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Convergence Criteria and European financial crisis

Convergence Criteria and European financial crisis. ECONOMIC AND MONETARY UNION (EMU). Optimal Currency Area. The Optimal C urrency Area theory was behind the European Single Currency argument. It requires: An absence of asymmetric shocks

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Convergence Criteria and European financial crisis

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  1. ConvergenceCriteriaand Europeanfinancialcrisis ECONOMIC AND MONETARY UNION (EMU)

  2. Optimal Currency Area The Optimal Currency Area theory was behind the European Single Currency argument. It requires: • An absence of asymmetric shocks • A high degree of labour mobility and wage flexibility • Centralised fiscal policy Thus, to meet conditions above, there is a convergence criteria for establishing Eurozone.

  3. Economic benefits of EMU • Removes exchange rate uncertainty on intra-EMU trade • Avoids competitive devaluations • Eliminates transaction costs • Increases price transparency • Low and stable inflation and interest rates • Promotes international specialisation and improves EU competitiveness • Boosts the EU’s international economic profile

  4. Economic risks of EMU • Short term deflation • ‘Can one monetary policy fit all’? • Loss of economic sovereignty and self determination in monetary policy • Asymmetric shocks? – especially if EMU lead to specialisation. • Lack of real economic convergence • Burden of adjustment on wages and prices – internal devaluation needed

  5. The path to Euro • Werner Report – proposes EMU by 1980 • 1979 European Monetary System - ERM, ECU • 1989 Delors Report – 3 stage approach to EMU • 1993 Maastricht Treaty – EMU framework and timetable • 1992-3 ERM (Exchange Rate Mechanism) crises • 1.1.99 - fixing of exchange rates • 1.1.02 – notes and coins in circulation

  6. Convergence Criteria(Maastricht criteria) • For European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro as their currency • The 4 main criteria are based on Article 121(1) of the European Community Treaty.

  7. Convergence Criteria • The purpose of setting the criteria is to maintain the price stability within the Eurozone.

  8. Convergence Criteria • Monetary criteria • Inflation no more than 1.5 percentage points above the average of the 3 countries with the lowest rates • Long term interest rates no more than 2 percentage points above the average of the 3 countries with the lowest rates Exchange rate – has joined ERM II (Exchange Rate Mechanism) for previous 2 years and not devalued its currency

  9. Convergence Criteria • Fiscal criteria • National budget deficit less than 3% GDP • National debt less than 60% of GDP – or heading in the right direction

  10. Convergence Criteria • 12 member states form the Euro-zone – all pre-2004 member states • UK and Denmark ‘opt-out’ • Danish referendum: February 2000 – 53% against • Sweden remains out: September 2003 ‘no’ vote

  11. European Central Bank (ECB) • Independent and supranational • Primary objective is price stability • Responsibility for monetary policy – i.e. interest and exchange rate policy. • Fiscal policy – remains national – but Growth and Stability Pact to stop member states undermining ECB

  12. €/S rate: Jan 1999 - May 2012 Source: European Central Bank

  13. March 2005 – Stability and Growth Pact reforms • 3% budget deficit/60% debt thresholds remain • ‘relevant factors’ to enable member states to avoid ‘excessive deficit’ procedures • e.g. economic cycle, structural reform, research and development, public investment, etc • Countries have longer time to correct ‘excessive deficit’ – 2 years. Can be extended further.

  14. UK - not on the agenda in short or medium term • Political parties • Labour in favour ‘in principle’ but some dissenters • Conservatives – mostly Eurosceptic – some pro • Liberal Democrats – the most ‘pro’ • Businesses – divided • Foreign investors – more pro • Big companies – more pro than anti • Small companies – more anti than pro • Public opinion • Heavily anti – how deeply held?

  15. Sweden and Denmark • Referenda defeat pushed membership back • Some more positive attitudes to membership emerging but: • Politicians wary of further defeats • Difficult to justify

  16. Convergence criteria - 2003

  17. Convergence criteria - 2004

  18. Convergence criteria - 2005 Source: national governments and Eurostat: X = above threshold value

  19. Sovereign Debt • Government (sovereign) debt typically considered to be of the highest quality due to ability to manage fiscal (tax) policy and monetary policy • Eurozone members control fiscal policy for their own countries but not monetary policy • Different levels of debt are incurred by each of the eurozone countries as seen in Exhibit 5.10 • Greece with a debt/GDP ratio of 166% is the highest

  20. Exhibit 5.10 European Sovereign Debt in 2011

  21. The European Debt Crisis of 2009-2012 • October 2009 the newly elected Greek government discovers the previous administration has systematically under-reported the government debt • Greek financial instruments are down graded • Financial markets fear Greek default and financial contagion to other financially weak eurozone countries • March 2010 the IMF helps establish a plan to stabilize the Greek economy

  22. The European Financial Stability Facility (EFSF) • EFSF designed to raise €500 billion to extend credit to distressed member states • Ireland: • Unlike Greece, their problems are similar to those in the U.S., a property bubble and the failure of the banking system • Portugal • Problems may actually be contagion as their financial problems did not appear to be as serious as Greece or Ireland

  23. Transmission • Greek, Irish, and Portuguese government debt was held by many European banks • These banks were considered too big to fail • The risky sovereign debt was trading at deep discounts and with high yields • Further bailouts of Greece and others were becoming necessary • Exhibit 5.11 illustrates what happened to interest rates • Who would buy such risky debt? See Exhibit 5.12

  24. Exhibit 5.11 European Sovereign Debt and Interest Rates

  25. Example 5.12 Holders of Sovereign Debt

  26. Moving Ahead in Europe • How much money is needed in the coming years for eurozone countries? Exhibit 5.13 • Solutions to the debt crisis • Greece needed immediate capital to manage debt obligations and run their government • European banks needed to be protected from the plunging value of the sovereign debt of Greece, Ireland, Portugal and the like • Address the long-term fundamental issues of government deficits with ...in some cases austerity measures

  27. Exhibit 5.13 Selective Eurozone Financing Needs

  28. Alternative Solution to the Eurozone Debt Crisis • The Brussels Agreement - a failed attempt to write down sovereign debt values, increase funds in the EFSF, and increase required bank equity capital – contingent upon Greek acceptance of new austerity measures, but the Greeks hesitated • Debt-to-Equity Swaps – these come at a cost as the debt value is trimmed before conversion to equity • Stability Bonds – Issued with the full backing of every eurozone country rather than individual sovereign debt – resisted by the stronger countries

  29. Currency Confusion • Has the sovereign debt crisis put the euro at risk? • YES • Too much euro-denominated sovereign debt could raise significantly the cost of financing as could the failure of eurozone countries to meet convergence standards • No • Bad sovereign debt should affect each country more than the group of euro nations • Very little empirical evidence thus far that the crisis has really devalued the currency

  30. Sovereign Default • Exhibit 5.14 provides a brief history of sovereign defaults since 1983, and their relative outcomes. • U.S. response to the 2008-2009 credit crisis was: write-offs by holders of bad debt, government purchase of debt securities, and government capital injections to support liquidity • Europe has chosen a similar path as the last technique. • banks are not participating to the same extent as in the U.S.

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