries to become uncompetitive both
inside and outside the EU. Difficulties in firing employees have prompted
companies to be excessively cautious in creating new jobs and, e.g., pushed
unemployment to close to 25% in Spain. However, structural differences and
diverging competitiveness do not preclude the existence of a successful monetary
union. The lack of a common fiscal and financial policy and of institutions to ensure
the stability and liquidity of public finances were the major reasons why the situation
got out of control. By improving existing legislation (e.g., the fiscal compact) and
creating new institutions (the European Stability Mechanism, or ESM), the EMU
should be able to function better despite country differences (see questions 75 and
76 for a further discussion on institutions needed to fix the EMU).

6. In what way is the crisis an issue of confidence for politicians and other
policymakers?

Although the US and UK have worse debt and budget deficit indicators, they are
able to borrow at significantly lower interest rates than most European economies.
This suggests that there are significant flaws in the design of the EMU, and
investors doubt whether the politicians and the ECB will be willing to avert the
default of a member country. Germany’s initial insistence that the ESM, which will
have the mandate to lend to members in need, should have elements of private
sector involvement prompted investors to avoid EMU sovereign bonds in general.
Only later was this idea dropped and did European politicians start to claim that the
restructuring of Greek debt was a unique case that would never be repeated in any
other EMU member country.

Politicians’ actions during this crisis can be described as “kicking the can down the
road” due to their unwillingness (or inability) to take quick measures and stop the
contagion. The initial response of building the European Financial Stability Fund
(EFSF) was clearly an insufficient and only temporary measure. Most probably,
politicians were not in a hurry to build firewalls, stop the contagion, or rebuild
confidence because of the moral hazard – a quick fix would have never forced
Greece, Italy, and other countries to embark on the wide-scale reforms that they
were able to initiate only with the markets breathing down their neck.

Matters are made worse by the airing of public disagreements between member
countries on why, when, and how they should bail each other out. Many important
decisions had to be voted on in national parliaments, and this process did not go
smoothly – in Slovakia, e.g., disagreement on this matter caused the government to
collapse. In most of the troubled countries, politicians are unable to explain to the
public that the path of fiscal austerity and structural reforms is the least painful way
out of this crisis. Upcoming elections in Greece and France this year, and Italy next
year, complicate matters further, as there is a risk that populist politicians will make
decisions that, although less unpopular with their constituencies, may have
negative consequences.


B. The economic, political and social impact of the crisis

7. How much must the euro area consolidate in fiscal terms and what is the
impact on growth?

To achieve long-term and sustainable public finances in the euro area, fiscal
consolidation programs need to be implemented. At the EU Summit on December 9
2011, an agreement was reached on stronger fiscal cooperation, i.e., a fiscal
compact. Countries are now required to limit their structural budget deficits (budget
balance excluding cyclical influences, interest payments, and one-off items) to 0.5%
of GDP, and public debt ratios to 60% of GDP over some 20 years.

It is difficult to measure how growth will be affected. One simple rule of thumb is
that, if the public deficit is cut by 1%, growth is reduced by 0.5 %. In the euro area,
the need for austerity amounts to 3.3% of GDP – the level required in order for
countries on average to reach a structural deficit of 0.5% of GDP. This would mean
some 1.7% of GDP in negative growth effect, spread out over perhaps two years.
However, for some countries like Greece, the difficulty will lie in reducing the debt
level to 60%, as this means much larger negative growth effects since a very large
primary surplus is needed for many years.

In the current overall weaker economic climate, the large fiscal consolidations
should be significantly contractionary, at least in the short term, for activity in those
countries with the largest imbalances, such as Greece, Italy, Spain, and Portugal. If
the planned fiscal consolidation does prove to be contractionary for the affected
economies, this will imply renewed pressure on government revenues and fiscal
positions. This suggests that fiscal consolidation in these countries will have to be
carefully managed and highlights the desirability of policy measures to improve
confidence, increase medium-term growth, and bring down bond yields, so as to
offset the contractionary effects on the consolidation that is being undertaken.

8. Will the crisis cause a recession in the euro area?

Yes, a mild recession is expected in 2012 in the euro area as a whole, with negative
GDP growth in the first quarters of 2012 before a gradual recovery in the second
part of 2012. Large differences between countries are expected, however. Most
vulnerable are those countries with the largest imbalances in public finance and
with unfavourable competitive business sectors. Greece, e.g., is facing a very deep
and long recession, or depression, whereas Germany’s recession is likely to be
milder and shorter.

9. Will the euro area have a long period of no or low growth, i.e., stagnation and
deflation, like Japan?

It depends on how economic policy develops in the euro area. If the structural
reforms to increase growth, competitiveness, and labour market participation are
not undertaken, the outlook for the euro area worsens and stagnation can be
expected. Moreover, the likelihood for deflation and a new recession will increase in
combination with political and social unrest. If the financial markets do not find the


agreements in the fiscal compact credible, the debt problems could worsen, and the
growth outlook would be very bleak.

The euro area crisis has some similarities with the Japanese balance-sheet
recession, but while Japan had a financial crisis resulting from a massive real
estate bubble that burst, with a subsequent buildup of public debt, the euro area
crisis is focussed on sovereign debt and insufficient monetary union institutions. To
a large extent, the increase in the Japanese public debt was mainly driven by the
overtaking of private debts—an action taken to avoid a collapse of the Japanese
banking sector when asset prices fell dramatically in the beginning of the 1990s. In
the euro area, the increase in the public debt is mainly explained by a fast growth in
public expenditures to stimulate the economies after the deep recession in 2008-
2009.

A different approach to policymaking in the euro area could prevent a long period of
no or low growth. Measures to co- ordinate fiscal policy to reduce the public debt
are more pronounced in the euro area than in Japan. Euro members will have to
build up larger primary surpluses in order to reach the mandated debt ratio of 60%
of GDP. A more rapid treatment of the banking crisis in the euro area, including
higher capital requirements, is a major difference compared with the treatment of
the Japanese banking sector.

