Balancing the EMU : the imbalances created by the euro : how could the implementation of Eurobonds contribute to the stabilization of the EMU?

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UNIVERSITY OF AMSTERDAM

Balancing the EMU

The imbalances created by the euro: ‘How could the implementation of Eurobonds

contribute to the stabilization of the EMU?’

Eveline van ’t Spijker

10400982

BSc Economics and Business

Supervisor: Dr. C.G.F. van der Kwaak

04-‐07-‐2015

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Balancing the EMU

Abstract

The purpose of this paper is to provide insights in the underlying risk factors of the EMU that eventually led to the European Sovereign debt crisis, and how its economic consequences incited the debate about how Eurobonds could play a role in the stabilization of the monetary union. It describes that neither the ESM nor the unconventional policy measures of the ECB provided the long-‐term solution to the European debt crisis. This paper suggests that the analysed Eurobond proposals provide some aspects, such as improved liquidity, reduced contagion between the EMU countries, and the elimination of the feedback loop between banks and sovereigns that could contribute to the stabilization of the EMU. However Eurobonds do not provide an answer to the structural problems of unsustainable government debts and low competitiveness.

Keywords: Eurobonds, European sovereign debt crisis, Economic Monetary Union.

-‐Eveline van ‘t Spijker

Statement of Originality

This document is written by Student Eveline van ’t Spijker who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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. The European Sovereign Debt Crisis

13

2.1 Start of the Global Financial Crisis 13

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2.2.1 Deterioration in government accounts, banks 14 balance sheets and Target balances

2.2.2 Determinants of interest rate differentials in EMU 16

2.3 Policy responses to the European debt crisis 17

2.3.1 The EFSF and ESM 17

2.3.2 The SMP, LTRO and OMT 17

2.3.3 The Fiscal Compact 19

3. Eurobonds

19

3.1 Introduction to Eurobonds 20

3.12 Arguments in favour of Eurobonds 20

3.1.3 Arguments against Eurobonds 21

3.2 Eurobond Proposals 22

3.4.1 The Blue-‐red bond 22

3.4.2 The Euro T-‐bills 23

3.4.3 European investment bank 25

3.4.4 European Safe Bonds (ESBies) 26

3.4.5 Euro-‐insurance bonds 28

3.5 Implementing Eurobonds 29

3.5.1 Political resistance 29

3.5.2 Legal barriers 30

3.5.3 Practical matters and criticism on the proposals 31

4. Risk premium on Eurobonds 33

4.1 The model 33 4.2 Results 34 5. Conclusion

36 Appendix

38 Reference list

39

List of figures and tables

Figure 1. 10 year government bond spreads EMU-‐countries to German Bunds 7

Figure 2. Government Debt in 1997 and 2013 8

Table 1. Current Account Balances 9

Figure 3. Real effective Exchange Rate (unit labour costs) 10 Table 2. Violations of fiscal rules 13

Figure 4. Target Balances in the EMU 16

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Figure 6. Country Weights for EIB and ESBies 27 Table 3. Overview and common factors of Eurobonds 29

Table 4. Overview of Eurobond features 31

Figure 7. Risk premium on Eurobonds in percentage points (2001-‐2014) 35 Table 5. Borrowing costs for EMU-‐countries (2001-‐2014) 36

Introduction

The burst of the housing bubble in the USA in 2007 triggered a subprime mortgage crisis that became a global crisis due to the interdependence of the banking system and the contagion of the financial system. During 2008 and 2009 the financial markets remained relatively calm in Europe. Only at the end of 2009 the global crisis spread to the eurozone causing the European Sovereign Debt crisis. The shock of the financial crisis hit the euro countries asymmetrically. Especially the countries that had established weak fiscal positions and current account deficits in the years before 2007 faced liquidity problems when the international money markets dried up. The yields on the southern European government bonds rose rapidly because investors recognized the liquidity problem that later became a solvency problem, especially for Greece. Many European banks had a great exposure to governments bonds leading to a more aggravate

problem.

When entering the Economic Monetary Union (EMU), most of the member states did not satisfy the criteria of the Maastricht Treaty. With the introduction of the euro, the government spreads against the German bund fell to almost zero leading to an increase in borrowing by households and governments in the southern EMU countries. The low interest rates further triggered capital flows from northern Europe to Southern Europe leading to current account

imbalances in the EMU.

