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ECB: Eurozone, European crisis & policy responses
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In this context, the outlook for income growth in the peripheral countries was widely believed to have been transformed for the better. As a consequence, demand for credit expanded rapidly: households and firms in the periphery sought to borrow, so as to reap the available growth opportunities via investment and enjoy the benefits of prospective wealth gains immediately. This surge in the demand for borrowing was met with a relaxation of the credit supply (Chart 5). Financing conditions eased significantly as real rates fell. Country risk premia diminished, as peripheral countries adopted a credible and stable currency. Spreads between government bond yields of euro area countries narrowed to very low levels. Financial institutions could borrow more easily abroad, as currency risk diminished. Deeper and more integrated capital markets facilitated greater opportunities for cross-country diversification. And greater competition spurred rapid adoption of financial innovations, with securitisation and risk transfer markets playing an important catalytic role in expanding the loan supply.
Credit growth surged dramatically. No doubt part of the rapid expansion of credit was justified on fundamental grounds. After all, studies by the European Commission during the 1980s and 1990s had promised a sizable growth dividend from the Single Market and Monetary Union.
[3] But, in an environment of large-scale structural change in peripheral economies and their financial systems, distinguishing the impact of improved fundamentals from that of ‘bubble-like’ behaviour proved a formidable challenge.
Supported by the dynamism of the real estate market, the peripheral economies grew rapidly. But the growth achieved was not balanced: sectors of the economy associated with the housing boom – construction and financial services – grew disproportionately (Chart 7), drawing resources away from other activities, raising concentrations in loan books and increasing macroeconomic vulnerability to sector-specific shocks. Rapid economic growth led to increased demand for imports, while strong wage growth put pressure on the price competitiveness of the tradable sector. Large deficits on the current account of the balance of payments therefore emerged (Chart 8). Inflows of financial capital from abroad – the proverbial ‘hot money’ – were needed to finance the current account deficit. Such unbalanced growth also had important consequences for the fiscal accounts (Chart 9). The housing boom (and its positive impact on broader economic activity and spending) increased tax revenues, dramatically in some cases. These ‘windfall’ increases in tax revenue were treated as structural rather than cyclical in nature, as the housing boom was prolonged and appeared to survive the cyclical weakness in activity in mid-decade.
[4] In Greece, tax windfalls allowed successive governments to obscure a fundamental weakness in the fiscal system, which was only later revealed when the public accounts statistics were improved. In Ireland, the windfalls supported the implementation of a pro-cyclical fiscal policy, as governments used revenue strength to justify tax reductions and higher public spending. Massive implicit liabilities towards the financial sector were accumulated as banking sectors grew rapidly.
Ultimately, the real and financial imbalances created by these dynamics proved to be unsustainable. The global financial crisis in 2007-08 was the crucial triggering event (Chart 10). First, the onset of global recession led to a deterioration in growth performance, rendering the fiscal and financial burdens imposed by past behaviour unsupportable. Second, the financial tensions led to a disruption of domestic financial intermediation, with severe consequences for both private and public financing. In Greece, the banks – which were reasonably strong in a ‘stand-alone’ sense – were undone by revelations about the weakness of public finances. In Ireland, causation ran in the opposite direction: the bloated and failing domestic banking system imposed an intolerable burden on what, prior to the crisis, had been a superficially strong fiscal position. Regardless of the causation, the consequences were the same: as confidence eroded, the inflow of foreign capital dried up. Subject to a ‘sudden stop’ in external financing,
[5] the European sovereign debt crisis – itself inextricably linked with problems in the financial sector – erupted, forcing Greece and Ireland to seek financial assistance from the European Union and IMF. 3. What can we learn from the emerging market crises of the past thirty years?
Extensive economic literature has analysed these events and identified important roles for many of the phenomena I have just described.
[6] It is therefore useful to explore parallels between the emerging market experience and what we are currently seeing in Europe. Here in Hong Kong, it is natural to focus on the Asian experience in the mid- to late-1990s, although events in Latin America are also useful to bear in mind.
The accumulation of financial imbalances and vulnerabilities prior to the crisis is an important feature of both the European and Asian experience. Over-optimistic expectations of longer-term growth performance stimulated a surge in credit expansion and economic activity, associated with massive inflows of capital from abroad (Chart 11).
[7] The risks associated with these capital inflows were under-appreciated by investors and therefore under-priced by markets, in part because the aggregate and systemic consequences of a ‘sudden stop’ in such flows were neglected in the decisions made by individual investors (Chart 12). Rating agencies acted in a pro-cyclical manner, also failing to adequately assess systemic risk (Chart 13).
The inflationary consequences of strong growth led to a loss of competitiveness, as the real exchange rate appreciated (Chart 14). The current account of the balance of payments shifted into deficit, creating a dependency on the inflow of foreign capital (Chart 15).
[8] And the rapid pace of economic growth obscured the underlying weakness of public finances, in some cases abetted by creative accounting practices, such as shifting government liabilities off the balance sheet. The case of Ireland seems particularly close to Asia’s experience in the 1990s: while public finances appeared relatively strong, a vast external debt was being accumulated by the banking system. The implicit government liabilities towards the financial sector arising from deposit insurance schemes and the need to manage systemic risks were neither fully recognised nor appropriately priced (Chart 16).
A further important similarity between the emerging market experience and that of the peripheral euro area countries is that the external debt is denominated in a currency which the national authorities do not completely control. In emerging markets, so-called ‘original sin’ – that is, a lack of credibility created by poor macroeconomic discipline in the past – implied that external debt was overwhelmingly denominated in US dollars.
