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WorldMarch 2 2015

Eurozone meltdown: how can it be avoided?

As the need to resolve the eurozone crisis intensifies, member states seem to be moving further apart on key issues, including the architecture of the union and the terms of Greece's bail-out package. But while political rifts open up, many economists agree that the only way forward is by working towards greater economic integration. 
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Eurozone meltdown: how can it be avoided?

Resolving the eurozone crisis is one of the greatest challenges facing the global economy. Steady global growth cannot resume until a proper solution is found, as nearly all major economies – the US, China and Brazil – are impacted by failure in the common currency area. But, for the past five years, the euro area has lurched from one disaster to another, amid bitter argument over who is to blame and with reform and key initiatives moving at a snail’s pace.

The latest crisis in Greece is a case in point. The inability to come up with a formula that returns Greece to a sustainable growth path has led to political fallout, with January's Greek presidential election resulting in the radical left-wing Syriza party winning the vote, on a pre-election promise that it would renegotiate the terms of the 2010 bail-out and curtail the country's austerity programme.

Radical and populist parties on both the left and right are gaining traction across the eurozone, leading to fears that the current stand-off in Greece may be repeated in Spain, Italy or France. At the same time, countries that are contracted to join the common European currency, such as Poland and Hungary, look as if they may delay entry as long as possible. (Lithuania, however, has taken the plunge, joining in January.)

Sticking together

While most observers agree that the right way forward for the eurozone is a more federal structure with greater fiscal union, the political reality is taking the eurozone in the opposite direction – towards stronger national positions.

With the European Central Bank’s (ECB's) belated quantitative easing (QE) programme, for example – which was instigated seven years after equivalent programmes in the US and UK, the delay mostly down to German objections – it was decided that 80% of purchased bonds will sit on the balance sheets of the national central banks rather than the ECB. This outcome was largely driven by Germany’s fears of being responsible for losses if one of the peripheral countries defaulted – but it is hardly a demonstration of faith in the eurozone’s future.

Despite all the arguments and political ill-feeling, few analysts expect the common currency zone to break up or for Greece to leave. It is widely thought that the consequences of a Greek exit would be disastrous for both sides. Greek companies and banks would likely fail and the national economy would go into meltdown, while the reality that a country could leave would make the remaining eurozone even more unstable. Markets would begin speculating immediately on the next departure.

However, if a eurozone break up is to be avoided, solutions have to be found.

Lucas Papademos, Greece’s prime minister between 2011 and 2012, vice-president of the ECB between 2002 and 2010, and governor of the Bank of Greece between 1994 and 2002, believes that the institutional architecture of the economic and monetary union (EMU) must be completed, and that its economic and structural foundations need to be strengthened.

“The first step is to complete the European banking union. The establishment of the banking union is a tremendous achievement and will help protect financial stability,” he says. “But there is also a need to complete and improve it by creating a single deposit insurance for the eurozone, and by amending certain features of the single resolution mechanism for failing banks and of the rules for direct recapitalisation of banks by the European Stability Mechanism [ESM].”

An unhappy union?

Steps towards integration will not please all eurozone member states. “The issue is complex and difficult because it involves decisions that are profoundly political,” says Mr Papademos. “A fully fledged banking union requires more risk sharing by member states, and hence a higher degree of fiscal integration.”

Mr Papademos adds that it would not be necessary to create a federal state in order to achieve a more efficient and robust eurozone. He sees no immediate need to create a political union in the eurozone as “this is not necessary and clearly not envisaged” for some time to come.

“The practical and immediate task is to define the kind of policies and the appropriate institutional set up for a more integrated fiscal framework in the eurozone,” he says. “It is likely that we will follow a step-by-step approach as required by evolving circumstances and needs. It is not easy to predict how quickly a greater degree of fiscal integration, and the necessary political underpinnings of it, will be established.”

Mr Papademos also supports calls for “the joint issuance of public debt up to a certain level and subject to conditions” and he could go as far as supporting “the pooled financing of expenditure related to public goods, such as infrastructure projects, and a joint European defence capacity”. He is also agreeable to the possibility of a eurozone-wide unemployment insurance system, which he says “could help address cyclical employment fluctuations due to asymmetric shocks". 

Jens Weidmann, president of the Deutsche Bundesbank, believes that domestic discussions within European member states make a true fiscal union unfeasible “either now or in the foreseeable future” and therefore sees “no viable alternative to reinforcing the original set-up of the monetary union”. In a speech delivered in Venice on February 5, 2015, he further cautioned that the eurozone should “not take the second step before the first”, referring to attempts to broaden joint liability before ceding budgetary sovereignty.

Enter at your own risk

Meanwhile, the Maastricht criteria – the minimum standards for entry into the eurozone – have been criticised for being inadequate. The Maastricht criteria require that EU member states applying for entry to the eurozone have an annual budget deficit-to-gross domestic product (GDP) ratio of no higher than 3%; a government debt-to-GDP ratio not exceeding 60%; and average 10-year government bond yields of no more than 2% – criteria that were not always met by existing members.

Reforms to the criteria, added in recent years, including the fiscal compact initiative (see table), aim to strengthen the economic pillar of the EMU. The two-pack reform package introduced additional checks, such as the requirement that national government budgets are approved by the European Commission (EC), but when the budgets submitted by France and Italy in 2014 were criticised by the EC for containing “excessive government deficits” this prompted further concerns about the effectiveness of the new criteria. 

