metadata: authors: 0: author: Lin, Justin Yifu
1: author: Treichel, Volker
count: Europe,World
docna: 0: docna: The crisis in the Euro zone : did the euro
            contribute to the evolution of the crisis ?
docty: Policy Research Working Paper
subtopic: Urban Housing and Land Settlements,Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,Urban Governance and Management,Urban Housing,International Trade and Trade Rules,Inflation,Macroeconomic Management,Municipal Management and Reform,Business Cycles and Stabilization Policies
teratopic: Private Sector Development,Finance and Financial Sector Development
abstracts: cdata!: The simmering sovereign debt crisis in
            the Euro Zone represents a looming threat to the recovery of
            the world economy and could lead to a renewed global
            financial crisis. The purpose of this paper is to analyze
            the root causes of the crisis in Europe and assess the
            extent to which it was driven by the global financial crisis
            and by factors internal to Europe, notably the adoption of
            the common currency. Adoption of the euro led to convergence
            of interest rates in periphery countries to the levels in
            core countries and, in combination with rising capital
            inflows owing to greater financial integration, set off a
            consumption and real estate boom in periphery countries,
            leading to higher growth and increases in government revenue
            and spending. The resulting real appreciation led to a loss
            of competitiveness in periphery countries, adversely
            affecting export performance and causing rising current
            account imbalances. While the fiscal position remained
            manageable before the crisis owing to rising revenue, the
            recession brought about by the global financial crisis led
            to the burst of real estate bubbles and a financial sector
            crisis and to sharply increased budget deficits and worsened
            debt indicators and triggered the sovereign debt crisis.
            Core countries, in particular Germany, maintained a
            competitive edge through wage restraint allowing them to
            increase exports to periphery countries, while their banks
            profited from increased lending to non-core countries. In
            sum, the euro exacerbated intra-European imbalances whose
            unsustainability became evident in the aftermath of the
            global financial crisis and triggered the current sovereign
            debt crisis.
repnme: repnme: The crisis in the Euro zone : did the euro
            contribute to the evolution of the crisis ?
display_title: The crisis in the Euro zone : did
            the euro contribute to the evolution of the crisis
listing_relative_url: /research/2012/07/16607788/crisis-euro-zone-euro-contribute-evolution-crisis
topicv3: Current Account m1326278 1135,Manufacturing Sectors m1326521 1281,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Land and Housing m1327648 817
publishtoextweb_dt: 2012-07-01T00:00:00Z
historic_topic: Private Sector Development,Finance and Financial Sector Development
no_of_pages: 36
model_extractions: WPS6127 Policy Research Working Paper 6127 The Crisis in the Euro Zone Did the Euro Contribute to the Evolution of the Crisis?

_Justin Yifu Lin Volker Treichel_ The World Bank Development Economics Vice Presidency July 2012
Policy Research Working Paper 6127

# **Abstract**

The simmering sovereign debt crisis in the Euro Zone represents a looming threat to the recovery of the world economy and could lead to a renewed global financial crisis. The purpose of this paper is to analyze the root causes of the crisis in Europe and assess the extent to which it was driven by the global financial crisis and by factors internal to Europe, notably the adoption of the common currency. Adoption of the euro led to convergence of interest rates in periphery countries to the levels in core countries and, in combination with rising capital inflows owing to greater financial integration, set off a consumption and real estate boom in periphery countries, leading to higher growth and increases in government revenue and spending. The resulting real appreciation led to a loss of competitiveness in periphery countries, adversely affecting export performance and causing rising current account imbalances. While the fiscal position remained manageable before the crisis owing to rising revenue, the recession brought about by the global financial crisis led to the burst of real estate bubbles and a financial sector crisis and to sharply increased budget deficits and worsened debt indicators and triggered the sovereign debt crisis. Core countries, in particular Germany, maintained a competitive edge through wage restraint allowing them to increase exports to periphery countries, while their banks profited from increased lending to non-core countries. In sum, the euro exacerbated intra-European imbalances whose unsustainability became evident in the aftermath of the global financial crisis and triggered the current sovereign debt crisis.

This paper is a product of the Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at vtreichel@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
THE WORLD BANK GROUP

# **The crisis in the Euro Zone**

# **_Did the euro contribute to the evolution of the crisis?_**

Justin Yifu Lin and Volker Treichel<sup>1</sup> JEL Classification: E61, E63, E65 Keywords: Sovereign debt crisis in Europe, global financial crisis, real estate bubble, adoption of Euro, financial integration.

Sector Board: EPOL

> 1This paper is a product of the Development Economics Unit. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at vtreichel@worldbank.org. The authors wish to thank James Trevino for outstanding research assistance.
# **The crisis in the Euro Zone**

# **_Did the euro contribute to the evolution of the crisis?_**

1. The global financial crisis that erupted with the collapse of Lehman Brothers in September 2008 ushered in a period of recovery in 2010 and 2011 driven primarily by growth in emerging markets. Yet, the simmering sovereign debt crisis in the Euro Zone represents a looming threat to the recovery of the world economy and could lead to a renewed global financial crisis.  The purpose of this paper is to analyze the root causes of the crisis in Europe and assess the extent to which it was driven by the global financial crisis and by factors internal to Europe, notably the adoption of the common currency.

2. The crisis in Europe reflects primarily the reaction of financial markets to over-borrowing by private households, the financial sector and governments in periphery countries of the Euro Zone. In many analysts‘ views, the European debt crisis—which led to economic adjustment programs sponsored by the EU and the IMF in Greece, Ireland and Portugal—was caused by fiscal profligacy on the part of noncore countries driven primarily by the expansion of a welfare state model and rising public sector wages.<sup>2</sup> Proponents of this view argue that if countries had balanced their budgets and avoided the temptation to create a welfare state, excessive private spending would not have occurred and investors and banks would have been more aware of the risks involved. Consequently, noncore countries must adopt a realistic position regarding their fiscal policy stance and renounce their welfare objectives. The generalized commitment to fiscal discipline will allow Europe‘s currency to regain strength, without further need for fiscal stimulus. Among European countries, Germany is a particularly strong proponent of the view that fiscal austerity is crucial to addressing the crisis, and under its influence, the G-20 Toronto summit in June 2010 established fiscal consolidation as the new policy priority.<sup>3</sup> 3. This paper will argue that—in the peculiar policy and regulatory environment of the Euro Zone—the adoption of the euro itself was a major factor in bringing about excess consumption and exacerbating weak competitiveness in periphery countries in the Euro Zone. The euro was a crucial factor in promoting financial integration and lowering interest rates in periphery countries. While financial integration itself would have been a desirable outcome, it triggered large inflows of capital from core into non-core countries that financed rising consumption, partly encouraged by rising wages, as well as a real estate boom. In addition, much like in the United States, financial deregulation prompted the development of new financial instruments and

> 2For an example, see Weidmann (2012).

