Euro-zone and Growth

Information Security Identification: Confidential

Euro-zone and Growth

Presented by Simon Derrick

February 2012


What is the Euro-zone?

• An economic and monetary union:

A trade bloc which is composed of a common market and customs union with a monetary union.

It is not a debt union

It is not a fiscal union

It is not complete economic integration

• As a result

Monetary policy of the zone is the responsibility of the European Central Bank

There is no common representation, governance or fiscal policy for the currency union.

• The primary means for fiscal coordination are the Broad Economic Policy Guidelines. These are not binding.

• Members are expected to respect the Stability and Growth Pact, which sets agreed limits on deficits and national debt, with associated sanctions for deviation.


The post 2002 external environment

• Since start of 2002 the average Fed Funds target rate has been 2.01%. The average level of headline inflation has been 2.41%.

• US was not the only nation pursuing an aggressively easy monetary policy. In March 2001 Japan introduced policy of quantitative easing.

• US, Japan and China also involved in extended battle over currency policy.

• Investor behaved in a rational manner and bought:

Currencies supported by central banks with a strong, anti-inflationary stance.

Precious metals such as gold

Equity markets in nations with currencies linked to the USD that were likely to benefit from export fuelled growth

Commodities (such as oil) that were likely to be in demand as export booms in China (and elsewhere) continued on.


Central bank behaviour

• According to the IMF, in the first quarter of 2002 total FX reserves globally stood at just over USD 2 Trn. Out of this amount the Fund knew how USD 1.57 Trn of reserves had actually been allocated with 71% being held in USDs and 19.7% in EURs.

• By the summer of last year total FX reserves had jumped to over USD 10 Trn while the USD now only represented 60% of known holdings. The EUR’s share, in contrast, now came to 26.7%.

• The main growth in the reserves of emerging and developing economies, rising from USD 824 Bn to USD 6.844 Trn. The USD moved from representing 74% of known holdings to 56.5%. The EUR’s share, in contrast, moved from 19.3% to 28.6%.

• China has seen the most dramatic growth in its reserves, rising from USD 227 Bn at the start of 2002 to USD 3.201 Trn at the end of September 2011.

• Although we do not know how the split of these reserves has changed over time, we do know that according to The China Securities Journal (in an article from Sept 2010) around 65% of the nation’s reserves remained in the USD while 26% was invested in the EUR, 5% in GBP and 3% in JPY.



Investors treated Euro-zone as if it were a debt union


Investors treated Euro-zone as if it were a debt union (2)




Public sector borrowing boomed in Italy…


…and in Greece


And the impact was…

-8

-6

-4

-2

0

2

4

6

8

Mar

-01

Sep-0

1

Mar

-02

Sep-0

2

Mar

-03

Sep-0

3

Mar

-04

Sep-0

4

Mar

-05

Sep-0

5

Mar

-06

Sep-0

6

Mar

-07

Sep-0

7

Mar

-08

Sep-0

8

Mar

-09

Sep-0

9

Mar

-10

Sep-1

0

Mar

-11

Sep-1

1

Italian GDP % y/y German GDP % y/y


And the impact was…

-8

-6

-4

-2

0

2

4

6

8

10

12

Mar

-01

Jul-0

1

Nov

-01

Mar

-02

Jul-0

2

Nov

-02

Mar

-03

Jul-0

3

Nov

-03

Mar

-04

Jul-0

4

Nov

-04

Mar

-05

Jul-0

5

Nov

-05

Mar

-06

Jul-0

6

Nov

-06

Mar

-07

Jul-0

7

Nov

-07

Mar

-08

Jul-0

8

Nov

-08

Mar

-09

Jul-0

9

Nov

-09

Mar

-10

Jul-1

0

Nov

-10

Mar

-11

Greek GDP % y/y German GDP % y/y


The December summit

• The real choice facing the Euro zone at the December summit was whether or not is was going to remain a “stability union”.

If it was then its more peripheral members would need to decide whether they were going to transform themselves into Germanic economies or make a dignified exit.

If, instead, it was to make the move towards true “fiscal” union then Germany (and the other Northern European states) would need to be prepared to pay more to borrow money themselves while the more peripheral members would have to be willing to sacrifice a significant degree of political independence.

• The December 9th decision made it clear that the Euro zone will remain a “stability union”


Greece

• Spiegel Online reported in September that a representative from the German finance ministry had given a presentation in Brussels on the possible consequences of a Greek default.

The official argued that there were two basic possibilities: Either Greece remained in the EUR or exited. In either case there would be a significant haircut. As a result, the goal should be to contain the damage.

Magazine also quoted the “government experts” as arguing that even if Greece were to exit then the consequences would be manageable.

• Der Spiegel reported again in November that the German government had put together contingency plans in the event that Greece quit the Euro-zone.

• President Sarkozy and Chancellor Merkel stated in November that “the question is whether Greece remains in the Euro zone. That is what we want, but it is up to the Greek people to answer that question.”