In the aftermath of the Global financial crisis, policymakers responded with several measures to tackle the liquidity problems and dramatic increase in the government spreads over the German bunds in the periphery countries. Several funds as the EFSF and later on the ESM were established. The ECB conducted its monetary policy using unconventional tools and open market operations by the means of the SMP and OMT programmes. Although these measures could partially solve the problems in the short run, there is still not a real long-‐term solution to

safeguard the future of the euro.

This thesis studies how Eurobonds might be able to fulfil this function. On the one side, Eurobonds can increase liquidity and reduce the debt servicing costs of the weaker countries; on the other side it increases moral hazard, fiscal indiscipline and the borrowing costs for the core

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economies. The research question will therefore be: ‘How could the implementation of Eurobonds contribute to the stabilization of the EMU, is it enough or would more be needed?’

To be able to answer this research question, we will discuss the Eurobond concept, analyse several proposals in literature of implementing Eurobonds and discuss the potential advantages and disadvantages. The thesis is structured in the following way. The first section of the thesis will discuss the institutional set-‐up of the Economic and Monetary Union from the Maastricht Treaty towards the Euro, the development of the underlying pre-‐crisis risk factors and the flaws in the design of the EMU. The next section covers the beginning of the global financial crisis with the burst of the housing bubble and the run up to the European sovereign debt crisis. In addition, this section considers the policy measures and the unconventional measures taken by the ECB to address the problems in the euro area. Furthermore, section 3 contains the discussion of the different aspects of Eurobonds, several Eurobond proposals and what should be taken into account before implementing Eurobonds. In section 4, the actual borrowing costs of 11 EMU countries are compared to the costs when we would have had Eurobonds from the start of the euro. The calculations will be based on Boonstra ‘s (2012) model for the risk premium on Eurobonds. With the information of those four sections, we will in section 5 conclude whether Eurobonds could help in balancing the EMU and reducing the problems created by the euro and the European debt crisis.

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1. The prior crisis phase

This section discusses the possible causes of the Sovereign debt crisis that were created by the institutional design of the EMU. It examines how the Maastricht treaty and Stability Pact were brought into practice, in how far there was convergence between the countries in the run-‐up towards the euro, and how imbalances had the chance to grow over the years. In this section we will also apply the Optimum Currency Area (OCA) theory to the EMU by analysing how asymmetric shocks could be absorbed in a monetary union.

1.1 The developments towards a single currency

1.1.1 The Maastricht Treaty and Stability and Growth Pact

To secure a sound monetary union and to converge and coordinate the participating economies, in 1992 the Maastricht Treaty took effect. With the Maastricht Treaty, the EU members agreed to introduce the euro upon several convergence criteria that must be fulfilled for membership to the currency union. The convergence criteria emphasize the need for price stability, sustainable fiscal situations, the stability of the exchange rate and low interest rates. In total, the Maastricht Treaty outlines four criteria: 1) to secure price stability, the average inflation rate could not be higher than 1.5 percentage points compared to the three best performing members; 2) The fiscal convergence criterion requires that the EMU-‐countries’ net deficit cannot exceed 3 per cent of its GDP. Moreover, the government debt must not exceed 60 per cent of the country’s GDP (De Haan, Gilbert, Hessel & Verkaart 2013); 3) The currency of the member states could only fluctuate ‘normally’ within in the defined margins of the Exchange Rate Mechanism (ERM) to ensure exchange rate stability; 4) The last criterion regarding the interest rates states that countries’ average long-‐term interest rate could not exceed the rate of the three best performing member states by more than 2 percentage points (Eijffinger & De Haan 2000).