> 3 Parkin (2010).  See also Wolf (2012).

2
derivatives which further spurred the real estate boom.<sup>4</sup> Rising wages and the real estate boom initially helped increase fiscal revenue and allowed deficits to remain in line with the Maastricht criteria (except for Greece), in spite of government expenditure that rapidly rose due to increasing government wage bills and social transfers. Yet, with growth increasingly driven by unsustainably high domestic consumption, periphery countries lost export competitiveness and the manufacturing sector declined. At the same time, core countries‘ competitiveness and their external surpluses improved, as a result of wage restraint and the relative undervaluation of the euro compared to the earlier national currencies.

4. The global financial crisis since September 2008 led to a recession in Europe and triggered the burst of the real estate bubble; both resulted in a ballooning of fiscal deficits and a massive deterioration of debt indicators that set the stage for the sovereign debt crisis in the Euro Zone that began with the Greek crisis in early-2010.

<!-- Start of picture text --> Percent change, Figure 1: Euro Zone growth: Projections and reality<br>year over year<br>4 Actual<br>Projected<br>3<br>2<br>1<br>0<br>2005 2006 2007 2008 2009 2010 2011 2012 2013<br>-1<br>-2<br>-3<br>-4<br>-5<br>Note: Projection data from previous year of actual GDP growth.<br>Source: World Economic Outlook, various years.<br><!-- End of picture text --> 5. The dynamics between core countries, especially Germany, and non-core countries in the Euro Zone appear analogous to those between East Asian surplus economies and the United States in the run-up to the global financial crisis.<sup>5</sup> Excess consumption in the United States brought about by a real estate boom and low interest rates allowed East Asian countries to expand their exports, until the burst of the real estate bubble and the ensuing crisis of the financial sector triggered a global recession. The consumption boom in the United States went

> 4 Lin and Treichel (2012).

> 5 _Ibid_ .

3
hand in hand with a decline in the competitiveness of the US economy, in particular in the manufacturing sector.

# **I. The euro and financial integration and deregulation in Europe**

6. The road to financial integration in Europe began in early 1957, when under the so-called European directives most countries began to lift capital controls and deregulate interest rates, with a view to creating a single market in banking and financial services. However, only by the late 1980s and early 1990s did most countries embark definitively on a financial liberalization strategy, spurred by the single European Act of 1987 (Table 1).

||**Table 1: Financial li**<br>|**beralization and inte**<br>|**gration in Europe **<br>||
|---|---|---|---|---|
||**Lifting of capital**<br>**controls**|**Interest rate**<br>**deregulation**|**First Banking**<br>**Directive**|**Second Banking**<br>**Directive**|
|**Belgium**|1991|1990|1993|1994|
|**Denmark**|1982|1988|1980|1991|
|**France**|1990|1990|1980|1992|
|**Germany**|1967|1981|1978|1992|
|**Greece**|1994|1993|1981|1992|
|**Ireland**|1985|1993|1989|1992|
|**Italy**|1983|1990|1985|1992|
|**Luxembourg**|1990|1990|1981|1993|
|**Netherlands**|1980|1981|1978|1992|
|**Portugal**|1992|1992|1992|1992|
|**Spain**|1992|1992|1987|1994|
|**United Kingdom**|1979|1979|1979|1993|
|**Source: Buch and Hei**|**nrich(2002).**||||

7. In 1999, the adoption of a five-year financial harmonization program—the Financial Services Action plan (FSAP) —brought about a new level of financial integration. The FSAP‘s main objectives were (i) the development of a single market for wholesale financial services; (ii) the creation of open and secure retail markets; (iii) the establishment of clear, efficient, prudential rules and supervision of financial services; and (iv) the establishment of the conditions for an optimal single financial market. The Lisbon agenda (2000) and the re-launching of the Lisbon strategy (2005) further reinforced the goal of creating a single financial market. These reforms resulted in a fully integrated financial market. Using the Chinn-Ito index which measures openness in capital account transactions the table below shows that countries reached the status of full liberalization after the adoption of the euro in 2002 (Table 2).

4
**Table 2: Chinn-Ito Index of capital account liberalization for selected groupings**

||**1990–1994**|**1995–1999**|**2000–2004**|**2005–2009**|
|---|---|---|---|---|
|**Core Countries**|83.2|96.1|97.4|100.0|
|**Non-Core Countries**|19.5|80.5|96.6|100.0|
|**Other Euro Countries**|-37.9|-9.5|24.7|81.3|
|**Non-Euro Countries**|8.8|39.0|66.9|87.9|

Note: The Chinn-Ito Index is expressed in terms of its highest value for all countries considered in their sample. Thus, a value of 100 means complete liberalization. Core countries include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include Greece, Ireland, Italy, Portugal, and Spain. Other Euro countries include Estonia, Malta, the Slovak Republic, and Slovenia. Non-Euro countries are comprised of Sweden and the United Kingdom. Source: Chinn and Ito (2008).

8. Financial integration resulted in a sharp increase in cross-border capital flows with claims by core countries on non-core countries‘ banking systems dominating the increase. Lending by German and French banks to non-core countries‘ banks was by far the most important factor in this increase.

**Figure 2: Core bank claims in Non-Core countries**

<!-- Start of picture text --> US$ billions<br>2500<br>Dutch banks<br>2000<br>German banks<br>French banks<br>1500<br>Belgian banks<br>1000<br>500<br>0<br>Note: Non-Core countries are Greece, Ireland, Italy, Portugal, and Spain.<br>Source: Bank for International Settlements.<br>Dec.1999 Jun.2000 Dec.2000 Jun.2001 Dec.2001 Jun.2002 Dec.2002 Jun.2003 Dec.2003 Jun.2004 Dec.2004 Jun.2005 Dec.2005 Jun.2006 Dec.2006 Jun.2007 Dec.2007 Jun.2008 Dec.2008 Jun.2009 Dec.2009 Jun.2010 Dec.2010 Jun.2011 Dec.2011<br><!-- End of picture text --> 5
9. Financial integration was also promoted by greater economic alignment among Euro Zone countries, resulting from the observance of convergence criteria for inflation, fiscal balances, exchange rate and interest rates that had been established as pre-conditions for the adoption of the euro. However, it was the adoption of the euro itself in 2002 which brought about a marked increase in financial integration. Table 3 shows the substantial growth in balance sheets in particular in non-core countries, following the adoption of the euro.

