INTERNATIONAL FINANCIAL MANAGEMENT

GROUP 2HASAN NAYYAR 16CJASMIT SINGH CHAWLA 19CKAPISH KAUSHAL 20CKUMAR VIVEK 22CNISHANT SHEKHAR 27CSHASHWAT SINHA 41CSHREYASH AGARWAL 42CSURJODEB SARKAR 44CVAIBHAV GUPTA 47C

LAYOUT

GREECE, PORTUGAL, SPAIN, IRELAND AND

ITALY: DETAILED REVIEW

CAUSES OF THE CRISES IN GENERAL

OPTIMUM CURRENCY AREA THEORY

FROM EMS TO EURO

GENESIS OF “THE IDEA OF A COMMON CURRENCY”

After the end of WW II in 1945, many EU leaders agreed that economic cooperation and integration among the former belligerents would be the best guarantee against a repetition of the 20th century’s two devastating wars.

The result was a gradual ceding of national economic policy powers to centralized EU governing bodies such as European Commission in Brussels and European System of Central Banks, headquartered in Frankfurt, Germany.

The first significant step was the European Monetary System

EUROPEAN MONETARY SYSTEM

Germany

(2.7% inflation)

Italy (12.1%

inflation)In 1979, with a wide divergence in inflation rates, the prospects for a successful fixed rate area looked bleak

However, through a mix of policy cooperation and realignment, the EMS fixed exchange rate club survived

MEASURES TAKEN TO MAKE EMS SUSTAINABLE

•Most exchange rates fixed actually could fluctuate up or down by as much as 2.25% relative to assigned par value

•Several members were able to negotiaite bands of +_6%.

Monetary Policy

Autonomy

•Generous provisions for the extension of credit from strong to weak currency members

•Maintaining capital controls

Safety Valve

•Italy gained creditability by placing monetary policy decisions in the hands of the inflation fearing German Central Bank

Creditability

FROM EMS TO EURO

A SINGLE EU CURRENCY WAS INTENDED AS A POTENT SYMBOL OF EUROPE’S DESIRE TO PLACE COOPERATION AHEAD OF THE NATIONAL RIVALRIES, AND ACTING AS ONE TO COMPETE AGAINST THE DOLLAR

Greater degree of European market integration.

Eliminating costs to traders of converting one EMS currency into another

ECB would be more considerate of other countries problems

THE THEORY OF OPTIMUM CURRENCY AREAS

This theory predicts that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

THE MORE EXTENSIVE ARE CROSS BORDER TRADE AND FACTOR MOVEMENTS, THE GREATER IS THE GAIN FROM A CROSS BORDER EXCHANGE RATE

GG SCHEDULE LL SCHEDULEGG

Degree of economic integration between the joining country and the exchange rate area

Monetary Efficiency gain

LL

Economic Stability Loss

GG Schedule shows how the potential gain to a particular country from joining the Euro Zone depends on the country’s trading links with that region.

The cost of joining the Euro is that the country will have to give up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. This economic stability loss from joining is related to the country’s economic integration with exchange rate partners and graphically shown by LL schedule

Degree of economic integration between the joining country and the exchange rate area

Gains and losses for the joining country

LL Schedule

GG Schedule

Q1

Gains exceed lossesLosses exceed gains

The country should only join the single currency, if its degree of economic integration is greater than Q 1

IS EUROPE AN OPTIMUM CURRENCY AREA?

The overall degree of economic integration can be judged by looking at the integration of product markets, that is, the extent of trade between the joining country and the currency area, and at the integration of factor markets, that is , the ease with which labor and capital can migrate between the joining country and the currency area.

There is evidence that national financial markets have become better integrated with each other as a result of the Euro, and this has promoted intra-EU trade. But while capital moves with little interference, labor mobility is nowhere near the high level countries would need to adjust smoothly to product market disturbances through labor migration.

Britain Germany Italy USA

1.7 1.1 0.5 3.1

People changing region of residence in the 1990s(% of total pop)

Source: Peter Huber

CAUSES OF THE EURO CRISIS

Euro Introduced => Interest rates decline in PIIGS countries to

those of Europe’s stable countries

Domestic demand and consumption in PIIGS increased => increased spending led to higher foreign

debts

The prices of domestic activities

rose=> Investment in non-tradable sectors increased vis-à-vis

ExIm

Exports from prosperous Eurozone countries increased

following the growing demands in PIIGS. Deutschemark

higher than Euro

Demand spurred increased wage

costs. Emergence of China =>lower

competence of PIIGS

Pan-European monetary policy , loose on PIIGS &

tight on Germany=> loss of

competitiveness

Tax revenues increased in PIIGS,

govts. increased spending.Blatant

fiscal mismanagement in

Greece

2008 crisis made tax revenues collapse.