In 1997 the Stability and Growth Pact (SGP) came into force to strengthen the surveillance of the fiscal positions and rules – the preventive arm, and to outline the details of the excessive deficit procedure – the corrective arm (Buti, Franco & Ongena 1998). When the deficits and government debt ratios do not satisfy the convergence criteria, a country enters the excessive deficit procedure (EDP) and is obliged to correct for the fiscal situation. When a state does not comply with the correction, the European Council can impose sanctions such as non-‐ interest bearing deposits that amount 0.2% of GDP and must be placed within the European Commission (EC). When the member state made not enough effort to adjust its excessive deficit, the deposit will be converted into a fine (Regulation EU No 1173/2011). There could be made an exception to the EDP when the ratios have declined significantly towards the target ratio or a

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country is hit by a severe economic downturn (De Haan et al. 2013). Besides the EDP the pact contains a no-‐bail out clause. When forming a monetary union, there arises a free-‐rider problem. Countries might have the incentive to borrow substantially since they know they are likely to be bailed out by other countries that fear contagion to the rest of the union, due to the interdependence of the financial system and the issuance of debt in the same currency. So to ensure the credibility of the monetary union, and to cope with the potential free-‐rider problem, the pact includes a no-‐bail out clause, meaning that a sovereign default takes place when a member does not hold on to the fiscal rules (Lane 2012). This rule was to ensure the risk premiums would price in the sovereign risk (De Grauwe 2012b).

1.1.2 Convergence in the EMU-‐area

As becomes clear from the graph in figure 1, in the period prior to the introduction of the euro, the government spreads over the German bunds of countries like Greece, Ireland, Italy, Portugal and Spain (GIIPS) were high but decreasing from significant values. De Grauwe (2012b) argues that this is due to the decline in devaluation risk when approaching the introduction of the euro, which has previously been a major source of the risk premium. In addition, Hans-‐Werner Sinn (1997) argues that the spread on the left-‐hand side of the graph was also due to inflation risk. Before the introduction of the euro, the national central banks (NCB) had autonomous monetary policy, meaning they could print money, causing inflation and a devaluation of their currency. With the euro, printing money by one NCB was cancelled out by the reduction in money by other NCBs. When a NCB creates seigniorage wealth it has to place equity in the ECB, to distribute the profits among the other member states based on equity shares (Sinn & Feist 1997). Additionally, the anti-‐inflationary policy of the ECB also eliminated the fear of inflation (Feldstein 2011). In 2001, when the devaluation risk was entirely eliminated, the spreads were almost zero. The EMU established a common market for government bonds. The fixed-‐income government securities denominated in the same currency were seen as substitutes, although not perfect substitutes (Favero, Ambrogio & Missale 2012).

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Figure 1. 10-‐year government bond spreads EMU-‐countries to German Bunds

Source: Fred Economic Data. St. Louis FED (Long-‐Term Government Bond Yields: 10 year).

While the EMU countries had reduced their fiscal budgets in the convergence phase before the launching of the euro, most of the countries did not meet the planned goal of 60 per cent debt to GDP from the Maastricht Criteria (De Haan et al 2013). It appears from figure 2 and Sinn (2014b) that only about five of the eleven participating countries met the criteria in 1997. However, all countries that exceeded the 60 per cent limit could join the euro since their deficit was moving towards the 3 per cent requirement. In 2002, with the introduction of the euro bills and coins, Greece had a debt/GDP ratio of 101.7 per cent and Italy a ratio of 105.7 per cent (Eurostat). Despite the structural economic differences in the euro countries, the financial markets did not anticipate a default risk for almost 10 years, leading to lower interest rates on the government debts (De Grauwe 2012b). In countries such as Greece and Portugal, the governments used the low interest rates to increase their borrowing. Those countries did not use the advantage of lower debt servicing cost to repay more debt; instead a major motivation to join the currency union was to get access to lower interest rate on their sovereign debt. In Spain and Ireland there was no such excessive public borrowing when joining the euro (Sinn 2014b). 0 5 10 15 20 25 Greece France Portugal Spain Ireland Italy Netherlands France Finland Austria

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Figure 2. Government Debt in 1997 and 2013

Source: IMF database, World economic outlook (general government debt).

In addition, in most of the periphery countries, a private credit boom occurred. With the cheap credit, Greece and Portugal increased the wages and hired more workers in the public sector, however it did not lead to productivity gains. In Ireland and Spain the cheap credit was used in the construction sector and to buy real estate. In Spain for example, the banks became more relaxed in terms of providing loans. The banks required less collateral and financed bigger proportions of the property prices than would be common in for instance Germany (Sinn 2014b). Hence, the boom drove up wages, goods prices and property prices (Sinn 2014a).