10. What is needed to create a recovery?

Establishing a credible economic policy in the euro area is an important step
towards restoring confidence among households and firms and the financial
market. The EU agreement in December 2011 of stronger fiscal cooperation, the
ECB's measures supporting the banks, the strengthening of the European Stability
Fund (ESM), and the large budget consolidations in the crisis-struck countries are
small but positive steps towards improvement in the euro area.

Long-term solutions to the euro area's problems also require economic reforms in
the labour and product markets to increase competitiveness and reduce labour
costs, especially in the peripheral countries. First, well-functioning labour markets
are needed. Necessary labour supply-side measures include the reform of tax and
benefit systems to strengthen incentives to work. Also, the use of flexible forms of
work, such as part-time and temporary work, may provide further incentives. To
stimulate labour demand, there is a need to promote wage flexibility and address
labour market rigidities.

Increasing competition is the second prerequisite for better economic performance.
In order to improve competition, additional deregulation of the labour and product
markets is needed in many member countries. Europe should step up measures to
boost competition in services markets in order to support a higher level and growth
rate of labour productivity and promote more dynamic economies.
The third prerequisite for higher growth in the euro area is the unlocking of business
potential by improving the entrepreneurial-friendly economic environment and
lowering administrative costs imposed by the public sector. The immense
importance of this issue is increasingly appreciated, and several initiatives at the
national or EU level aim at better regulation.


Fourth, to fully exploit productivity potential, labour and product market reforms
need to be complemented by policies that help to diffuse innovation, including
measures to support more investment in research and development. To be most
effective, these measures should be accompanied by efforts to raise the labour
force’s level of education and expertise such that human capital is continuously
adjusted to labour market needs.

11. How are the labour markets affected by the crisis?

In the euro area, the unemployment rate has increased every month since its low in
March 2008. In the beginning of 2012, the unemployment rate was above 10% of
the labour force, which is the highest level reached in a decade. All member states
in the euro area are seeing rising unemployment, but the magnitude of the increase
varies considerably from country to country. The highest unemployment rates are in
countries with the largest imbalances, such as Greece and Spain, with
unemployment rates higher than 20% of the labour force. Youth unemployment has
also reached record levels, with unemployment rates above 40% in Greece, Spain,
and Portugal.

In Germany however, total unemployment has fallen and was below 7% in the
beginning of 2012. The differences within the European labour market have fuelled
a growing mobility, with people moving to regions with smaller economic
imbalances. Higher productivity growth and subdued wage increases will lower unit
labour costs, particularly in the PIGS countries. But these countries will still be less
competitive than the EU average unless structural reforms are implemented to
strengthen competitiveness and increase the growth potential.

12. Will the euro area crisis cause unrest, strikes, and riots in the short term, and
what will be the impact on the EU social model in the longer run?

When the consolidation packages are implemented, the current EU welfare system
will be significantly reduced in the short term, particularly in the crisis-struck
countries. Lower wages, reductions in social benefits, and a high unemployment
rate are expected to increase the number of people in poverty and homelessness.
Increasing income inequalities within the euro area are also a ground for social
unrest, nationalism, and the creation of populist parties. The sustainability and
financing of the current EU welfare model will be more difficult to manage in the
longer term due to a strict fiscal discipline, according to the fiscal compact, and an
aging population. However, this could initiate a change in the social security
system, driven by deregulation of the labour market and incentives to increase the
participation rate in that market.

13. What are the longer-term effects on democracy of the euro area crisis, not
least since many feel alienated from the newly created technocratic
governments?

Technocratic governments are nothing new in the EU. Italy formed several such
cabinets in the 1990s to overcome financial crises, and Greece had a similar
interim government in 1989-1990.The current technocratic governments in Greece


and Italy are temporary and will be replaced through ordinary parliamentary
elections. In Greece, a parliamentary election is planned for April 2012. The Italian
government will last longer and has more support for reforms and budget
consolidation.

The gradual shift in decision making from the national to the central level (Brussels)
will probably be accelerated due to the sovereign debt crisis and in order to speed
up the structural reform process. Additional steps have been taken in the EU and its
member states, including a new set of rules for economic and fiscal surveillance.
These new measures, the so-called Six Pack, comprise five regulations and one
directive proposed by the European Commission. This change represents the most
comprehensive reinforcement of economic governance in the EU and the euro area
since the launch of the Economic Monetary Union almost 20 years ago. The
legislative package marks decisive step towards ensuring fiscal discipline, helping
to stabilise the EU economy, and preventing a new crisis in the EU. A major
element of the Six Pack is that a new numerical debt benchmark has been defined:
if the 60% reference for the debt-to-GDP ratio is not respected, the member state
concerned will be put into an excessive deficit procedure (EDP) (even if its deficit is
below 3%). A new expenditure benchmark caps the annual growth of public
expenditure according to a medium-term rate of growth.

Stronger co-operation in fiscal policy and measures to reduce the imbalances mean
the fiscal policy will be more norm oriented, like the monetary policy. The politicians
in the member states will therefore have weaker mandates going forward; some will
object to this as reducing democracy in the EU.

14. How is the crisis in the euro area affecting the global economy at large?

The global economic outlook is dependent on political and psychological factors in
the euro area. One possible scenario is small positive steps towards improvement
in the euro area and a mild recession, if the recovery picks up in the US and
emerging markets' growth momentum holds on. The main arguments for this
scenario are the latest agreement of fiscal co-operation among the EU member
states, the ECB's liquidity injections to support the European banks, and large
budget consolidations and intensified structural reforms in several countries.

A scenario of a gradual deterioration in the euro area, with lower confidence and
increased financial stress fuelling larger demands for extended policy responses
and leading, in turn, to a deeper recession in the difficult-to-gauge euro area, would
have a much bigger negative impact on the global economy and on the financial
markets.
A scenario with a breakup of the euro would have even more significant effects on
the global economy. Global growth would most likely be negative in this scenario
since the euro area is heavily linked to the rest of the world through financial
markets and trade. The long-term costs of a breakup would be large as well, as EU
cooperation would be affected through the poorer functioning of the single market;
moreover, the outlook for Europe's ability to compete globally would be weakened.