Govt. spending unfeasible &

competitiveness decreased, so

foreign demand couldn’t be tapped

Greece

agriculture: 3.6%industry: 18%services: 78.3% (2011 est.)

GDP

Unemployment rate

INVESTMENT

DEBT

Inflation

EXPORTS

IMPORTS

Exchange Rates

0.7715 (2010) 0.7179 (2009) 0.6827 (2008) 0.7345 (2007) 0.7964 (2006)

Country--Old Currency Rate

Belgium--Belgian franc 44.3399Greece--Greek drachma 340.750France--French frank 6.55957Italy--Italian lira 1936.27Netherlands--Dutch guilder 2.20371Portugal--Portuguese escudo 200.482Germany--Deutsche Mark 1.95583Spain--Spanish peseta 166.386Ireland--Irish pound 0.787564Luxembourg--Luxembourg franc 40.3399Austria--Austrian schilling 13.7603Finland--Finnish markka 5.94573

GREECE

Debt repayment

With any debtor, there is a chance they will not be able to repay their debts. These figures in the above graph express the likelihood as a percentage called the Cumulative Probability of Default (CPD)

The figures express the probability of a country defaulting sometime over the next five years

Greece : Economic Woes

• Its government owes about 300bn euros ($400bn; £260bn)• spread over three years - but on condition that Greece slashes

public spending and boosts tax revenue.• Ratings agency S&P has already downgraded Greek debt to

"junk", which means it views Greece as a highly risky place to invest.

• As the money flowed out of the government's coffers, tax income was hit because of widespread tax evasion.

Options for Greece Europe/IMF continues to bail out Greece• Bail out are most effective for temporary and short term mismatches• Greece lacks any credible fiscal control program• Spending cuts have met with widespread resentment• Large current account deficit means a pressure to raise foreign savings

Exit the EURO• Could default and devalue its currency, thereby providing scope for improving

competitiveness• Would shift some of the debt burden to foreign creditors and avoid further debt build-up• Could trigger an even greater financial crisis• Reintroducing Drachma would lead to re-pricing of all contracts with no clear idea of how

to achieve this• It will also antagonize other Euro members and have huge political risks• Will affect trade with Euro zone which accounts for 2/3 of its total trade• There is no provision in Euro treaty for a country exiting the same and thus it will affect all

contracts and other legalities

Greece Defaults and Restructures its debt• Most viable option available• Will affect the banking system but that is a price for ignoring associated risks for

such a long time• There are fears that this might lead to a Lehman king of moment due to huge

interlinks in the banking system

Soft Restructuring involving private sector• Plans to share the debt burden with private sector akin to soft restructuring of

government debt• Would involve creditors exchanging their soon to mature bonds with debt for

longer maturity• Would however lead to large losses for banks and recapitalizing them would

require further borrowing

The way out !! • Restructuring its debt while at the same committing to strong fiscal

measures • Cut its budget deficit, or the amount its public spending exceeds

taxation, to 8.7% of its GDP in 2010, and to less than 3% by 2012. • Just before the massive bail-out package was announced the Greek

government pledged to make further spending cuts and tax increases totalling 30bn euros over three years - on top of austerity measures already taken.

• Greece plans to freeze public sector workers' pay, make further cuts in civil servants' benefits, hike VAT (sales tax) and fuel duty, raise the retirement age and reduce pensions.

• Greece's Socialist government says the nation faces "sacrifices" in a "choice between collapse or salvation".

PORTUGAL

• Unlike its most vulnerable Euro area counterparts, Portugal saw its boom that followed the adoption of the euro fade quickly.

• In the run up to the launch of the euro, its GDP had grown at an average annual rate of almost 4 percent —one of the highest rates in the Euro

• However, the demand boom, which was triggered by a sharp decline in interest rates and fueled by expansionary fiscal policy, was not followed by a parallel increase in potential supply

• Between 1995 and 2000, private savings dropped by about 7 percentage points of GDP, while average gross fixed capital formation had accelerated. Household and non-financial sector debt more than doubled in percent of GDP terms between the mid-1990s and 2002.

• Reflecting external borrowing’s role in financing consumption and investment, the current account deficit soared to 9.0 percent in 2000, up from near-zero in 1995.

The euro’s adoption led interest rates to fall sharply in Portugal—from an average of 12.3 percent in 1991–1995 to about 6 percent in 1996–2000—setting the stage for a consumption boom.

After formal adoption of the euro, monetary policy in the Euro area, while clearly too loose for Greece, Spain, and Ireland, who saw housing booms, was too tight for Portugal, where housing investment as a percentage of GDP had declined over time and inflation had dropped.