**Table 3: Growth in balance sheets in European Union measured by external position vis-à-vis all sectors as percentages of GDP**

||**Assets**|
|---|---|
|**Period**|**Core countries**<br>**Non-Core countries**<br>**Non-Euro**|
|**1990–1995**|47.40<br>22.52<br>58.97|
|**1996–2001**|61.96<br>55.74<br>76.40|
|**2002–2010**|118.31<br>96.15<br>131.37|
||**Liabilities**|
|**Period**|**Core countries**<br>**Non-Core countries**<br>**Non-Euro**|
|**1990–1995**|41.79<br>19.89<br>63.26|
|**1996–2001**|63.40<br>60.31<br>84.35|
|**2002–2010**|102.44<br>107.22<br>148.44|
|Note: Core countri|es include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include|
|Greece, Ireland, Ita<br>Source: Bank for In|ly, Portugal, and Spain. Non-Euro countries include Sweden and the United Kingdom.<br>ternational Settlements.|

10. Kalemli-Ozcan et al (2009) investigate in greater detail the impact of the euro on financial integration. They find that following the adoption of the euro bilateral bank holdings and transactions increased by roughly 40 percent among the Euro Area countries. The significance of the euro for this result is underscored by comparing the increase in bank holdings in the 12 countries that first adopted the euro with the three EU 15 countries (Denmark, Sweden and United Kingdom) that have not joined the currency union.

11. After quantifying the total effect of the euro, Kalemli-Oczan also analyze the deeper roots of the impact of the euro on financial integration. Specifically, they ask whether the euro promoted financial integration by (i) reducing the currency risk and eliminating exchange rate fluctuations, (ii) through legal harmonization or (iii) through higher trade. They find that the euro‘s impact on capital flows was largely driven by the elimination of the currency risk. In addition, they confirm that the 27 directives of the FSAP had a major impact on financial integration and on the intensity of capital flows across member states.

12. They also investigate the hypothesis of whether cross-border banking integration is driven by an increased volume of transactions in international trade. As goods and assets move 6
in tandem and currency unions raise bilateral trade, the positive impact of the single currency on financial integration may partly be coming from goods trade. Kalemli-Oczan et al. establish econometrically, though, that trade cannot explain any part of the effect of the euro on financial integration.

13. The elimination of the currency risk and the easier access to international capital markets that followed EMU membership led to convergence of interest rates in periphery countries to the level of core countries. The resulting fall in lending rates on commercial bank loans as well as on the cost of sovereign debt in periphery countries was perhaps the single most important effect of the adoption of the euro and had profound implications for the financial system in Europe and the structure of European economies (Figure 3).

**Figure 3:  Convergence in inflation rates and long-term bond yields**

<!-- Start of picture text --> Average aggregate rate, percent<br>25<br>Core Inflation<br>Periphery Inflation<br>20<br>Core Bond Yields<br>Periphery Bond Yields<br>15<br>10<br>5<br>0<br>-5<br>Note: Core countries are Austria, Belgium, France, Germany, and the Netherlands. Periphery countries are Greece,<br>Ireland, Italy, Portugal, and Spain.<br>1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011<br><!-- End of picture text --> 14. As pointed out by Perez-Caldentey and Vernengo (2012), interest rate convergence also lowered interest rate margins especially in noncore countries. Between 1990–95 and 1996–2001, interest rate margins—as a percentage of total earning assets—declined from 3.9 percent to 2.8 percent, while they remained roughly constant in core countries. This translated into a decline in the rate of return over assets in noncore countries from 0.8 percent to 0.5 percent between 199095 and 1996-2001. In the face of a decline in ROA (as in the case of noncore countries between 1990-95 and 1996-2007) or for a roughly constant ROE (as in the case of both core and noncore countries between 1996-2001 and 2002-2007) the levels of profitability (ROE) of the financial system can be maintained or increased by higher levels of leverage (or indebtedness). Available 7
evidence on Germany (Bloomberg) shows that leverage for the major banks increased on average from 27 to 45 percent between 1996 and 2007 (Table 4).

**Table 4: Selected indicators of the performance of the banking system in the European Union**

|**Period**|**Financial**<br>**deepening**|**Co**<br>**Costs/Income**|**re Countries**<br>**Interest**<br>**margins**|**ROA**|**Concentration**|**Z-Score**|
|---|---|---|---|---|---|---|
|**1990–1995**|92.5|72.8|2.3|0.3|67.2|15.4|
|**1996–2001**|103.5|67.8|2.5|0.9|67.2|9.4|
|**2002–2007**|108.2|70.2|2.1|1.0|68.2|7.3|
|||**Non-**|**Core Countries**||||
|**Period**|**Financial**<br>**deepening**|**Costs/Income**|**Interest**<br>**margins**|**ROA**|**Concentration**|**Z-Score**|
|**1990–1995**|56.8|67.6|3.9|0.8|72.1|23.9|
|**1996–2001**|73.3|70.8|2.8|0.5|66.7|25.6|
|**2002–2007**|112.8|66.5|2.2|0.4|68.9|15.8|
|||**Euroz**|**one Countries**||||
||**Financial**||**Interest**||||
|**Period**|**deepening**|**Costs/Income**|**margins**|**ROA**|**Concentration**|**Z-Score**|
|**1990–1995**|77.0|65.8|3.1|0.6|73.7|18.1|
|**1996–2001**|77.3|69.9|2.7|0.7|68.8|12.7|
|**2002–2007**|101.3|67.6|2.4|0.8|70.8|10.4|

Note: Core countries include Austria, Belgium, France, Germany, and the Netherlands. Non-Core countries include Greece, Ireland, Italy, Portugal, and Spain. “Financial deepening” is measured by private credit, deposit money banks, and other financial institutions. “Cost/Income” is measured as total costs, as a share of total income of all commercial banks. “Interest margins” equals the accounting value of a bank’s net interest revenue, as a share of its interest-bearing (total earning) assets. ROA equals “rate of return over assets.” “Concentration” refers to assets of three largest banks as a share of assets of all commercial banks. “Z-Score” is estimated as ROA+equity/assets/sd(ROA); the standard deviation of ROA, sd(ROA), is estimated as a 5-year moving average. Source: Beck and Demirgüç-Kunt (2009).

15. Where did the increase in lending go? The sharp fall in interest rates led to a very significant increase in consumer lending; and in Ireland and Spain, and to an extent in Greece, much of it was channeled into real estate (Figure 4). As a result, from 1997 to 2007, housing prices rose at an average annual rate of 12.5 percent in Ireland and 8 percent in Spain, compared to 4.6 percent in the United States during its bubble. Over the same period, construction as a share of gross output rose from 9.8 to 13.8 percent in Spain, and from 7.9 to 10.4 percent in Ireland. In the United States, the same figure only increased from 4.6 to 4.9 percent.<sup>6</sup> Yet, the channeling of funds into real estate allowed bubbles to emerge in Ireland and Spain whose burst was at the core of the economic crisis.

> 6 Dadush (2010) p.13.