C. The effect of the euro area crisis on the financial sector

15. Why are banks affected by the sovereign debt crisis in the euro area?

Sovereign debt and banking difficulties are inextricably intertwined in the EMU and
have become even more so in the course of the crisis. European banks face
liquidity shortages, but for some banks their deeper problem is weak solvency as a
result of exposure to sovereign debt, particularly in the periphery countries.2 The
crisis therefore poses great risks to many of the continent’s banks that invested
heavily in government bonds. For these banks, raising money from private
investors has become more difficult – especially as many of them also suffered
deep losses from investing in troubled American banks in 2007 and 2008. Now,
politicians have made regulations stricter, as capital requirements will be raised
already in June this year, and banks must add EUR115 billion of extra capital to
reach the new standard.

The effect on banks, financial systems, and economies at the epicentre of the crisis
was immediate. However, the crisis also spread to a wider circle of countries
around the globe. For these countries, the transmission channels were less direct,
resulting from a severe contraction in global liquidity, cross-border credit availability,
and demand for exports. Given the scope and speed with which the recent and
previous crises have been transmitted around the globe, as well as the
unpredictable nature of future crises, it is critical that all countries make their
banking sectors more resilient to both internal and external shocks.3

16. In which countries have banks the largest exposure to the crisis-struck
countries, and how large are these exposures?

Rising current account deficits in the periphery countries were financed by foreign
lending, both private and public; this was easy for much of the 2000s as the
European Central Bank (ECB) kept interest rates low. The exposure of core banks
– mostly French and German - to the periphery peaked in early 2008.

French banks have the largest debt holdings in the five crisis-hit countries (Greece,
Portugal, Spain, Italy, and Ireland), at USD620 billion as of September 2011,
according to data from the Bank for International Settlements in Basel (BIS); 60% of
these holdings are in Italy.

The banking sectors in Germany and the UK are the two next-largest lenders, with
exposure to crisis-struck countries equivalent to USD456 billion and USD326
billion, respectively. The largest exposure ratio to GDP is in France (22%), Portugal
(17%), the Netherlands (16%), and Belgium (14%).

2
”Breaking up? A route out of the euro zone crisis”, RMF (Research on Money and Finance) Occasional report 3 //
November 2011. www.researchonmoneyandfinance.org
3
“Basel III: A global regulatory framework for more resilient banks and banking systems”, Basel Committee on
Banking Supervision, December 2010 (rev June 2011). www.bis.org/publ/bcbs189.pdf


Bank exposure to European debt to crisis-struck countries, September 2011 ($ bn)

Greece Italy Portugal Spain Ireland Total % of GDP
France 47.9 372.4 25.8 144.5 29.0 620 22.4%
Germany 18.6 144.7 30.0 160.9 101.6 456 12.7%
UK 11.5 61.3 23.4 93.1 137.1 326 13.5%
Netherlands 4.1 38.2 5.2 70.0 15.9 133 15.9%
Spain 1.0 35.5 78.8 8.6 124 8.3%
Belgium 1.4 22.2 3.2 21.2 23.4 71 13.9%
Switzerland 2.5 24.1 2.0 21.2 14.6 64 10.1%
Italy 3.2 3.5 29.5 15.9 52 2.4%
Portugal 8.7 2.5 24.5 5.2 41 17.2%
Austria 2.6 21.4 1.2 6.2 2.4 34 8.1%

Source: Bank for International Settlements

17. How are banks affected by the private sector involvement (PSI) in Greece, and
in what way could it affect interest rate premiums for other countries?

European leaders agreed to provide a second loan rescue package for Greece
worth EUR130 billion. The rescue package was conditioned on Greece’s private
sector creditors reducing their outstanding loans. It was thus agreed that private
sector holders of Greek debt - mostly banks and investment funds - which own
around EUR200 billion in Greek government bonds, will take losses of 53.5% on
the nominal value of their bonds, equivalent to around a 75% loss on the net
present value of the debt.

Investors agreed to exchange Greek bonds for new securities with longer maturities
and lower interest rates. The coupon on the new Greek government bonds will be
structured so that it will be 2% for the three-year period from February 2012 to
February 2015; 3% for the following five years from 2015 to February 2020; and
4.3% for the period from February 2020 to February 2042.The weighted-average
coupon based on the weighted-average interest payments on the outstanding new
Greek government bonds for the first eight years is 2.63%; it is 3.65% over the full
30-year period. Bondholders will exchange 31.5% of their principal for 20 new
Greek government bonds with maturities of 11 to 30 years replicating an
amortisation of 5% per annum commencing in 2023, and the remaining 15% will be
in short-dated securities issued by the European Financial Stability Facility (EFSF).
The new securities will be governed by UK law.

This would reduce Greece’s debt by EUR107 billion (out of a total of about EUR360
billion). This second bailout package, designed by the so-called Troika-- the
International Monetary Fund, the European Union, and the European Central Bank-
- will enable Greece to repay bonds totalling EUR14.5 billion that come due March
20, 2012, thereby avoiding a default and a potential exit from the European single-
currency area.

Most investors (86 %) accepted the deal. It was better for banks to accept a
reduction of the value of their assets than to risk the contagion of an uncontrolled
Greek default. Because banks have already written down the value of their Greek
debt, the impact should be limited. Due to the high exposure, Greek banks will still
be hard hit. Thus, creditors will be reimbursed for more than 50% of the nominal
value of the Greek bonds, whose real price in the secondary market is around 36%


of their face value. The banks will exchange today’s “junk bonds” for AAA-rated
bonds. On top of that, they will receive 15% (or EUR30 billion) in cash. 4

This decision has raised the cost of financing in the euro area by introducing
additional risk for private investors. But it is not without a useful purpose. The PSI
risk has raised (disproportionately) the cost of financing member states with larger-
than-projected levels of debt. Thus, it serves as a disincentive to fiscal profligacy,
thereby guarding against moral hazard and reducing the risk of future crises.
Adding the PSI risk could therefore improve governance. 5

On the other hand, since political leaders have concluded that the PSI risk in
Greece is unique, and necessary to stop the increase of yields in other crisis-struck
countries, the effects on governance are likely to be less pronounced. However,
since investors still feel uncertainties with regard to future PSI, interest rates will not
come down as if there were total certainty; in this respect, some governance effects
could remain.