Significant labor market tightening and rapid wage increases had characterized the

boom.

The consequence was an appreciation in the real effective exchange rate (REER)—about

12 percent from 1994 to 2000.

This appreciation led to a build-up of macroeconomic imbalance & was reflected

in current a/c deficits.

Effects of the euro boom

As household spending stalled amid high levels of debt—the investment and consumption boom came to an end.

Causes of end of Euro boom.

• Portugal’s export structure at the launch of the euro was too weighted towards traditional slow-growing sectors where comparative advantage was shifting toward the emerging economies in Asia. The share of production in low-tech manufacturing sectors, for example, was 80 percent in 1995 and 73 percent in 2001.

• Another important factor was the inflexibility of portugal’s labor markets.• Rapid deterioration of competitiveness

Reasons for it:

• The country’s relatively low human capital formation • Limited use of information technology

At the same time, labour productivity slowed & was well below EU average—32 percent in agriculture, for example—in all sectors of the economy.

Effect of crisis on

unemployment

•There has been an increase in unemployment after 2002

The downturn also had a significant impact on unemployment, which reached 10.7 percent in 2010, up three percentage points from two years ago—a relatively modest increase by the standards of Spain and Ireland.

• Portugal’s spending on R&D as a percentage of GDP is half of the average in the Euro area. • Furthermore, its governance and business climate indicators are today among the lowest in

the euro area.

Current scenario

Increase flexibility in labour markets.

Increase competition in relatively sheltered backbone services.

Impr

ove t

he

huma

n ca

pital

base s

o t

hat

pr

oductivity is i

mpr

ove

d a

nd c

ountry regai

ns attractive

ness

wit

h f

oreig

n i

nvest

ors.

Policy Recommendations

SPAINSjfjfjkjSPAIN

Euro timeline of Spain

Joined EU

Adopted euro as the official currency

Issuance of euro banknotes and coins after a 3 year transition period

1986

19992002

Problems After Euro adoption

•Huge misallocation of resources

•Loss of competitiveness

•Large Deficits and rising public debt

Public Debt(% of GDP) Unemployment rate(%)

Causes of the Crisis

Housing sector boom and bust: At its peak, construction value-added reached 17 percent of GDP. In just ten years, Spain’s housing prices more than doubled, and, at the peak in 2006, Spain started more homes than the UK, Germany, France, and Italy combined.

Interest rates plummeted and confidence soared, leading domestic demand and inflation to rise more than 1.5 times faster than the Euro area average.

Labor cost and the unit labor cost increased by nearly 200% between 2000-2010 which was not in line with productivity

19981999

20002001

20022003

20042005

20062007

20082009

-2

-1

0

1

2

3

4

5

6

7

8

ULC(%)

ULC(%)

RemediesStart with government spending

Encourage reallocation across sectors

Reduce the unit cost of labor

Remedies

IRELAND- The Celtic TigerThe collapse of the Irish economy has come as a particular shock to many people, at home and abroad, because of its seemingly remarkable success in the preceding years

THE GOOD OLD DAYS• Growth was largely based on the attraction of (mainly US) multinationals taking advantage of Ireland’s low corporate profits tax rate• using the country as a base from which to export to the EU• ‘Transfer pricing‘ mechanisms used• After 2001, economic growth was based largely on a property price bubble

THE PROBLEMThe Main Reasons for the country specific problem

After 2001, economic growth was based largely on a property price bubble

Investment in buildings accounted for 5% of output in 1995 but for over 14% in 2008

Fuelling the property price bubble was a massive rise in household debt, which shot upwards from €57 billion in 2003 to €157 billion in 2008

Lending for mortgages rose from €44 billion in 2003 to €128 billion in 2008

Irish banks were themselves borrowing in order to lend on to their customers: the 6 main Irish banks borrowed €15 billion from abroad in 2003 but this figure had risen to €100 billion by 2007.

The European DimensionThe European Dimension

•This reckless splurge was facilitated by liberalised lending practices across the EU and by lax cross-border regulation of the financial sector• The very design of Economic and Monetary Union (EMU) helped cause the crisis by establishing exchange rates that left peripheral EU countries uncompetitive relative to Germany and encouraged the peripherals to rely on the accumulation of debt to ‘compensate’ for this• The Irish authorities also contributed to the property bubble with a range of tax incentives to property development.