8
<!-- Start of picture text --> 50<br>" FR<br>30 = / ><br>20 floS<br>10 =<br>0 T T T T T T T 1<br>1999 2000 2001 2002 2003 2004 2005 2006 2007<br>-10<br>seeeGermany @=—=Greece T==lrcland =ltaly sm Spain @==Portugal<br><!-- End of picture text -->
18. Recent research empirically assesses the impact of securitization. Mian and Sufi (2009) show that securitization played an important role in the expansion of the supply of credit. Dell‘Arriccia _et al_ . (2012) suggest that lending standards declined more in those areas in the United States experiencing larger credit booms, housing price increases and higher mortgage securitization rates. Furthermore, results from Keys _et al_ . (2010) show that existing securitization practices adversely affected the screening incentives. There is also evidence that securitization has quantitatively increased the amount of credit granted making it less dependent on specific banking or monetary policy condition (Loutskina, 2010; Loutskina and Strahan (2009)). There is also considerable evidence that securitization makes further acquisition of risks more attractive for banks (Krahnen and Wilde (2006); Uhde and Michalak (2010); Instefjord (2005); Hansel and Krahnen (2007)).

19. What was the impact of securitization on the housing market in Spain? Carbó Valverde, and Rodríguez Fernández (2010), using cointegration and vector-error-correction models on a sample covering the 1988Q4 to 2008Q4 period, find that housing prices and mortgage credit interact in the short and the long run. Their results also suggest that there was a regime shift in mortgage lending in Spain starting in 2001 when mortgage credit securitization grew substantially. In the development of the credit boom from 2007 to 2010, the use of ABS and MBS grew significantly. The outstanding values of these securities gives an idea of the significant potential risk transferring associated with them. In particular, the outstanding values of Spanish ABS grew from 42 billion euros in 2008Q1 to 81 billion euros in 2009 Q4, declining to 75 billion euros in 2010 Q1. As for the MBS, the outstanding values changed from 112 billion euros in 2008 Q1 to 172 billion euros in 2009 Q2, falling afterwards to 164 billion euros in 2010Q1. So, overall securitization was a very important factor in the Spanish real estate bubble.

20. Convergence of interest rates within the Euro Zone also created a gap between the interest rates that would have been desirable from the point of view of a member country‘s individual circumstances and those that prevailed, thus underscoring the fact that the Euro Zone was not an optimal currency area. In fact, a recent study by the OECD finds that, using the Taylor rule, policy interest rates over 2001-2006 were approximately 500 basis points too high for Germany, but between 300 and 400 basis points too low for Spain, Greece and Ireland (Ahrend _et al_ (2008)), and that these relatively low interest rates are correlated with increases in asset prices. They argue that accommodating monetary policy over the period 2002-2005 in combination with rapid financial market innovation seems to have been in retrospect among the factors behind the run-up in asset prices and consequent financial imbalances.

21. The abundance of capital flows throughout Europe, substantially lower borrowing costs, easy access to liquidity via leveraging and as a result of growing lending from core banks to noncore banks, and no exchange rate risk provided an illusionary sense of prosperity in a lowrisk environment. The sense of prosperity was illusionary because it was not matched by 10
improvements in productivity or the business environment that would have laid the foundation for sustained long-term growth. In fact, the sudden abundance of financial flows in non-core countries resulting from the adoption of the euro exacerbated weak competitiveness that had already adversely affected these countries before the adoption of the common currency.<sup>9</sup> 22. One of the factors contributing to this loss of competitiveness was the sharp rise in wages in non-core countries. Between 2001 and 2011 per unit labor costs in Greece rose by 33 percent, 31 percent in Italy, 27 percent in Spain and 20 percent in Ireland, while they grew by only 11 percent in the United States and by only 0.9 percent in Germany (Table 5).<sup>10</sup> This increase in wages was primarily driven by increases in public sector wages—aimed at swaying the electorate towards the ruling parties—which then also triggered increases in private sector wages. Expenditure increases were considered to be manageable, though, owing to the substantially lower borrowing costs for sovereigns in the aftermath of the adoption of the euro and rapidly rising revenue reflecting the increase in economic activity and the real estate boom (Table 6 and Figures 3, 5 and 6).

**Table 5: Percent increase in unit labor costs, Q1 2001–Q1 2011**

|**Greece**|33.2%|
|---|---|
|**Italy**|30.7%|
|**Spain**|26.6%|
|**Ireland**|20.0%|
|**United States**|11.5%|
|**Germany**|0.9%|
|Source: OECD.Stat.||

**Table 6: General government deficit,** **<u>percentage of GDP</u>**

||**2000**|**2001**|**2002**|**2003**|**2004**|**2005**|**2006**|**2007**|**2008**|**2009**|**2010**|**2011**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|**Greece**|-3.7|-4.5|-4.8|-5.6|-7.5|-5.2|-5.7|-6.5|-9.8|-15.6|-10.3|-9.1|
|**Ireland**|4.7|0.9|-0.4|0.4|1.4|1.7|2.9|0.1|-7.3|-14|-31.2|-13.1|
|**Italy**|-0.8|-3.1|-3.1|-3.6|-3.5|-4.4|-3.4|-1.6|-2.7|-5.4|-4.6|-3.9|
|**Portugal**|-3.3|-4.8|-3.4|-3.7|-4.0|-6.5|-4.6|-3.1|-3.6|-10.2|-9.8|-4.2|
|**Spain**|-0.9|-0.5|-0.2|-0.3|-0.1|1.3|2.4|1.9|-4.5|-11.2|-9.3|-8.5|
|**France**|-1.5|-1.5|-3.1|-4.1|-3.6|-2.9|-2.3|-2.7|-3.3|-7.5|-7.1|-5.2|
|**Germany**|1.1|-3.1|-3.8|-4.2|-3.8|-3.3|-1.6|0.2|-0.1|-3.2|-4.3|-1.0|
|Source: Euro|stat||||||||||||

> 9 Gwartney _et al_ (2010).

> 10 Dadush (2010) p.32.

11
**Figure 5: Annual growth of government expenditure, percent average for 1997–2007**

<!-- Start of picture text --> 12<br>10<br>8<br>6<br>4<br>2<br>0<br>Source: Eurostat.<br><!-- End of picture text -->

**Figure 6: Annual growth of government revenue, percent average 1997–2007**

<!-- Start of picture text --> 12<br>10<br>8<br>6<br>4<br>2<br>0<br>Source: Eurostat.<br><!-- End of picture text --> 23. Bibow (2012) argues that one of the core reasons behind the current crisis of the Euro Zone is the lack of wage coordination which is normally critical in preventing asymmetric shocks and sustaining a monetary union (Mundell (1961)). In fact, since 1996, Germany established its own new lower norm of zero nominal unit labor cost inflation resulting from a consensus between the trade unions, workers‘ representatives and employers that wage restraint was pivotal to preserve Germany‘s competitiveness, reduce unemployment and prevent further relocation of labor to Eastern Europe and other low-wage countries. Most European countries, especially on the periphery, found themselves unable to emulate German wage restraint, 12
reflecting the political economy in their countries that resulted in pressure to increase wages at a time when the adoption of the euro seemed to herald a new era of prosperity.