18. What impact does the credit default swap market in the euro area have on the
crisis?

The European sovereign debt crisis of 2010 has created concerns regarding the
abuse of the credit default swap (CDS) market by speculators. In particular,
governments have accused investors of using CDSs to make bets about sovereign
defaults and to exacerbate the financial crisis by panicking investors. It is argued
that a heightened or speculative activity in CDS markets caused the prices of
protection against the respective sovereign defaults to go up. As the price of CDSs
rose, the price of the related bonds went down, and that, in turn, affected the price
of CDSs. A vicious spiral was started whereby CDS market activity led to a
continuing rise in prices of CDS and plummeting of the underlying bond prices.

In response, German financial regulators banned naked short selling 6 of CDSs on
euro area governmental bonds in May 2010, and the European Parliament did the
same in November 2011. Though naked trading did not cause the euro area debt
crisis, it can aggravate price declines in distressed markets. Indeed, the premiums
on CDSs of Greek, Spanish, Portuguese, and other European sovereign bonds
reached record highs, creating suspicion that a few hedge funds were driving up
prices to spread panic and make large profits. 7 The small size of the CDS markets
can mean they are easier to manipulate. Certain hedge funds are believed to have
squeezed prices higher in the CDS market so that they could then sell protection
later for profit.

4
“What are bankers doing inside EU summits?”, January 24, 2012 http://www.neurope.eu/blog/what-are-bankers-
doing-inside-eu-summits
5
“Time to jettison the plans to hit Greek creditors”, January 5, 2012. http://www.ft.com/intl/cms/s/0/5560c714-36dc-
11e1-b741-00144feabdc0.html#axzz1pjUPpxbZ
6
Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first
borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When
the seller does not obtain the shares within the required time, the result is known as a "failure to deliver”. The
transaction generally remains open until the shares are acquired by the seller, or the seller's broker settles the trade.
7
“Has the CDS market amplied the European sovereign crisis?“, Anne-Laure Delatte, Mathieu Gex, Antonia López-
Villavicencio, September 10, 2010


But there is a risk that political interference in the CDS markets may end up hurting
the peripheral and other economies by forcing borrowing costs higher and ushering
in tighter lending conditions for banks and companies, rather than helping to
navigate the continent’s debt crisis. 8 A number of rigorous economic studies have
since shown that this thesis of speculatively driven CDS prices is largely
unfounded. 9

The Greek parliament voted to include retroactive collective action clauses (CACs)
on domestic Greek debt when it gave the go-ahead to the impending debt swap. If
Greece had not received the required voluntary participation rate, the use of the
CACs would have triggered a CDS on the USD3.2 billion net notional amount of
CDS contracts outstanding. While this is not a vast amount, the simple result of
such an event might have led to some risk-averse trading. One aspect of the Greek
swap that bears noting is the potential negative subordination effects that may
spread to other peripheral European nations as a result of the ECB’s exclusive
swap on its Greek debt holdings.10 There is still a possibility that the part of the debt
that has not been voluntarily written down will trigger a CDS.

19. What are the Basel rules and how will they be affected by the euro area
crisis?

The Basel Accord was implemented in the European Union via the Capital
Requirements Directive (CRD), which was designed to ensure the financial
soundness of credit institutions (banks and building societies) and certain
investment firms. The CRD came into force on January 1, 2007, and firms began
applying its advanced approaches on January 1, 2008. The introduction of Basel II
revised the CRD framework. Basel II was intended to create an international
standard for banking regulators to control how much capital banks need to put
aside to guard against the types of financial and operational risks banks (and the
whole economy) face.

The Basel II framework introduced the concept of three “pillars.” Pillar 1 sets out the
minimum capital requirements that firms will be required to meet for credit, market,
and operational risk. Under Pillar 2, firms and supervisors have to take a view on
whether a firm should hold additional capital against risks not covered in Pillar 1
and then take action accordingly. Pillar 3 aims to improve market discipline by
requiring firms to publish certain details of their risks, capital, and risk management.

The crisis in financial markets during 2008 and 2009 prompted a strengthening of
the Basel rules, called Basel III, to address the deficiencies exposed in the previous
set of rules. One of the main reasons the economic and financial crisis became so
severe was that the banking sectors of many countries had built up excessive on-
and off-balance-sheet leverage. This was accompanied by a gradual erosion of the
level and quality of the capital base. At the same time, many banks were holding
insufficient liquidity buffers. Thus, the Basel III proposals sought to strengthen the
regulatory regime applying to credit institutions.

8
“Bankers fear political moves will kill off CDS”, October 25, 2011 http://www.ft.com/intl/cms/s/0/dccc8d98-ff03-
11e0-9b2f-00144feabdc0.html#axzz1pjUPpxbZ
9
An AIMA Research Note (2011), “The European Sovereign CDS Market”
10
http://www.raymondjames.com/bond_market_update.asp


Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II)
and 9% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWAs).
Basel III also introduces additional capital buffers: (i) a mandatory capital
conservation buffer of 2.5%, and (ii) a discretionary countercyclical buffer, which
allows national regulators to require up to another 2.5% of capital during periods of
high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio
and two required liquidity ratios. The liquidity coverage ratio requires a bank to hold
sufficient high-quality liquid assets to cover its total net cash outflows over 30 days;
the net stable funding ratio requires the available amount of stable funding to
exceed the required amount of stable funding over a one-year period of extended
stress. 11

The new regulation aspires to make the banking system safer by redressing many
of the flaws that became visible in the crisis. Improving the quality and depth of
capital and renewing the focus on liquidity management are intended to spur banks
to improve their underlying risk-management capabilities. The rationale is that,
ultimately, if banks come to a fundamentally revamped understanding of their risks,
this should be good for their business and for consumers, investors, and
governments. The Basel III proposals are a long-term package of changes that are
due to commence on January 1, 2013; based on the European Commission’s
timetable, the transition period is expected to run until 2021.