At the introduction of the Euro, there was a common thought about the economic growth and prosperity the single currency would stimulate. The southern countries could get access to cheap credit, leading to capital flows from the core member states to the periphery countries (Sinn 2014b). This transfer was largely funded by private savings from the northern to the southern states leading to current account deficits of the latter. In fact, the current account is the difference between domestic saving and investment (Sinn 2012). Lane (2012) and Feldstein (2011) also address the variances in the current account and trade imbalances among the euro members. As can be seen in table 1, in countries such as Greece, Portugal and Spain, the current account deficits increased strongly since the introduction of the euro. Saving fell in the southern countries while investment increased. In the contrary, Germany established a current account surplus.

63 123 53 59 59 97 63 117 7 68 54 66 74 101 58 93 80 176 123 132 23 74 124 94 0 20 40 60 80 100 120 140 160 180 200 P er ce n ta ge o f G D P 1997 2013

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Table 1. Current Account Balances (Percent of GDP) 1993-‐1997 1997-‐2002 2003-‐2007 2008-‐2011 France 1.1 2.0 -‐0.2 -‐1.5 6.1 -‐11.5 Germany -‐0.9 -‐0.4 5.1 Greece -‐2.4 -‐6.3 -‐9.2 Ireland 3.6 -‐0.2 -‐2.8 -‐1.4 Italy 2.1 0.5 -‐1.0 -‐2.9 Portugal -‐2.4 -‐9.0 -‐9.2 -‐10.3 Spain -‐0.6 -‐3.1 -‐7.0 -‐5.7

Source: IMF database, World Economy Outlook (Current Account Balances).

However, the capital transfers from the northern states towards the periphery countries did not fuel the productivity growth of tradables but rather those of non-‐tradables such as real estate. This poses risk to the countries running a current account deficit, since this indirectly drives up the wages and constrains resources from sectors that have possible productivity growth (Lane 2012). Since the introduction of the euro, the real effective exchange rates of the GIIPS countries in terms of labour costs (see figure 3) and consumer goods increased significantly relative to the other euro countries. The relative price level of Greece increased by 67 per cent, the Spanish relative prices by 56 per cent, followed by 53 and 47 per cent for respectively Ireland and Portugal (Sinn 2014a). This is especially risky in the case of a currency area. When those periphery countries would not join the EMU, their exchange rates could devalue over time. This adjustment of the exchange rate would lead in the periphery countries to lower exports prices and higher import prices. In those countries, export will start to rise and imports will start to fall, which improves the competitiveness and prevents a growing current account deficit. This adjustment mechanism is absent in a monetary union and must now be achieved by cutting the real labour costs relative to the rest of Europe (Feldstein 2011). According to calculations of Goldman Sachs, Greece would need a painful price cut of approximately 20 to 30 per cent, compared to third quarter of 2008, in order to achieve a path of sustainable debt in the long run and restore its competitiveness relative to the rest of Europe (Sinn 2015).

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Figure 3. Real Effective Exchange Rate (unit labour costs)

Source: Fred Economic Data. St. Louis FED (Real Effective Exchange Rate Based on Unit Labour Costs).

The decline in government spreads triggered thus capital flows form north to south Europe, leading to the current account imbalances. However, as becomes clear from figure 1 and table 1, the government spreads over the German bunds had already declined while table 1 does not show big imbalances in the EMU in the period before 1997. Sinn (2014b) recognizes the existence of a timing problem. The investment boom in southern countries (e.g. real estate) can increase work opportunities and wages, which lead to an increase in import in those countries. The relative prices in the periphery countries increase when the wages increase relative to north Europe, thus reducing the export to north Europe. However, the change in relative prices and wages has a time lag and the reflections in the current account balances are therefore delayed.

1.2 Flaws in the institutional design of the EMU

1.1.2 The Optimal Currency Area

We have to address the economic consequences when having a single interest rate set by the ECB and a fixed exchange rate in countries facing asymmetric shocks and national fiscal tax systems. This can be done by analysing the Optimal Curency Area theory. The OCA theory was first introduced by Robert Mundell (1961). ‘The theory of monetary unions is a trade-‐off between the reduced costs of trade and the adverse macroeconomic effects of precluding interest rate and exchange rate variation’ (Mundell 1961). According to Feldstein (1997), when designing the EMU the policy-‐makers were especially driven by political motivations and the implementation of a single currency and less so by the economic consequences of a monetary union or whether the EMU would be an Optimum Currency Area. The reason being that at that