24. Wage increases and growth in government spending in non-core countries led to large increases in aggregate demand. In Greece, for example, aggregate demand grew between 2002 and 2007 by an average of 4.2 percent compared to a growth of only 1.8 percent in the Euro Area (Dadush (2010) p.34). This increase was financed by foreign borrowing and resulted in higher inflation with consumer prices in Greece rising since 1997 by 47 percent compared to an increase of only 27 percent in the Euro Area. Only over the past four years, the real effective exchange rate appreciated by 17 percent eroding Greece‘s competitiveness and resulting in a widening current account deficit.

25. In a quasi Dutch disease-type phenomenon, this loss of external competitiveness also led to a shift away from manufacturing sectors towards service and non-tradable sectors. Table 7 shows that, between 2000 and 2007, the share of manufacturing in GDP fell by 10 percent in Ireland, 3 percent in Italy, 4 percent in Spain, and 3 percent in Portugal and 1 percent in Greece (from its already low level of 10 percent). At the same time, the share of the service and construction sectors in Spain increased by 3.4 percentage points of GDP, while it increased by 2.3 percent points of GDP in Ireland. The shares of the construction sector did not increase in Greece and Portugal.

26. Yet, the share of the manufacturing sector rose by 1 percentage point of GDP in Germany. This increase in the relative size of Germany‘s manufacturing sector (from its already very high level) was also reflected in a rise of Germany‘s overall surplus position with the Euro Zone member countries.

**Table 7: Manufacturing Value Added,** **<u>percent of GDP</u>**

||**2007**|**Change since 2000**|
|---|---|---|
|**Germany**|24|+1|
|**Ireland**|22|-10|
|**Italy**|18|-3|
|**Spain**|15|-4|
|**Portugal**|14|-3|
|**Greece**|10|-1|
|Source: World Bank|||

27. The emerging divergence in competitiveness between core and non-core countries was partly conditioned by countries‘ desire to observe Maastricht stability criteria. In fact, prior to the global financial crisis most Euro Zone countries maintained their fiscal deficits at or below 3 percent of GDP (with the notable exception of Greece and—to an extent—Portugal, although Portugal managed to substantially reduce deficits in 2007 and 2008). Several countries, such as Ireland and Spain even had surpluses. Yet with core countries able to pursue wage moderation 13
and restraint policies and noncore countries not having the means to counteract and offset core countries‘ ̳beggar thy neighbor‘ policies, a growing competitiveness gap emerged leading to widening euro imbalances.

28. And this impacted countries‘ external position: the current account balance for noncore countries deteriorated sharply during the finalization of the European integration process, and even more so following the adoption of the euro. Much like in the United States<sup>11</sup> , this deterioration in the current account was driven by the sharp increase in housing prices.<sup>12</sup> While many Northern European countries‘ current account positions improved, including those of Austria, Finland and the Netherlands, it was the massive increase in Germany‘s current account surplus by over 10 percentage points of GDP since 2000, partly because of increasing exports to periphery countries, that was at the core of the emergence of intra-European imbalances (Figure 7). Figure 8 shows the evolution of export market shares for Greece, Spain and Portugal. Growth in these countries was more and more dominated by internal consumption.

**Figure 7: German trade surplus in Europe**

<!-- Start of picture text --> 160<br>140<br>120<br>100<br>80<br>60<br>40<br>20<br>0<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011<br>Greece, Italy, Portugal, Spain Rest of Europe<br>US$ (billions)<br><!-- End of picture text --> Source: Comtrade.

> 11 See also Figure 40 based on Laibson and Mollerstrom (2010), in Lin and Treichel (2012).

> 12 Bibow (2012) p.12.

14
<!-- Start of picture text --> 1995=100<br>130 a Spain Greece = Portugal<br>120<br>110<br>100<br>90<br>80<br>70<br>60<br>1995 1997 1999 2001 2003 2005 2007<br><!-- End of picture text -->
competitiveness. In fact, there is much evidence that Portugal‘s business climate is especially weak and further deteriorated following the adoption of the euro.

31. In the aftermath of the global financial crisis, most European countries entered a recession and the bubble in the real estate market burst, leading to sharp increases in nonperforming loans and subsequent government-financed bail-outs for the financial sectors. The increase in public debt resulting from these bail-outs was further compounded by the ballooning of government deficits resulting from the sharp fall in revenue as a result of the drop in output. Figures 9 and 10 show the evolution of fiscal balances and of the public debt burden following the crisis.

**Figure 9: Evolution of general government deficits, percent of GDP**

<!-- Start of picture text --> 10<br>5<br>0<br>Ireland<br>-5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011<br>Greece<br>-10<br>-15 Spain<br>-20<br>Portugal<br>-25<br>-30<br>-35<br>Source: Eurostat.<br>180 Figure 10: Evolution of general government gross debts, percent of GDP<br>160<br>140<br>120<br>Ireland<br>100<br>80 Greece<br>60 Spain<br>40<br>Portugal<br>20<br>0<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011<br>Source: Eurostat.<br><!-- End of picture text --> 16
# **II. Country cases**

32. Over-indebtedness resulting from the crisis and the adoption of the euro in the context of a weak policy and regulatory environment are common themes for all European countries currently affected by the euro crisis. There are, however, considerable differences among various countries.

# **Ireland**

33. The crisis in Ireland is essentially one of a boom and bust of a real estate bubble. Encouraged by the fall in interest rates that went along with the adoption of the euro, banks obtained funding from British, German and US banks, usually in the form of short-term debt, foreign-owned bank deposits, or foreign-owned portfolio equity, to expand credit to the private sector. Figures 11 and 12 below indicate the degree of Irish indebtedness.