Meanwhile, for the largest banks, Sweden, Switzerland, and the UK are
implementing higher capital adequacy requirements than required by Basel III. The
Riksbank, in collaboration with the Swedish Financial Supervisory Authority and the
Ministry of Finance, announced new rules that will require the four big banks –
Handelsbanken, Nordea, SEB, and Swedbank – to hold a minimum 10% of RWAs
in common Tier I equity by January 1, 2013, with the capital buffer rising to 12% of
RWAs on January 1, 2015.

As in Basel III, the levels include a capital conservation buffer of 2.5%, but no
countercyclical buffer. In Switzerland, an expert committee has proposed
progressive capital adequacy requirements for its two major banks, UBS and Credit
Suisse, of 19%, at least 10% of which is to be common equity Tier I, with the
remaining 9% supplied by contingent convertibles – debt instruments that can be
converted to equity in certain circumstances. In the UK, the Vickers Commission
has proposed measures to introduce a structural separation of retail and investment
banking, with total capital in major banks amounting to 17–20%.

20. Capital requirements have been raised before the new Basel III rules take
effect – how much is needed and when must banks have fulfilled these?

At the European summit of October 26, 2011, it was decided to leave it to the
European Banking Authority (EBA) to draft the text for an initiative to raise capital
requirements in the EU. The EBA released its recommendations on December 8,
2011. This will help banks to continue their lending activities in 2012 and to avoid a
spiral of forced deleveraging and the ensuing credit crunches, which would weaken
the real economy.

11
http://www.basel-iii-accord.com/


The new capital requirements to restore stability and confidence in the markets are
the following. First, those institutions that are affected by the initiative should
achieve a core Tier I capital ratio of 9% by June 2012. Second, additional capital
buffers have to be introduced to cope with possible losses from exposures to
government debt in the euro area. The size of these buffers is determined by banks’
exposure to central and local governments of the European Economic Area
countries. The difference between market prices and the current balance-sheet
valuations determines the required additional capital buffer. To avoid an immediate
sell-off by banks of government bonds, the capital buffer is to be calculated on the
basis of September 2011 data. The building of these buffers will allow banks to
withstand a range of shocks while still being able to maintain an adequate capital
level.

According to the EBA, the new capital requirement of European banks, which is
estimated at EUR114.7 billion, shall mainly be achieved by increasing equity
endowments and reinvesting profits. Accordingly, the EBA is appealing to banks to
reduce dividend and bonus payments. The EBA additionally required banks to seek
approval by their national supervisory authorities of their plans on how to fulfil the
new capital requirements by January 20, 2012. The national supervisors will, in
turn, consult with the EBA. This procedure should prevent extensive deleveraging.
Hence, national supervisory authorities are likely to approve plans only if they
believe that these will not unduly restrict the national credit supply.

21. How are stress tests carried out in the EMU?

The aim of the 2011 EU-wide stress test was to assess the resilience of the banks
involved in the exercise against an adverse but plausible scenario. For the 2011
exercise, the European Banking Authority (EBA) allowed specific capital increases
in the first four months of 2011 to be considered in the results. Banks were
therefore given incentives to strengthen their capital positions ahead of the stress
test. The 2011 EU-wide stress test results show the following:

• At the end of 2010, twenty banks would have fallen below the 5% core Tier I ratio
(CT1R) threshold over the two-year horizon of the exercise. The overall shortfall would
have totalled EUR26.8 billion.
• Between January and April 2011, a further net amount of some EUR50 billion of capital
was raised.
• Taking into account these capital-raising actions implemented by end-April 2011, eight
banks fall below the capital threshold of 5% CT1R over the two-year time horizon, with
an overall CT1 shortfall of EUR2.5 billion, and sixteen banks display a CT1R of
between 5% and 6%.

On the basis of these results, the EBA has also issued its first formal
recommendation: national supervisory authorities should require banks whose
CT1R falls below the 5% threshold to promptly remedy their capital shortfall. The
EBA notes that this is not sufficient to address all potential vulnerabilities at this
point. Therefore, the EBA has also recommended that national supervisory
authorities request all banks whose CT1R is above but close to 5%, and which
have sizable exposures to sovereigns under stress, to take specific steps to


strengthen their capital positions. These would include, where necessary,
restrictions on dividends, deleveraging, issuance of fresh capital, or conversion of
lower-quality instruments into core Tier I capital. The EBA will monitor the
implementation of these recommendations and produce progress reports in
February and July 2012.

On December 8, 2011, the EBA published the results of its updated stress tests,
which conclude that European banks must raise EUR114.7 billion (EUR8 billion
more than estimated in October) as an exceptional and temporary capital buffer
against sovereign debt exposures to reflect market prices as at the end of
September. Furthermore, banks must reach 9% core Tier I capital by the end of
June 2012. The announcement suggests that national authorities may allow banks
to achieve this target through the sale of certain assets, where this will not reduce
lending to the real economy. The announcement emphasises that banks should not
be allowed to use changes to internal models to meet the capital target. Europe’s
banks are also required to raise a EUR39.4 billion sovereign buffer to insulate
themselves against losses in the government bond market.

Aggregated shortfall required by country EUR million
(1st column – new estimated (Dec 8th), 2nd – as published on Oct 26th)

Thirty-seven banks failed the EBA's stress test in December. The test identified that
German banks will have to raise EUR13 billion in additional capital, which is more
than double the previous estimates. Six out of the thirteen German banks tested will
have to raise additional capital, with Deutsche Bank needing to raise EUR3.2 billion
and Commerzbank EUR5.3 billion. French banks will require EUR1.5 billion less


capital than the EUR8.8 billion anticipated in October, reflecting third-quarter profits
and reduced holdings in sovereign bonds. Dexia, which was identified by the EBA
as having a shortfall of EUR6.3 billion, is exempt due to its restructuring. After the
cut-off date of September 30, the Dexia Group has been deeply restructured, and a
state guarantee will be provided on the funding issued by Dexia SA and its
subsidiary Dexia Credit Local, subject to the approval of the European
Commission. 12 Also, there is always a question about the credibility of stress tests:
how big is the implication of having 17 bank regulators all interested in having ”their
nations'” banks look the best?