[9] In the euro area, debt is denominated in euros. Although this is obviously the currency of euro area countries, the single monetary policy aims at price stability across the euro area and thus cannot take account of national priorities deriving from fiscal or financial weaknesses in peripheral countries.
First, in general terms, Europe is more advanced both economically and institutionally than Asia (even if there are notable exceptions, such as Singapore, Hong Kong and Korea).
[10] Advanced economies have higher ‘debt tolerance,’ because of their stronger institutions, a more favourable composition of debt and a more stable fiscal revenue base (less dependent on a small set of goods, such as commodities). Thus while the dynamics of financial crises may be similar, the level of debt at which they occur may be different. Of course, this can be a mixed blessing. The ability to accumulate more exposures may permit the pre-crisis boom to last longer. But it may also mean that the subsequent downfall is deeper.
On the other hand, devaluation offers some scope to improve external price competitiveness and thus boost growth via better export performance. The benefits of any such devaluation will be greater for countries that have an export-based model of economic growth, relying on price competitiveness to build market share. This is typical of the ‘Asian Tigers’, but may be less relevant for mature European economies where export performance is driven by other factors, such as quality or branding. For peripheral euro area countries, which cannot devalue, the way to improve competitiveness is via domestic wage restraint and structural reforms to boost productivity. In an environment where domestic debt overhangs are large, the former approach runs the risk of creating a debt-deflation spiral: domestic nominal incomes are driven down, while the nominal debt remains unchanged, thereby increasing the real burden of previously accumulated financial imbalances.
[11] Yet Europe’s sovereign crises have erupted in the context of a worldwide recovery, led by strong growth and a potential for inflationary pressure in the emerging markets. Such a situation contrasts with the global disinflationary environment of the Latin American crisis in the early 1980s, and the cyclical slowdown affecting Asia in the mid-1990s. Because of the inflationary pressure in some of their many export markets in the emerging world, euro area countries are more likely to regain price competitiveness now than other crisis-hit countries were in the past.
Aside from their role in fiscal consolidation, the European authorities have also offered support to the financial systems of the most adversely affected countries in the euro area. This has been done via EU/IMF programmes to support restructuring and recapitalisation of crisis-hit banks; and through ECB measures, notably its framework for ‘enhanced credit support’.
[12] By introducing a variety of operational facilities, the Eurosystem has ensured that liquidity continues to flow to the peripheral countries, preventing a seizing-up of financing flows in those hardest hit and a significant disruption to the European financial system as a whole. Indeed, one of the most important contributions made by the EU framework has been to ensure that the policy responses to the financial crisis have taken a sufficiently Europe-wide – or at least euro area-wide – perspective. Given that the responsibility for financial supervision and fiscal sovereignty remains at national level in the EU, at the peak of the financial crisis there was a natural tendency for Member States to resort to national solutions. A number of countries succumbed to this temptation, in the process imposing costly externalities on other Member States. For example, providing government guarantees for all bank liabilities in one jurisdiction prompted outflows of deposits from other jurisdictions, requiring similar guarantees to be offered elsewhere. This may have resulted in an overall level of intervention that was unnecessarily intrusive and undesirable in terms of the incentives created in the financial sector. In short, the existence of considerable externalities and scope for significant spillovers within a financially integrated region like the euro area may have led to individually reasonable actions resulting in a collectively inferior outcome.
Note: Growth rate shown in the chart is the percentage increase between 1997 and 2007.
Sources: Eurostat and Haver Analytics.
Note: Quarterly; 2000Q1=100.
Source: Haver Analytics and Eurostat.
Note: Series calculated as ten year benchmark bonds minus annual HICP inflation. Annual averages.
Note: Last observation refers to 14 February 2011. Daily.
MFI loans to households – MFI loans to non-financial corporations
Note: Last observation refers to 2010Q4. Quarterly; year-on-year % change; not adjusted for securitisation.
Note: Quarterly; 1998Q1=100.
Source: Hiebert and Vansteenkiste (2010).
Note: Growth rate shown in the chart is the percentage increase between 2000 and 2007.
Sources: Haver Analytics and Eurostat.
Note: 2009; % of GDP.
Note: % of GDP.
Sources: Haver Analytics; European Commission.
Household credit growth (annual % ) – General government budget balance (% of GDP)
Source: Haver Analytics, European Central Bank and Eurostat.
Note: annual averages of monthly growth rates.
Sources: Haver Analytics and IMF.
Note: in bp.
Source: Haver Analytics and JP Morgan.
Note: in percentage.
Source: Average values by estimates of Chinn (1998), Goldstein (1998), Tornell (1998) and Berg and Pattillo (1998).
East Asia (1996) – Euro area (2009)
Note: high scenario.
Share of foreign currency denominated debt in 2001: 97.59%
Chart 18: Exchange rates vis-à-vis the USD for selected emerging Asia countries
Note: 02/01/1997=100.
Source: Federal Reserve Board of Governors.
[2]See: Altunbas, Y., L. Gambacorta and D. Marques-Ibanez (2009). “
Securitisation and the bank lending channel”, European Economic Review 53(8), pp. 996-1009.
[9]See: Eichengreen, B., R. Hausmann and U. Panizza (2005). “
The pain of original sin”, in B. Eichengreen and R. Hausmann (eds.) Other people’s money, Chicago University Press, pp. 87-102.
[11]The classic reference is Fischer. I (1933).
“The debt-deflation theory of Great Depressions”, Econometrica 1(4), pp. 337-357.
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