<!-- Start of picture text --> Figure 11: Foreign bank claims in Ireland<br>1200<br>1000<br>US banks<br>800<br>British banks<br>German banks<br>600<br>French banks<br>Belgian banks<br>400<br>Other Europe<br>200 Rest of World<br>0<br>Dec.1999 Dec.2001 Dec.2003 Dec.2005 Dec.2007 Dec.2009 Dec.2011<br>Source: Bank for International Settlements.<br>US$ (millions)<br><!-- End of picture text --> 17
**Figure 12: Foreign claims on Ireland, December 2011**

<!-- Start of picture text --> 140<br>120<br>100<br>Non-bank private sector<br>Banks<br>80<br>Public sector<br>60<br>40<br>20<br>0<br>Source: Bank for International Settlements.<br>US$ (billions)<br><!-- End of picture text --> 34. Fuelled by a rapid expansion of credit, Ireland‘s housing market began to expand in 2000, resulting in a boom in property investment and construction. The wealth effect from this boom spurred higher levels of consumption and helped sustain high growth rates. Boosted by the real estate boom, Ireland's banking system ballooned to five times the size of the economy, and its external debt to over 1000 percent of GDP at the end of 2010. When in the wake of the crisis funds from the US and Britain dried up, the banking system experienced a liquidity crunch, thus slowing credit to the real estate market. As borrowing became more expensive, the demand for housing started to decline, resulting in a fall in prices and an oversupply of housing. This put pressure on the balance sheets of banks many of which had relied extensively on profitable mortgage loans to boost their earnings. The authorities‘ extensive support as well as access to emergency support from the Central Bank was vital to address financial stability concerns. Yet, the bailout or purchase of failing banks also led to a crisis of confidence, as the government bailout package reached 20 percent of GDP and the budget deficit shot to 32 percent of GDP in 2010, leading to outflows of foreign assets. Figure 13 below shows the extent to which Ireland 18
and other countries in the periphery experienced major withdrawals of foreign-owned funds in the course of the crisis. The crisis exposed Ireland's vulnerabilities to financial contagion.<sup>13</sup> <!-- Start of picture text --> Figure 13: Foreign-owned banking sector liabilities<br>30000%<br>25000%<br>20000% Ireland<br>Spain<br>15000% Iceland<br>Switzerland<br>10000%<br>5000%<br>0%<br>Percent GDP<br><!-- End of picture text --> Sources: BIS; and IMF, World Economic Outlook database.

35. The housing boom was also the crucial factor obfuscating the soundness of Ireland‘s fiscal position. On the surface, Ireland had pursued conservative fiscal policies and in fact had been running fiscal surpluses since the mid-90s, except in 2002. However, these surpluses were increasingly driven by tax revenue boosted from the property bubble. In fact, during 2000-2007, driven largely by the revenue boom, revenue from capital taxes and stamp duties increased from 2 percent in 2000 to 4 percent of GDP, while VAT increased by one percentage point of GDP to 7 1⁄2 percent.<sup>14</sup> At their peak in 2007, these revenues represented over a third of total current revenue, as opposed to one-fifth of current revenue in Spain and the UK, two other countries with large asset booms. This asset-related revenue encouraged increases in structural expenditure and masked a rising structural deficit. When adjusting for the impact of asset prices, the Irish structural deficit reached 8 percent in 2007 (as opposed to a measured surplus of 0.9 percent of GDP), spiking to 12 percent of GDP in 2008.

> 13 Lenihan and Honohan (2010).  Also, Lane (2011), which discusses how Ireland was able to refinance their debt through the ECB-IMF.  Iceland, on the other hand, was not able to do so, and had to negotiate directly with UK and Dutch governments in order to refinance, paying higher interest rates in the process. 14 IMF (2010).

19
<!-- Start of picture text --> 25 180 + 1.8<br>@Goods.and semices<br>20 mGoods 160<br>15 BServices 140 an 14<br>| ~ /<br>10 ~ 1.0<br>| 100 pa<br>it] | | Se| | | 0 aa Volume Share, index 06<br>- =———— Value Share, percent (rhs)<br>— AQ 02<br>1990 1993 1996 1999 2002 2005 2008 1980 1985 1990 1995 2000 2005<br>Source: WEO Source: Comtrade, WEO<br><!-- End of picture text -->

Share of Imports of Services from Ireland

||2004|2005|2006|2007|2008|
|---|---|---|---|---|---|
|UK|9.2|9.3|92|10.7|11.1|
|US|2.2|1.6|2.0|22|1.8|
|France|40|3.8|3.4|49|5.0|
|Germany|3.0|3.6|3.3|3.5|3.5|
|Italy|3.2|3.5|46|5.0|5.1|
|Spain|2.3|2.5|2.6|29|3.0|

Source: Eurostat
fuelled bubbles in all asset classes, particularly the stock market and real estate. Inflated asset prices and non-transparent cross financing and related party lending between banks and holding companies helped mask poor asset quality and facilitated the financing of credit expansion by borrowing abroad, increasing vulnerability. Moreover, like in other European countries, domestic demand grew rapidly, fed by capital inflows and reflecting growing imbalances. Real GDP expanded by 28 percent during 2003-07, driven by private consumption and large investments in power-intensive industries. The spending boom was underpinned by strong growth of disposable income, easy credit, rapid increase in housing and equity wealth, and low unemployment. At the same time, external balances ballooned and net external indebtedness deteriorated sharply, exceeding 110 percent of GDP while the expansion of Icelandic companies and banks abroad bloated gross international liabilities to 625 percent of GDP in 2007.

<!-- Start of picture text --> Figure 15: Foreign bank claims in Iceland<br>60<br>50<br>US banks<br>40<br>British banks<br>German banks<br>30<br>French banks<br>20 Belgian banks<br>Other Europe<br>10 Rest of World<br>0<br>Dec.1999 Dec.2001 Dec.2003 Dec.2005 Dec.2007 Dec.2009 Dec.2011<br>Source: Bank for International Settlements.<br>US$ (billions)<br><!-- End of picture text --> 38. In the wake of the global financial crisis in late-2008, Iceland experienced a deep financial and economic crisis of its own.<sup>15</sup> Given their high leverage, Icelandic banks, which were relying on wholesale funding—primarily from German banks—were cut off from financing and a brief attempt to nationalize one of them revealed the severe problems facing the banking system which contributed to a downgrade of the sovereign. Within a short period of time, the three largest banks (Landsbanki, Glitnir and Kaupthing) collapsed. The banking crisis reflected

> 15 IMF (2012).

21
poor asset quality and bubbles, a worsening of credit conditions, intensified financial disruptions and dislocations, and a major equity market sell-off. Confidence evaporated, the currency depreciated sharply and the exchange rate market ceased to operate, while other assets prices were in freefall. During 2009-10, real GDP and domestic demand declined cumulatively by a 10 1⁄2 and 23 percent, respectively. Following a deterioration of the budget deficit to 8.6 percent of GDP in 2009 from a surplus of 5.4 percent of GDP in 2007, the government‘s fiscal position improved to a deficit of 4.6 percent of GDP in 2011. In contrast to Ireland, where the deterioration of the fiscal position reflected mostly the size of the bail-out package, Iceland‘s fiscal position was primarily the result of the collapse in economic activity. Iceland allowed its banking system to collapse.