22. Banks will shrink their balance sheets to meet the new rules, causing a credit
squeeze or a credit crunch – how will companies and households be
affected?

Leading European banks say they would rather sell assets than raise expensive
new capital to meet compulsory demands from European Union for higher capital
ratios, thereby threatening a further contraction of credit to the enfeebled euro area
economy. By shrinking assets – the denominator of capital ratios – many banks
believe they can reach the targets without having to raise new capital or resorting to
government recapitalisation. That is, banks will shrink to meet the targets by selling
risky assets. This strategy of the banks is likely to prove controversial with
politicians and regulators, if it were to lead to bankers’ lending less money to
customers, and thereby jeopardising the fragile recovery of the euro area.

The new rules have forced lenders to re-assess their clients more rigorously and
either tear up lending agreements completely or attach higher costs to loans and
funding. Europe's banks are preparing to ditch up to EUR3 trillion of loans in the
next couple of years as they "deleverage" their balance sheets, roughly 5-7% of
those banks' assets. As a result, businesses must pay more to borrow money,
leaving some firms scrambling to stay afloat and increasing the cost of their goods
to consumers. Banks are cutting the number of firms they will lend to, or scaling
back on loans, even to firms they have worked with for years. This is not only hitting
Europe's economy hard, but may also derail growth in Asia and the recovery in the
US.

Tighter borrowing conditions could squeeze domestic liquidity and raise domestic
interest rates. Many times, a credit crunch is accompanied by a flight to quality by
lenders and investors, as they seek less risky investments (often at the expense of
small to medium-sized enterprises). On the other hand, except for businesses that
are countercyclical or in a niche that is doing well, fewer companies are trying to
borrow right now. And in the countries where housing bubbles were a big part of the
debt explosion, mortgage debt is going to shrink over time.

The ECB introduced three-year long-term refinancing operation (LTROs) in
December as it sought to quell fears of a potential near-term funding crisis for euro
area banks. The injection of liquidity was credited with reopening some funding
channels, though some still remain largely closed. European banks grabbed a
larger-than-expected EUR529.5 billion in cheap loans as the ECB conducted its

12
http://www.eba.europa.eu/


second and possibly last three-year LTRO in February 2012. The ECB said a total
of 800 banks were allotted funds under the LTRO. The loans could also influence
banks’ solvency since there are possible profits to make by borrowing at a 1%
interest rate and lending to crisis-struck countries, where government bonds yield
more than 5%.


D. European politicians’ response to the euro area crisis

23. How have politicians in the euro area responded to the crisis, i.e., what are
the major policy measures?

In May 2010, the EC, ECB, and IMF (commonly called the Troika) engineered a
bailout of Greece and provided a EUR 110 billion loan, in exchange for
implementation of harsh fiscal austerity measures. Despite the bailout, confidence
did not return, and borrowing costs in most troubled countries continued to
increase. European policymakers indicated that future bailouts must have private
sector involvement, which further dissipated the illusion that no EMU country could
default and that investments in their debt were virtually risk free. In March 2012, a
second loan of EUR 130 billion was agreed, together with a debt write-down by
private investors exceeding EUR 100 billion, with the goal of reducing the
government debt to 120% of GDP in 2020.
The initial response of building the European Financial Stability Fund (EFSF) was
clearly an insufficient and only temporary measure. Most probably, politicians were
not in a hurry to build firewalls, stop the contagion, or rebuild confidence because of
the moral hazard – a quick fix would have never forced indebted countries to
embark on the needed wide-scale reforms. The European Stability Mechanism
(ESM) will replace the EFSF this year and will be a permanent rescue fund with
more (yet widely considered insufficient) firepower and a stronger mandate 13.
These funds are supposed to work as firewalls that prevent a crisis from spreading
to other vulnerable countries.
Core euro area countries offered financial assistance in the form of loans to crisis-
struck countries under the condition that fiscal austerity measures would be
undertaken. However, short-term measures are not sufficient, and the underlying
causes of the crisis have to be addressed to prevent it from reoccurring. In the
medium term, it is important to restore competitiveness and limit government
budget deficits. Therefore, together with financial assistance, structural reforms
regarding labour and product markets are being pushed through. Furthermore, in
order to prevent such a crisis in the future, more fiscal and economic unity is to be
introduced, in the form of a Fiscal Compact. In the past, many countries broke the
Stability and Growth Pact rules on national debt and budget deficit limits. In the new
agreement, which all EU countries except the UK and the Czech Republic have
approved, compliance should be achieved through more accountability and more
application of automatic sanctions for those countries that do not respect the
agreement. Responsible fiscal policy rules will also have to be included in the
national legislation.
24. The process of politicians addressing the crisis has been described as
“kicking the can down the road” – what does this mean?

Although the short-term impact of the crisis has been addressed by Europe’s
policymakers, they have been criticised for not dealing with the root causes of the
crisis. Instead, the crisis response has been characterized as cosmetic measures

13
For more details, see Question 26


taken for the short term, without sufficient long-term solutions. As such, this has
been described as “kicking the can down the road.”

However, quick solutions, such as Eurobonds, have not been offered, so as to
prevent a moral hazard. A moral hazard is a situation in which bad behaviour is
rewarded and good behaviour is punished. In addition, voters, primarily in Germany,
are very sceptical about extending permanent support for the southern European
crisis countries; meanwhile, voters in Greece have had difficulties accepting the far-
reaching consequences of long-term reforms. Taxpayers in Germany, which is the
largest donor in the rescue loans, do not feel that it is fair to charge them for the
irresponsibility of southern member countries. Since there was resistance from
populations in both countries to providing and accepting assistance, far-reaching,
long-term agreements (like the Fiscal Compact) could be made only after the crisis
deepened sufficiently to scare the politicians.
Therefore, even though policymakers have been criticised for the policy of kicking
the can down the road, it may have been the only possible response – there was no
quick way to create necessary institutions during calm times. It is worthwhile to
remember the ominous words of Romano Prodi, then-EU Commission President,
more than ten years ago: “I am sure the Euro will oblige us to introduce a new set
of economic policy instruments. It is politically impossible to propose that now. But
some day there will be a crisis and new instruments will be created.” These
necessary institutions (financial union, fiscal union, and permanent lender or last
resort to sovereigns) have not yet been created, but there is progress in the right
direction.
25. To what extent has the EMU turned into a “transfer union” despite the EU
Treaty?