Developments since November

• The IMF now predicts that the Greek economy will have contracted by up to 6% in 2011 (versus Greece's official estimate of -5.5%) ahead of a downturn in 2012 in the region of 2.75% to 3%.

• It argues that “the most important factor has been the slowing pace of structural reforms this year … Greece is still well away from the critical mass of reforms needed to transform the investment climate.”

• Der Spiegel reported last month that the Fund is losing confidence in Greece's ability to clean up its public finances and work off its mountain of debt. The magazine said the IMF saw three options:

Athens enacts further austerity measures

Private creditors write off more of their investments in the country's sovereign debt

States in the Euro-zone increase bailout aid.


The “so what”

• In late November the Bank of Greece argued in its interim monetary policy report that the EUR130 billion bailout package represented a last chance for the government to make good its reform program.

• It said that a failure would lead to “an uncontrolled downward trajectory that would undermine many of the achievements that have been attained in recent decades, drive the country out of the euro area and set Greece's economy, standard of living, society and international standing back many decades.”

• Even more bluntly it stated: “What is at stake is whether the country is to remain within the euro area.”

• Government spokesman Pantelis Kapsis told Skai TV at the start of this month: “The bailout agreement needs to be signed otherwise we will be out of the markets, out of the EUR … The situation will be much worse.”

• Prime Minister Lucas Papademos : “Without an agreement with the troika and further funding, Greece in March faces an immediate risk of an uncontrolled default”

• German Chancellor Angela Merkel: “We want Greece to remain in the EUR but it must respect the Troika.”


Argentina/Greece:


Argentina/Greece:


What would an “exit” entail?

• The announcement would have to come as a “surprise.”

• Markets would remain closed for a number of days in order that the bare minimum of financial plumbing could be carried out.

• A number of other announcements would have to take place at the same time.

Withdrawals from banks would have to be significantly limited to prevent a run.

Concurrently with this capital controls would be introduced (along with travel curbs). However, it also seems reasonable to suppose that any money looking to leave Greece has already done so.

Wages would have to be redenominated

Domestic debt contracts would have to be redenominated rapidly to prevent the bankruptcy of most households.

Temporary banknotes would need to be provided until permanent new notes could be introduced. A number of suggestions have been made including the “overstamping” of existing banknotes.

Price controls could be reintroduced on a temporary basis.

• Problems

Private borrowers with debts outside Greece would not be able to re-denominate them in the new national currency.

What would the monetary status of the debts of the national central bank be towards other national banks in the Euro System?

• Are there lessons to be drawn from the Asian crisis (many Asian companies had borrowed heavily in USDs rather than in their local currency)?


Beyond Greece..

• Portugal:

International Financing Review reported that Portugal has been sounding out advisers on options to restructure its debt. The magazine says that ministers “have been watching developments in Greece closely with a view to replicating elements of any final agreement.”

• Ireland

Finance Minister Michael Noonan said on Wednesday evening that Ireland would look for concessions from the European Central Bank if the bank contributes to OSI. He told RTE: “If the ECB are prepared to make this kind of concession to Greece it would encourage me to think that they might be ready to make concessions on the promissory note to Ireland (used to rescue Anglo Irish Bank). I see it, if it occurs, as a strengthening of our negotiating position.”

• Italy:

Euro group ministers were reportedly warned in November that: “The risks of a full-blown sovereign liquidity crisis can increase rapidly in the absence of a determined policy response … Persistently high interest rates increase the risk of a self-fulfilling 'run' from Italy's sovereign debt. A liquidity crisis could then turn into a solvency crisis, whose repercussions for other large euro area countries would be very acute given their exposure to the Italian economy.”


Funding the safety net

• The IMF

European Union initially promised it would provide EUR 200 Bn in new funding to the IMF at the December summit (scaled back to EUR 150 Bn).

White House spokesperson Jay Carney: “Our position hasn't changed which is that IMF has substantial resources and that American taxpayers are not going to have to make any more commitments to the IMF.”

Chinese vice foreign minister Fu Ying: “China has 120 million people living on one dollar a day so it is not the kind of country rich enough to talk about saving others.”

Japanese finance minister Jun Azumi stated that Europeans must first decide on the size of their own firewall before seeking IMF money. He added that he also understood the negative stance of both the US and Canada on the issue of IMF funding for Europe.

• The EFSF

At the end of 2012 the EFSF had effective funds available of EUR 275 Bn (following the pledges of support to Greece, Ireland and Portugal). However, the downgrades of France and Austria reduced the effective amount of funds available to EUR 95 Bn.

Chancellor Merkel: “I don’t see any need to change anything with regard to the EFSF”





Conclusion

• In the absence of a safety net, Italy looks set to pay the type of risk premiums that used to be demanded prior to its re-entry into the ERM in 1996.

• Risk of a default in Greece in Q1 growing rapidly.

• May also entail an exit from EUR.

• If so then other nations will watch carefully to see how Greece copes with reintroducing its own currency.


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Euro-zone and Growth

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