# **Spain**

39. The evolution of the crisis in Spain followed similar patterns to that of Ireland. As in Ireland, the lowering of interest rates accompanying the introduction of the euro plus the growing financial integration in Europe led to a sharp increase in lending which primarily fuelled the real estate market. While in Ireland, German banks were second to British banks in providing funding, in Spain (like in Iceland) German banks played the most important role as lender (Figure 16). When funds from German banks ceased to flow in the context of the global financial crisis and economic growth stagnated, the bubble burst, leading to an avalanche of nonperforming loans in the banking system (Figure 17), especially the ̳ _cajas_ ‘ where political meddling and profiteering from local politicians allowed loans to be extended to a segment of borrowers with questionable credit worthiness, somewhat similar to the subprime mortgage market in the United States.<sup>16</sup> <!-- Start of picture text --> 160 Figure 16: Foreign claims on Spain, December 2011<br>Non-bank private sector<br>140<br>Banks<br>120 Public sector<br>100<br>80<br>60<br>40<br>20<br>0<br>US$ (billions)<br><!-- End of picture text --> Source: Bank for International Settlements.

> 16 Deutsche Bank Research (2004).

22
<!-- Start of picture text --> 30,000,000 30,000,000 300 300<br>000000 WOtherloansNPLs (Mortgage NPLs ZN 250 i 250<br>i<br>ot<br>im]<br>200 et<br>20,000,000 20,000,000 NeLMortoagas‘i' 200<br>‘'<br>''<br>* i4 150<br>15,000,000 ; t<br>15,000,000 # noLotberloans<br>100 ;tof\s' '\ 100<br>10.000.000 if \<br>10,000,000 Resdenial if \<br>50 Moriga '' H i/ \ 50<br>iat sr<br>5,000,000 ; \<br>5,000,000 ; Ny herlog is ;<br>SSARARARFERASSLESSRARSTES<br>ByBSSSSSgssssNONONS PPEsessPEEPessesert sas<br>0 NOOMNDYOMNDHOYAMANDYOAND3828SaSS8SSonePEE:co do SsS8S8ercsResssS88ssssssnr @ 99°94 0 50 “50<br><!-- End of picture text -->
# **Greece**

42. Greece also experienced a real estate bubble and a sharp increase in household debt with a similar genesis to that of Spain and Ireland. However, in contrast to Iceland, Ireland and Spain, Greece pursued sharply expansionary fiscal policies, largely driven by social transfers and increases in civil service wages, and had not been observing the Maastricht criteria (Table 6 and Figure 3).<sup>17</sup> Loose fiscal policy could be sustained for a long time because of low interest rates on euro-denominated bonds and buoyant revenue reflecting strong, largely consumption-driven economic activity. In the absence of structural measures to improve the competitiveness of the economy, growth weakened and debt sustainability indicators worsened laying the ground for the crisis of confidence of the financial markets in the solvency of Greece and the ongoing sovereign debt crisis in the Euro Zone.

43. While the real estate bubble was important in Greece, fiscal profligacy along with failure to implement structural reforms aimed at improving competitiveness was the critical factor in Greece.

44. Since 2009, Greece has been unwinding imbalances, but through deeper recession and slow improvements in competitiveness. Real GDP has declined by more than 13 percent since 2009. Private investment led the downturn in 2009, while public retrenchment started only in 2010. With falling incomes and employment, private consumption took over as the main driver of the recession in 2011. Current and leading indicators suggest that domestic demand continues to contract sharply: retail trade volume shrank by around 11 percent year-on-year in the fourth quarter; industrial production declined by 11 percent year-on-year in the fourth quarter; the manufacturing PMI has fallen to close to historical lows; and industrial new orders declined by 8 percent in the fourth quarter of 2011. Competitiveness gains are not yet evident on an economywide basis. The recession and losses from government debt exposures have taken a deep toll on the banking system, undermining financial stability.

# **Portugal**

45. The genesis of Portugal‘s crisis was different from that of the other countries in that it did not reflect the burst of a real estate bubble or fiscal profligacy, but mainly a broad deterioration of the business environment and competitiveness, seemingly accelerated by the country‘s accession to the Euro Zone. In the context of the recession brought about by the global financial crisis, this poor competitiveness resulted in unsustainable debt indicators and triggered the crisis of confidence.

46. Prior to the crisis, Portugal had begun consolidating its finances; in fact, between 2005– 07 the government succeeded in reducing the structural balance by over 3 percentage points of

> 17 Recent corrections of government statistics on the fiscal position showed that Greece had misreported the fiscal deficit prior to the adoption of the euro.

24
<!-- Start of picture text --> 22.9<br>225<br>18.9<br>16.5<br>12.5<br>99 10.1<br>1980 1985 1990 1995 2000 2005 2007<br><!-- End of picture text -->
<!-- Start of picture text --> Portugal's income gap was mostly in productivity... ...feflecting weak TFP growth...<br><!-- End of picture text --> <!-- Start of picture text --> 20 5<br>10 PercentaggContnbutionsgap of Realwith respectIncome Differences,toUS GDP per2007 capita Percent)FP Growth 1/<br>| 1/<br>0 | | | 4 1995-2000<br>-10 | — LJ — | 2001-2005<br>H<br>| | | 3<br>-20 | rl<br>-40 | 1<br>-50 , =<br>-60 | ;<br>OContnbution of Labor Resource Utilization<br>70 O Contribution of Labor Productivity 1<br>=X¥FzZzeo£Rseteo-etmee Ww ag"2092320752RE=~ WmwWws>aasz” F432z2aeFueEEruw 24545= © tertEBSao =a<br>.<br>45 ..-and low labor productivity growth. ; Productivity growth fell in most sectors of the<br>Labor Productivityper Unit Labor Input 1/<br>AQ (Percent, Annual Growth Rate)<br>0.2<br>3.5<br>3.0<br>0.0<br>2.5<br>2.0<br>-0.2<br>1.5<br>1.0<br>-0.4<br>0.5<br>Changes in labor productivity growth 2/,<br>oo; -0.6 avg(Percentage .2001-2006points) vs avg. 1996-2000<br>-0.5 1995 gecSscseseregesshessesCP RsoaePa tPesg4ta -9a BG<br>1997 1999 2001 2003 2005 2007 Sse RuUPSHeae sxe ccSeagss<br>aooS250pez sPsolgS4158 gS5LgstVEG oaeRe"raa<br>8 RETOE GegesiT} FF F£<br>s<br><!-- End of picture text -->

Source: OECD, BoP, and IMF Staff Calculations. 1/Data are from OECD. The latest available data for Portugal's total factor productivity growth were upto 2005. 2/Data are from BoP.
48. At the same time, Portugal became one of the most highly indebted countries in Europe. Government debt has risen sharply over the past decade, corporate leverage has increased, and household debt, driven by low savings, is among the highest in the Euro Area. This has been reflected in sustained large current account deficits financed mainly by bank borrowing from abroad, and a negative net international investment position of about 100 percent of GDP in 2008, one of the weakest among advanced countries. Increasing debt in the context of the crisis has fostered rising risk premia (Figure 20).