By “transfer union” it is meant that a country in the EMU supports another member
country through a fiscal transfer. Article 125 of the EU Treaty forbids vouching or
joint liability for other member states ‘debt. This means that the only option the
treaty leaves is debt reduction by the insolvent sovereign country itself. 14 However,
euro area countries have provided and plan to provide financial assistance for
troubled countries through the EFSF and the ESM. These mechanisms enable
stronger countries to pool funds and lend money to the weaker ones, but, as they
do not create mutual liability, they do not violate the EU Treaty.
Some economists claim that the EMU is already a transfer union and was deemed
to become one by its construction. According to the professor of economics Philipp
Bagus (2010) 15, “by deficit spending and printing government bonds, governments
can indirectly create money.“ As the ECB accepts bonds as collateral, such bonds
create money. This has enabled some countries in the euro area to run budget
deficits and enjoy higher living standards at the expense of countries with smaller
budget deficits. However, the ECB accepts only the highest-quality (investment-
grade) government bonds as collateral and can always adjust this benchmark. This
means that individual governments do not have discretionary power to create
money – once their public finances threaten to become unsustainable, banks can

14
http://www.ft.com/intl/cms/s/0/622595e2-37c7-11e1-a5e0-00144feabdc0.html#axzz1o2bRWi6p
15
Philipp Bagus (2010). The Tragedy of the Euro.


no longer use their bonds as collateral to borrow from the ECB. Recently, the ECB
was increasing its amount of money by buying government bonds in the secondary
market via the Security Markets Programme and the long-term refinancing
operation (LTRO); however, these are temporary measures meant to improve
confidence and liquidity.
Suggestions have been made to create more direct instruments, such as
Eurobonds, also called Stability bonds. Such bonds, which would be backed
commonly, would replace national ones. This would create a bigger market for euro
area debt financing and might lower interest rates. However, Germany, together
with some other governments, remains opposed to such a move. Furthermore, it is
unclear if such joint liability would not contradict the aforementioned Article 125 of
the EU treaty.
26. What characterises the most important support mechanism of the transfer
union, the European Financial Stability Facility (EFSF), and in what way will
the next measure, the European Stability Mechanism (ESM), be different?

The European Financial Stability Facility (EFSF) was created in 2010 by the euro
area countries. Its mains goal is to safeguard financial stability in the euro area by
raising funds in capital markets and to provide loans to euro area countries facing
financial difficulties. It can also, on the basis of ECB analysis, intervene in the
secondary bond market. 16 The EFSF is backed by guarantee commitments from
the euro area countries and had an initial lending capacity of EUR 440 billion. The
fund has so far been used to support Greece, Ireland, and Portugal. The EFSF has
remaining a lending capacity of EUR 250 billion. The temporary EFSF should by
midyear be changed or complemented by the permanent European Stability
Mechanism (ESM), whose capacity is EUR 500 billion. Its lending capacity may be
increased to EUR 700 billion as the current capacity is thought to be too low if some
bigger countries had to be bailed out. The euro area members, central bankers, and
finance ministers plan to discuss the size of the bailout fund in Copenhagen on
March 30-31. 17 Nevertheless, concerns have been expressed by IMF, ECB, and
other officials that the size of the firewall is not sufficient and that it should be
increased to EUR 1 trillion.
The ESM will have the same main features as the EFSF; however, the new fund
should be more robust as money will be put in up-front. In addition, there will be
more flexibility and independence as the new treaty will have an emergency voting
procedure, whereby financial assistance can be granted if supported by a qualified
majority of 85% of the votes cast. 18 The ESM also includes heightened economic
surveillance of the EU. There will be more focus on the prevention of crises, debt
sustainability, and more effective enforcement. Financial assistance will be
conditional on the ratification of the Fiscal Compact by the ESM member state.
Also, liquidity and solvency crises will be separated. In case of a liquidity problem,
the ESM will step in with support, which will be conditional on an adjustment
program. Private creditors will be encouraged to maintain their exposure. However,
if an analysis reveals that a country could become insolvent, a plan will have to be

16
http://www.efsf.europa.eu/about/index.htm
17
http://www.reuters.com/article/2012/03/16/us-eurozone-bailout-capacity-idUSBRE82F0JM20120316
18
http://www.efsf.europa.eu/attachments/faq_en.pdf


negotiated with private creditors; assistance from the ESM will be provided as well.
It is planned to facilitate cooperation between a debtor and creditors. For all new
euro area sovereign bonds, collective action clauses (CACs) will be included in the
terms and conditions. CACs will allow creditors to agree on and make legally
binding a change to the terms of payment. Such changes could involve a standstill,
extension of maturity, interest rate cut, and/or a “haircut.” 19

27. What is included in the Six Pack EU budget rules?

The Six Pack EU budget rules, which, except for the fiscal framework, came in
force in 2012, are a set of measures that should ease the process of imposing
sanctions on EU countries that do not comply with the rules. The six-Pack is made
up of five regulations and one directive proposed by the European Commission and
approved by all 27 EU countries and the European Parliament in October 2011.
These rules address fiscal policy and macroeconomic imbalances.
Fiscal policy

1. Strengthening of budgetary surveillance and coordination of economic
policies
The problem of sustainable budget planning was addressed by introduction
of a country-specific medium-term budgetary objective (MTO). This involves
a cap on the growth of public expenditure according to a medium-term rate
of growth. If budgetary plans deviate significantly from the rules, a country
may be requested to prepare and present a new plan. A non complying
country may be subject to financial sanctions (an interest-bearing deposit of
at least 0.2% of GDP, as a rule). The sanction can be overturned only if a
simple majority of countries (9 out of 17 euro area states) opposes it.
2. Speeding up and clarification of the implementation of the excessive
deficit procedure

This says that the deficit cannot exceed 3% of GDP, and debt cannot exceed
60% of GDP. If the 60% reference for the debt-to-GDP ratio is not respected,
the member state concerned will be put in the excessive deficit procedure
(even if its deficit is below 3%!), after taking into account all relevant factors
and the impact of the economic cycle, if the gap between its debt level and
the 60% reference is not reduced by 1/20th annually (on average over three
years). If the country fails to cut spending according to recommendations, it
can face a penalty of at least 0.2% of GDP. The sanction can be overturned
only if a qualified majority of countries (12 out of 17 euro area states)
opposes it.