60,0 65,0 70,0 75,0 80,0 85,0 90,0 95,0 100,0 105,0 110,0 Ind ex 2 0 0 7 = 1 0 0 Greece Portugal Italy France Ireland Spain Italy Germany

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time, the OCA theory was complex and not yet fully developed, leading to doubts about its meaning. Only in the years after 1992, a debate arose about the effect asymmetric shocks could have on Europe and about the issue whether the EMU would be an OCA when having a common currency or not. Feldstein (1997) outlines four factors identified by Mundell, that are important in the absence of flexible exchange rates and interest rates: homogeneity, wage and price flexibility, labour mobility and fiscal transfers. When countries in a monetary union are very different in economic structure due to differences in GDP structure and trading partners, a demand shock will have asymmetric effects in the union, which causes for example inflation in one country and unemployment in the other country. This requires expansionary monetary policy in the first country and contractionary policy in the second, which could not be achieved simultaneously with one monetary policy for the union thus making homogeneity between countries important (Mundell 61). In the EMU, countries also have different structures. The northern members have more capital and skilled labour endowments compared to the southern countries (Krugman, Obstfeld & Melitz 2012).

Flexible wages and prices could also smooth the shocks when adjusting to a level that maintains the full level of employment. Then the absence of national interest rates and exchange rates won’t be critical, since adjusting those variables is not necessary to restore employment. Nevertheless, it becomes clear from the structural employment level in the EMU that this is not the case in the Eurozone. In the short run, prices and wages are sticky, especially a downward stickiness applies for wages (Krugman et al. 2012). Another way that could keep the level of unemployment unchanged, is the existence of labour mobility. If employees are prepared to move to areas where there is demand of labour, unemployment could be reduced. Although there is free movement of labour in the EMU, labour migration is limited. The language and cultural barriers prevent mostly the cross-‐border movements. Also government regulations limit the mobility. Some European countries only provide unemployment benefits if the employees found residence, which make it harder to work elsewhere (Krugman et al. 2012). Finally, the existence of fiscal transfers could also offset a negative demand shock. Wyplosz (2006) argues that in order to attenuate asymmetric shocks, a fiscal transfer from the strong country to the weaker country is needed. These automatic transfers could be assured by tax systems. Since the EMU has only small fiscal federalism, it does not fulfil this criterion very well. In section 2 we will see how the shock of the global financial crisis hit the EMU countries, with structural economic differences, asymmetrically.

1.2.2 The weaknesses of the Stability and Growth Pact

At first the SGP was invented to ensure sound fiscal balances and sustainable government debt, however it suffered from critics about its weak enforcement and other flaws, such as the voting

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and decision making process (Irlenbush & Sutter 2006). De Haan, Berger and Jansen (2003) address the weak enforcement of the pact with a distinction between soft law and hard law. The first one refers to general rules not included in the legal force but which may have legal and practical effects. The latter one refers to legal rules that are binding, precise and assign authority to an independent entity for interpreting the law. The preventive arm of the pact relies mostly on soft law. For instance the ECOFIN Council (Economic and Financial affairs Council) cannot automatically impose sanctions, for the reason that the council needs to vote about the sanctions. Moreover, the ECOFIN council can never obtain control over the government budgets since there is fiscal sovereignty. The council can only exercise pressure on the countries to

reduce their deficits.

This pressure will be stronger in two cases. First, a country will experience more pressure the bigger the negative externalities of the excessive deficits. Unsustainable debt in one country can push up the interest rate in the union because of the anti-‐inflationary monetary policy, causing higher debt servicing costs for all the members (De Grauwe 2012b). However the main refinancing rate of the ECB remained fixed from 1999 to 2008 (ECB key interest rates). The second factor that could lead to pushing the weaker countries to tighten their budgets is the deterioration of its reputation by higher bond rates or lower credit ratings, however the countries were not severely punished by the financial markets and the interest rates on the countries with high debt burdens stayed relatively low (De Haan et al. 2003). The paper further argues that the corrective arm, the EDP, mainly relies on hard law. However, it also suffered from weak enforcement, for the reason being that the bigger EMU countries felt less obliged to bring down their deficits to the balanced budget than the smaller countries. The small countries had an average surplus of 1% between 1997-‐2002, while the bigger countries had on average a deficit of 1.5%. The medium-‐sized members were on average in balance in the same timeframe. This is related to the fact that bigger countries are less likely to loose their influence on European policies. So both the soft and the hard law mechanism didn’t work properly.