27
<!-- Start of picture text --> 80 General Government Debt 80 200 Household Financial Leverageg 16<br>(Percent of disposable incor)<br>G====5 Debt / income<br>70-4<br>_ Euroats L 70 160 === interest<br>-_——-"- ~ * pmts /income (hs) 12<br>aid ae<br>Portugal so -# fa=o EeBE =Eel EG]= EberBS = =<br>50 50 ee a ee 4<br>40 7 ES ess]. EDs]<br>(Percent of GDP) = = =e<br>40 40 QO a5 == =) =e act i= 0<br>2000 2002 2004 2006 2008 02 o3 04 O85 O06 OF a8<br>Non-financial Corporations Non-financial Corporations<br>100 Leverage 30 8 Profit and Interest Coverage 12<br>% % chang (in percent)<br>90 [== debt to equity 1/ A \<br>20 ——debttoequity(ns)1/ 20<br>8<br>70 /]<br>60 | 10 4 ---""<br>| > ae<br>50 “S27 4<br>——-—- Retum on investment<br>| 0 ceeeeeem= Retum on equity<br>. i it —_—_<br>30 -10 0 a]<br>05 06 O7 08 03 2000 2002 2004 2006 2008<br>250 ALS= Feb 9 40 Net International Investment Position<br>(Percentof GDP) a 20<br>200 a<br>L 7 0 ke<br>‘ pu<br>150 / 6 20 KE<br>/ / 5 Be<br>aN f 40 Ff:<br>100 F§ +7” -60 Fe<br>3 fe<br>-80 Be<br>50 —— Extemaldebt 2 eelF (Percentof GDP, 2008)<br>-100<br>——— Inton e xtemalrestdebt (RHS) 1<br>0 0 -120 EFQOSZaatqgeZzaqaQgDAb<br>1998 eSe = Ww a<br>2000 2002 2004 2006 2008 ae aI ae s eFr2c = suas<br><!-- End of picture text -->

Sources: Bank of Portugal, Eurostat and staff calculations. 1/Non-consolidated figures.
# **Italy**

49. While Italy‘s fiscal policy in recent years had been reasonably conservative—well below the Maastricht criterion of 3 percent of GDP—its vulnerability arises from fiscal profligacy in the past which resulted in a very high debt public burden (which was even slightly above that of Greece‘s in 2009). Like Portugal, vulnerability to adverse shocks in a highly uncertain post-crisis global environment reflects the combination of high debt, declining competitiveness and anemic growth. While like Portugal, Italy did not have a real estate bubble, a recent study by the European Commission showed that, from 1998 to 2008, exports of goods and services grew more slowly in Italy than in any other member country. Standard competitiveness indicators in Figure 21 show a rising gap since the late 1990s.

29
Global market shares have been declining...

<!-- Start of picture text --> 110 110<br>Export Market Share<br>100 (1996=100) 100<br>=<br>90 _o* 90<br>\<br>80 % 80<br>*.<br>70 “s<br>‘ 70<br>sy<br>60 Values ‘s 60<br>eee== Volumes my<br>50 50<br>1996 1998 2000 2002 2004 2006 2008<br>...and the real exchange rate appreciated.<br>145 145<br>REER Based on ULC and CPI<br>135 (1999=100)<br>F France (ULC) 135<br>= |i aly (ULC)<br>—— Germany (ULC)<br>115 fF teens italyGermany (CPD(CPI) 115<br>105 --"<br>ee<br>a.eee ae te led<br>we<br>95 tal «<br> a 28<br>85 85<br>2000 2002 2004 2006 2008<br>_..but the exports started to recover following<br>asharp decline ...<br>15 15<br>10 Exports<br>(Year-on-year percentchange) 7 10<br>5 Weck<br>‘ 9<br>0 = 0<br>~~<br>“10 ‘ 41 710<br>“15<br>-20 — Value , Fy 7<br>2 Volume F/ -20<br>-25 ws -25<br>-30 -30<br>2007q1 9 2007q4 9 2008q3 2009q2<br><!-- End of picture text -->

<!-- Start of picture text --> _.as labor costs have been relatively high...<br>7 7<br>ULC of the Total Econamy<br>6 (Percent change) ‘<br>é<br>ra<br>3 4 3<br>Fi<br>f<br>1 a / 4<br>--<=- =<br>* ’<br>-1 —— France ‘“\ Fd -1<br>=<<=- Germany —<br>——= fialy<br>-3 -3<br>2000 «©2002 «2004 «= 2006 )=—s 2008<br>Nominal exports fell sharper than than for peers...<br>20 20<br>Nominalexport growth<br>(Year-on-year percent change)<br>10 10<br>eee<br>|<br>|<br>-10 10<br>20 @Jan-Dec 2007 20<br>= an-Liec -<br>g@ Jan-Dec 200 98<br>-30 -30<br>Italy Germany Spain France<br>...with trade balances moving sideways.<br>6 6<br>Trade Balance<br>(Billions)<br>—— Goods<br>4 moene Services 4<br>2 2<br>0 AN \ ~\n | 0<br>| \ '<br>oi 2<br>-4 -4<br>Jan-07 Jul-O7 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10<br><!-- End of picture text -->

Nominal exports fell sharper than than for peers...

Sources: Istat; OECD; Eurostat; Bank of<sup>Italy; andIMFstaff estimates.</sup>
50. Banks proved resilient to the initial phase of the global financial crisis, as they benefited from a business model based on classical on-balance sheet lending-deposit activity, and strong customer relationships. With adequate liquidity and the absence of asset bubbles and toxic assets, this conservative business model sheltered Italian banks from the liquidity crunch at the onset of the crisis. However, the subsequent deterioration of the economy weakened banks‘ asset quality and profitability. Following the economic contraction, lending growth to the private sector slowed sharply, profitability declined, and asset quality deteriorated.

# **Concluding remarks**

51. The adoption of the euro prompted fundamental changes in the Euro Zone. Convergence of interest rates in periphery countries to the levels in core countries in combination with rising capital inflows owing to greater financial integration set off a consumption and real estate boom in periphery countries, leading to higher growth and increases in government revenue and spending. The resulting real appreciation led to a loss of competitiveness in periphery countries, adversely affecting export performance and causing current account imbalances. While the fiscal position remained manageable before the crisis owing to rising revenue, the recession following the global financial crisis led to the burst of the real estate bubble and a financial sector crisis and to sharply increased budget deficits and worsened debt indicators and triggered the sovereign debt crisis. Core countries, in particular Germany, maintained a competitive edge through wage restraint allowing them to increase exports to periphery countries, while their banks profited from increased lending to non-core countries. In sum, the euro exacerbated intra-European imbalances whose unsustainability became evident in the aftermath of the global financial crisis and triggered the current sovereign debt crisis.

31