19
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/10/636


3. Effective enforcement

Noncomplying countries can be fined 0.2% of the previous year’s GDP. Even
though the fines existed already under the Stability and Growth Pact, they
were never enforced, whereas reverse voting now makes it difficult for states
to overturn penalties. In addition, fines of 0.2% of GDP will be levied on
countries that falsify debt and deficit statistics to meet EU requirements, as
was the case in Greece. Penalties are first exacted in the form of interest-
bearing deposits. They can be returned together with accrued interests if
reforms are made. They are converted to non-interest bearing deposits and
eventually fines if the country fails to reform.
4. Fiscal framework of the member states—setting of statistical and
budgetary standards

National accounts should cover all state agencies and public corporations.
State accounts should be published monthly; regional accounts, quarterly.
Debt and deficit limits should be written into law (except in the UK). Budget
planning should be done over three years. Independent auditors should
check all government accounts. These standards will be applied beginning in
2014.
Macroeconomic imbalances

5. Prevention and correction of macroeconomic imbalances

The excessive imbalances procedure (EIP) will identify and correct the gaps
in competitiveness and macroeconomic imbalances, including public and
private indebtedness, house prices, unemployment, current account
balance, real effective exchange rates, etc. Preventive recommendation will
be given to member countries in the early stage of forming imbalances. In
the later stages, the countries will be required to submit a corrective action
plan with a road map and deadlines. If after six months and two warnings no
progress has been made, the country can be fined 0.1% of GDP. The fine
can only be overturned by reverse qualified-majority voting.
6. Enforcement action to correct excessive macroeconomic imbalances in
the euro area

An interest-bearing deposit can be imposed after one failure to comply with
the recommended corrective action. After a second compliance failure, this
can be converted into a yearly fine of 0.1% of GDP. 20Sanctions can also be
imposed for failing twice to submit a sufficient corrective action plan. At both
stages, decisions can only be overturned if a qualified majority of countries
(12 out of 17 euro area countries, with 157 out of 213 votes) opposes them.

20
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/898


28. What are the rules of the new Fiscal Pact and which countries belong to the
new pact?

The new Fiscal Pact, which was described as the first step towards fiscal union by
ECB President Mario Draghi, was approved by 25 out of 27 member states at the
end of January 2012 and was signed on March 2. The UK and the Czech Republic
did not approve it. Now countries will have to ratify the pact or they will not be able
to use bailout funds beginning in spring 2013. 21 The Fiscal Pact will add to the
Stability and Growth Pact, which was adopted by all 27 countries. The new Fiscal
Pact is an intergovernmental pact among 25 countries and therefore cannot be
considered as a change to EU law.
The aims of the Fiscal Pact are to insure greater fiscal discipline by introducing
semi-automatic sanctions and stricter surveillance. 22 The main rules says that
national budget has to be balanced or in surplus. This would be achieved if the
structural deficit 23 did not exceed 0.5% of nominal GDP. If a country did not comply
with this rule, the automatic correction mechanism would be applied. 24 Each country
would also have to put this balanced-budget rule into national legislation, preferably
on a constitutional level. In addition, countries will prepare reports on the plans for
the issuance of debt. All major economic reforms should be coordinated. 25
The Fiscal Compact, which is the fiscal part of the Treaty on Stability, Coordination
and Governance (TSCG) and the six-pack will run in parallel. On the one hand, a
couple of provisions included in the TSCG are mirroring concepts existing in the
Stability and Growth Pact as reformed by the six-pack. On the other hand, some
provisions of the TSCG are more stringent than the six-pack. For example, it says
that at each stage of the Excessive Deficit Procedure (EDP) "euro-area Member
States" will support the Commission's proposals or recommendations in the Council
if a "euro-area Member State" is in breach of the deficit criterion, unless a qualified
majority of them is against it. In practice this means that if a "euro-area Member
State" breaches the deficit criterion a kind of reverse qualified majority voting
(RQMV) applies to all stages of the EDP, even if not foreseen in the six-pack.
Moreover, as mentioned above, the TSCG requires Member States to enshrine the
country-specific MTOs in national binding law, preferably of constitutional nature. In
addition, the TSCG reinforces economic governance. 26
29. How will the sanctions system work?

If a country did not include a balanced-budget rule in its national legislation within a
year after the treaty was signed, the EU Court of Justice would have the right to
decide upon this issue. The court's ruling would be mandatory, and, if a country did
not comply, it could be fined up to 0.1% of GDP. If the country were in the euro

21
http://online.wsj.com/article/SB10001424052970203986604577256862951941608.html
22
see Question 27 on the “six pack”
23
Structural deficit occurs when a deficit budget is in place even when the economy is at its full capacity
24
look for more details on sanctions in Question 29
25
http://www.european-council.europa.eu/home-page/highlights/the-fiscal-compact-ready-to-be-signed-(2)?lang=lt
26
http://ec.europa.eu/economy_finance/articles/governance/2012-03-14_six_pack_en.htm


The Euro Area Crisis - 99 Q & A, March 2012

The Euro Area Crisis - 99 Q & A, March 2012

Empfohlen

Empfohlen

Weitere ähnliche Inhalte

Was ist angesagt?

Was ist angesagt? (17)

Ähnlich wie The Euro Area Crisis - 99 Q & A, March 2012

Ähnlich wie The Euro Area Crisis - 99 Q & A, March 2012 (20)

Mehr von Swedbank

Mehr von Swedbank (20)

Kürzlich hochgeladen

Kürzlich hochgeladen (20)

The Euro Area Crisis - 99 Q & A, March 2012