The second weakness of the pact, the voting process, is described by Irlenbush and Sutter (2006). They question the usefulness of the pact since it has a voting system that takes considerable time and is very complex. They studied the effectiveness of the institutional set-‐up of the SGP in relation to the sanctions of EMU-‐members in the excessive deficit procedure. Their results show the existence of two major shortcomings. First, it becomes clear that the bigger countries can more easily block sanctions relative to the smaller member states. The bigger economies have more voting rights and according to De Haan et al (2013) are less likely to loose influence on EU decisions. An example of the difference between the bigger and smaller countries is provided in 2002. When Portugal in August 2002, had a deficit of 4.1% of GDP, the European Council imposed the first excessive deficit procedure. However, when Germany was

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likely to exceed the 3 per cent deficit rule in October 2002, the European Commission argued for a looser interpretation, preventing Germany from entering the EDP (Irlenbush & Sutter 2006). At the time Germany and France exceeded their budget deficit/GDP ratio in 2003 and 2004, they successfully blocked sanctions that were imposed (Pilbeam 2013). Second, the decision mechanism allows that countries in the excessive deficit procedure can also vote about the sanctions of the other countries (Irlenbush & Sutter). The ECOFIN council consists of the ministers of economics and finance, including the ministers of the countries that broke the rules themselves. The table below illustrates how often the rules were not obeyed since 1995. Since 1995, not a single time a sanction was imposed although in 97 cases they should have been imposed (Sinn 2014b).

Table 2. Violations of fiscal rules

Deficit above 3% ceiling Due to severe recession Sanctions should be levied

148 51 97

Further, De Grauwe (2012b) argues that the no-‐bailout clause lacked credibility. The spreads on the government bonds in the eurozone over the bunds where almost zero since the start of the euro. Although a country could default since a bailout was forbidden, default risk was not priced in and ignored by the market.

2. The European Sovereign Debt Crisis

This section describes the onset of the housing crisis in the US and how it spilled over to the rest of the world. We will see how the imbalances and weak structural fundamentals created by the EMU in the periphery countries led to the Sovereign debt crisis in the euro-‐area and what the impact was on the government’s account, bank’s balance sheets and Target balances. In addition, the measures taken by the ECB and IMF in reaction to the crises will be covered.

2.1 Start of the Global Financial crisis

The first phase of the global financial crisis started with the shock to the house prices in in the US in 2007, significantly affecting subprime mortgages. The asset-‐backed securities related to those subprime mortgages declined sharply in value. The markets dried up and confidence decreased. As a consequence a bank run on short-‐term debt emerged. Because entities that were based on short-‐term debt could not roll over the debt, or were subject to withdrawals, this shock to housing prices spread rapidly to other asset classes. European banks were highly reliant on the US money markets with a high exposure to US asset-‐backed securities, leading to the global

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financial crisis.

The crisis got more severe with the collapse of Lehman Brothers in September 2008. In many European countries, announcements of bank bailouts were made. The most dramatic example of such a bailout in the eurozone was the bailout by the Irish government in September 2008. Almost all major banks, for instance the Anglo Irish bank, were nationalized (Pilbeam 2013). The bank bailouts included injections of equity, asset-‐purchase programs and debt guarantees, or sometimes a combination of those (Hoque 2013).

The financial crisis had as a consequence that the capital transfers between the euro countries changed. Investors were withdrawing their funds from the periphery countries and reinvested it back into the core countries. The current account surpluses of the stronger countries no longer increased, and the deficits in the periphery countries reduced, although the deficits were not entirely evaporated (Sinn 2012).

During 2008 and 2009, the main emphasis lied on the stabilization of the financial and banking system. The bond spreads on ten-‐year sovereign bond yields of member states such as Portugal, Ireland, Italy, Greece and Spain were still only slightly higher than on German bunds (Lane 2012).