Bailing out the banksBailing out the banks

• When the global financial crisis hit, access to credit declined drastically worldwide and asset values tumbled• The Irish government chose to respond to the plight of the banks in an extraordinary manner: on 30th September 2008 all depositors and senior bondholders (creditors to the Irish banks) were guaranteed by the state• An example of a contingent liability arises from the Irish state creating a National Assets Management Agency (NAMA) to buy up some of the worst property loans in the hope of selling them on later

THE PROBLEM

Corrective

actions

taken

Austerity for

ordinary people

A loan of €58 billion

from the IMF and

EU was contracted

in December

2010 - at an interest

rate of 5.8%

How Ireland is linkedHow Ireland is linked

• Despite all the upheaval surrounding bank funding and debt problems in Greece and Italy, investors are betting that one country is seeing better days: Ireland• Its economy expanded 1.6% in the second quarter after growing 1.9% during the previous quarter• Irish 10-year yields slipped below 10% for the first time since Portugal's rescue, according to Bloomberg• To be immune a cautious measure which helps increase further exports and spending• In spite of this there can be further problems as there are higher risks of the contagion

SOME OPTIONS

CAN EURO SURVIVE

• In June 2010, banks in Austria, France, Germany and the Netherlands had nearly one-quarter of their overall loans tied up in those weaker economies. Should the countries drop the euro and default on those loans, worth an estimated €1.9 trillion, the impact would be catastrophic for both the banks and their home countries• The countries that desert the euro and attempt to reinstate their old currencies inevitably would face rapid, severe devaluation• Greeks, fearing the disastrous consequences of a return to the drachma on their personal accounts, they would naturally transfer their assets to Germany or another euro zone state• European fiscal union• Eurobonds• The heads of state are confused and more of self interests are put forth.

Adoption of Euro, Confidence

goes up

Interest Rates fall to Stable North

European Economy levels

Domestic Demand rises, so Government Happy

Spending goes up, debts are born, often owned

abroad

Growth accelerates prices of domestic activities,

investment in less productive non-tradable sectors away

from exports, imports surge

Germany & Netherlands cash in, increase their

exports taking advantage of favorable monetary

policy

Rapid wage growth outpaces productivity,

increasing unit labour costs and eroding external

competitiveness further

China emerges; currency depreciation and rapid labour productivity growth in export

sectors of USA and Japan add to the competitiveness problems

Lower borrowing costs and the expansion of domestic

demand boost tax revenues, fiscal

mismanagement ensues

Recession hits - Result – High public and private

debtsWeak long-term growth

prospects

What is Italy’s Crisis???

Why is Italy in Crisis??? One of the largest economies of the world

(6 times that of Greece itself) Problematic Sovereign Debt & Fiscal Deficit Fragile European Banks (holding the debt) Secular Loss of Competitiveness due to Euro adoption

(too loose monetary policy) Political Instability, doubtful future Non-tradable investments increasing, hence exportables

not keeping pace with boom Specializes in low-skill goods, has lost the most market

share in its traditional geographic markets Heavily oil-reliant country that imports 93% of its supply

Numbers say it better…

Italy - Current Account BalanceSource: T,C&S & World Fact book

Numbers say it better…

Italy - Unemployment FiguresSource: Google Public Data

Numbers say it better…

Household savings rate drop 5.7 % points from 1997 to 2007

% increase in unit labour cost in Euros (Q1 2001 to Q3 2009)Italy: 32%Germany: 6%

Source- Carnegie Endowment For International Peace

From 1996 to 2004, Total Factor Productivity declined at an average annual rate of almost 1 %

Source- Carnegie Endowment For International Peace

What can/has to be done???POLICY RECOMMENDATIONS

Bring down debt-to-GDP ratio by increasing its primary

balance by 4 percent of GDP at least

Must cut its unit labour costs in order to regain its lost

competitiveness

Enact critical structural reforms that would include

removing rules that create a dual labour market and

increase the efficiency of backbone services

IS THERE LIGHT AT THE END OF THE TUNNEL?

The first step to the solution of protecting the Euro is a political support of all the governments because its not about saving one country or region. It is about saving the world from a downward economic spiral.

ECB can soothe markets by buying bonds, but only to a certain point.If the 17 member states of the single currency area would be able to borrow in bonds issued by a European debt agency. These would be jointly guaranteed by all euro area countries and underwritten by the most creditworthy of them i.e. Germany.

Advantages:

1. A common euro bond would create a large new government bond with lot of liquidity. This would attract a lot of investors particularly China, which is keen to diversify its dollar holdings.

2. An underlying rationale for Eurobonds is that the public finances of the euro area as a whole look quite respectable…The IMF envisages that general government debt will reach 88% of the single currency zone's GDP this year. This is lower than America's 98% and not much higher than Britain’s 83%. The euro area's projected budget deficit will be a bit above 4% of GDP, rather better than America's 10% and Britain's 8.5%