2.2 From Global Financial Crisis to Sovereign Debt crisis

2.2.1 Deterioration in government accounts, banks balance sheets and Target balances

At the end of 2009, the European sovereign debt crisis entered a new phase when some countries announced a higher deficit as percentage of GDP than was anticipated. Especially the revelation in October 2009 of the Greece budget deficit of 12.7 per cent of GDP, which was more than twice the estimated deficit of 6 per cent GDP, deteriorated the market sentiment in the euro-‐area (Gilbert, Hessel & Verkaart 2013). Moreover, the structural borrowing problem of Greece was totally revealed during the financial crisis. In addition, it became evident that French and German banks possessed 70 per cent of the Greek debt (Pilbeam 2013). The fear of default and contagion to other countries led to two rescue packages for Greece under supervision of the Troika, which consists of representatives of the European Commision, the ECB and the IMF (De Bruyckere, Gerhardt, Schepens & Vennet 2013). In 2010, the Irish deficit reached 30.6% of GDP. The bailout of the Anglo Irish Bank contributed 16 per cent of the deficit in this fiscal year. The Spanish Government made several capital injections into commercial banks as Banco Financiero y de Ahorros, consequently resulting in an increase of the sovereign debt level (Eurostat Government and Finance Statistics, Supplementary tables for The Financial crisis).

The increase in the Sovereign debt burden and the ongoing stress in the banking system further intensified the interdependence between the banks and the countries. Through four

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channels the high sovereign debt level spilled over to banks that had great exposure to this sovereign debt. First of all, the losses on sovereign debt led to a deterioration of the asset side of the balance sheet through the asset holdings channel. Many European banks had highly invested in Government bonds that were now decreasing in value (Feldstein 2011). The second channel is the collateral channel, since the value of collateral in the form of sovereign debt decreased. Third, the rating channel may cause a reduction in access to the money markets for the banks, because a downgrade in a countries credit rating may affect the rating of national banks. The last channel is called the guarantee channel. The governments became more vulnerable, reducing the value of government guarantees for the national banks (De Bruyckere et al. 2013).

As described in paragraph 2.1, the current account imbalances were reduced since the start of the crisis in 2007. However, to eliminate the current account deficits, a large cut in the real wages is needed that could lower the prices (Feldstein 2011). In 2011, in most of the southern EMU countries, the current account deficits were still the same as the average of the first five years of the single currency. Since the markets no longer provided funding for the current account deficits, the question is how these deficits were funded. Sinn and Wollmershäuser (2012b) describe this development with Target balances. Target (Trans-‐ European Automated Real-‐time Gross settlement Express Transfer system) is an acronym for the payment system of the ECB and the NCBs. These balances measure the intra-‐euro area claims and liabilities or the financial transfers between the NCBs in the EMU that arise when public or private financial entities make payment orders to the commercial banks. It shows how the net refinancing credit of the ECB is allocated trough the Eurosystem. To be able to finance the current account deficits, the periphery NCBs were lending at expense of the NCBs in Northern Europe. The first ones became net creditors of the Euro system, the latter ones net debtors. Those transfers included goods and assets, as well as financial transactions.

In figure 4 we see that up until the start of the crisis, the Target balances had been almost zero (Sinn & Wollmershäuser 2012b). In 2007, with the start of the financial crisis the imbalances grew, but started to increase dramatically by 2010 when the interbank lending declined substantially. Some countries needed credit to pay back their outstanding debt. This shortage was funded by the additional refinancing funds provided by the NCBs, by printing money, to the commercial banks and led to the Target imbalances. After 2012, the imbalances declined due to the guarantees of the OMT and the ESM, which will be discussed in paragraph 2.3. In case of a default and a country exit the euro, the claim against the negative balances of this country’s NCB remains. However, we could not be sure that when a country defaults, its NCB can service the losses. The losses are then imposed on the other NCBs, based on their capital share in the ECB, which could therefore be a threat to the persistence of the Eurosystem (Sinn & Wollmershäuser 2012a).

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Figure 4. Target Balances in the EMU

Source: CESifo, Target balances. Notes: Core countries: Germany, Netherlands, Luxembourg and Finland.

2.2.2 Determinants of interest rate differentials in EMU

Financial markets began to anticipate substantially the differentials in fundamentals between the EMU countries. This led to a further negative impact on the sovereign bond values causing the differentials in government spreads, over German bunds, to rise significantly (see Figure 1). Favero, Carlo Ambrogio, and Alessandro Missale (2012) argue that there are different reasons that could explain the difference in spreads. The first explanation they mention is the credit risk. Because investors require a risk premium when sovereign countries have a higher risk of default. The financial markets were concerned about a contagion between the GIIPS. When Greece would default, speculative attacks could cause such high yields on other GIIPS debt that they would also default. The second explanation is the liquidity risk. This risk arises when bonds must be sold or issued in a small market, causing unfair pricing and increasing transaction costs (Favero & Missale). Due to the panic that arose in the financial markets, investors turned their risky debt into assets that were considered safe. This panic resulted in a ‘ flight to safety’ to government bonds of countries as Germany and the US (De Grauwe & Moesen 2009).

Bernoth and Erdogan (2012) also explain the sudden increase in spreads by the time-‐ varying risk premium. They found that the influence of fiscal fundamentals and the investors’ risk aversion on the sovereign yields varies over time driven by market sentiment. When the credit boom burst the market response to the fiscal weakening now raised substantially due to the increase in risk pricing. This disciplinary role of the financial markets did not prevail at the beginning of the EMU.

-‐1100 -‐900 -‐700 -‐500 -‐300 -‐100 100 -‐100 100 300 500 700 900

1100 Billion euros Billion euros

Core Germany GIIPS (right-‐ hand scale)

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2.3 Policy responses to the European Debt Crisis

In the aftermath of the Global financial crisis and during the Euro crisis, several policy measures were taken. Two institutions were created by the euro area members to provide funding to distressed countries, the EFSF and later the ESM. The ECB responded with several unconventional policy measures, like the SMP and OMT, to provide liquidity and reduce the increasing sovereign spreads over Germany. This paragraph discusses these measures in more detail.

2.3.1 The EFSF and ESM

The European Financial Stability Facility (EFSF) was a temporary rescue fund that came into force in August 2010. The EFSF facilitated additional funding for the countries that had very limited access to the capital markets or paid exceedingly high interest rates on their debt. Since the high exposure of German and French banks to Greek debt and the debt of the other GIIPS countries, the EFSF was created to prevent contagion to other euro countries in case of a Greek default, and to persuade the financial markets of the support of the European leaders of the common currency. The EFSF was able to issue bonds backed by €440 billion, based on the countries’ capital placed in the ECB. The EFSF has provided loans to Ireland, Portugal and Greece. The persistent nature of the Euro Sovereign Debt crisis, the contagion to other euro countries and the danger of a Greek default in the fall of 2010 called for a bigger fund. The EFSF was only a temporary rescue fund and was replaced by the permanent rescue fund, European Stability Mechanism (ESM). The ESM took effect in October 2012 (Gocaj & Meunier 2013). The lending ability of the ESM was raised to €500 billion, guaranteed by the member states and could purchase bonds directly in the primary markets. A total amount of 80 billion of capital would be placed in the ESM by the member states. The EFSF could provide any new loans until June 2013. The loan to Greece, provided before June 2013, is extended until June 2015. A country that faces liquidity problems can request funding from the ESM upon austerity packages and several conditions related to the loans (Pilbeam 2013).

2.3.2 The SMP and the OMT

In May 2010, the Securities Market Programme (SMP) was called into action by the ECB. The programme was introduced to purchase government bonds to provide liquidity in the secondary market and reduce the government spreads. Those purchases were sterilized in order to keep the monetary base unchanged. The SMP was implemented in two phases, in the first half of 2010 and in the last half of 2011 (Falagiardaa & Reitzb 2015). The ECB announced that it would have a senior status to private lenders. In the months following the statement the government spreads against the German bund did not decline, instead they increased (Steinkamp & Westermann

Balancing the EMU : the imbalances created by the euro : how could the implementation of Eurobonds contribute to the stabilization of the EMU?

Balancing the EMU

The imbalances created by the euro: ‘How could the implementation of Eurobonds

contribute to the stabilization of the EMU?’

Eveline van ’t Spijker

10400982

BSc Economics and Business

Supervisor: Dr. C.G.F. van der Kwaak

04-­‐07-­‐2015

Balancing the EMU

Abstract

Table of contents

2

List of figures and tables

Introduction

1. The prior crisis phase

2. The European Sovereign Debt Crisis

04-‐07-‐2015