“The tougher fiscal rules are heading in the right direction, but they must now be implemented as well,” says Mr Weidmann. “Unfortunately, the rules have latterly become significantly more complex. A great deal of scope for interpretation and discretion has now been opened up. And the EC’s comments… with regard to its future interpretation of the fiscal rules unfortunately indicate that these tendencies are likely to become even stronger.”

Gabriel Sterne, economist and head of global macro investor services at advisory firm Oxford Economics, says: “The Maastricht criteria are what they are and, if people stick to them, they should be fine. But what we have seen, for example in the Irish case, [is] where the rise in leverage and lending went wrong and it blew out public debt quickly. I don’t think with the new firewalls put in place you can be sure that this would never happen again.”

Stakes are high

In the meantime, the clock is ticking on the review of Greece’s bail-out programme, and the two sides – the Greek government and the other eurozone members – are far from reaching a consensus. The Greek crisis has been especially painful, with the country's economy shrinking by 25% and unemployment reaching 26%.

Back in 2010, when the crisis erupted, the country received bail-out packages arranged by the 'troika' of the EU, the ECB and the International Monetary Fund. The country was offered financial support through the EU’s temporary European Financial Stability Fund, as well as from the other troika members, but the bail-out was linked to a programme that required the implementation of structural reforms and austerity.

While Ireland and Portugal, both of which entered into similar agreements, exited their programmes in mid-2014, as economic recovery and deficit reduction allowed the countries to regain full market access, Greece is not scheduled to conclude its programme before 2016. And now the country’s new government wants to renegotiate the terms.

The Greek programme was originally due for review at the end of 2014, but with elections scheduled for January 2015, the previous government asked for an extension until the end of February – a looming deadline for new prime minister Alexis Tsipras’s government at the time of writing.

“When European leaders and policy-makers stress that Greece has to respect its commitments they mean, among other things, the need to complete the assessment of the current programme,” says Mr Papademos. “A new programme can have different goals and modalities from the previous one, but it cannot be disjointed from it – there has to be a certain degree of continuity of commitments made and reforms implemented in the past, and the new policies to be adopted in order to achieve policy objectives in the future.”

The stakes are so high because without an agreement, Greece might end up without any access to emergency funding and sovereign debt sales would be limited – there is a €15bn limit under the current bail-out programme – and expensive.

Greek sovereign bonds have witnessed a sell-off in the market since the elections, which pushed yields on Greece’s three-year bonds to 17.83% and 10-year paper to 10.16% as of February 5, according to data from the Bank of Greece. At the same time, the country’s banks have witnessed sizeable withdrawals of deposits – of more than €10bn between the end of December and the end of January – which could result in need for support in case of a liquidity shortage, according to Nikolaos Georgikopoulos, visiting research professor at New York University, Stern School of Business and research associate at the Centre of Planning and Economic Research in Athens.

Playing hardball

Greece's new government won the elections on a promise that it would negotiate debt relief and an end to the country's austerity measures, and it aims to be a tough negotiator in the eurozone. While the Syriza party is not seeking an exit from the euro, it does not exclude the option as a last resort – a contingency investors are fearing. It would have wide-reaching implications for the Greek economy, including a likely collapse of its banking sector due to a liquidity crisis, and would raise the likelihood of subsequent exits from the eurozone, which would cause yields on the sovereign debt of other eurozone countries to soar.

Initial calls by Syriza for haircuts on the country’s €320bn debt bring difficulties because the lenders of this debt are effectively the eurozone’s tax payers. This is what makes the situation today fundamentally different to the reduction and restructuring of Greece’s debt in 2010, when private sector investors held most of the Greek government bonds, and which is why a write-off is politically difficult and hence unlikely to be agreed, according to Mr Papademos.

Mr Georgikopoulos suggests that one solution to Greece’s problem is to extend the maturity of its bonds by a significant term, such as 70 years, while locking in the interest rate on the majority of the loans at a level close to Euribor, which would make servicing the debt less expensive. This solution would mean that Greece would only have to pay the interest on its debt, allowing the economy to recover and grow faster. This would obviously not decrease the nominal value of Greece’s €318bn of debt; however, its debt-to-GDP ratio – currently 177.7% – would come down with economic growth.

“In November 2012, the troika had promised Greece that when it managed to achieve sustainable primary surplus for consecutive quarters, then it would further ease the burden of the debt,” says Mr Georgikopoulos. “This has not happened, but should be renegotiated. And, while it is difficult to bring about a haircut, an immediate debt relief could be achieved through re-registering the €25bn bail-out money to recapitalise the Greek banking sector, as well as the €14bn used to bridge a funding gap that was given to Greece through the European Financial Stability Facility and is registered as Greek public debt, to the ESM.”

Giving Greece a break

Greece’s troubles relate more to its ailing economy than to its high levels of debt, according to Mr Georgikopoulos. “Obviously, Greece is in a lot of debt, about €320bn, but the most important problem is the liquidity, just as it was in 2012,” he says. “How will they find money to implement the new programme, having no access to the financial markets, if they do not want to accept the last tranches from the previous programme, some €7bn, which is still meant to be released?” he asks.

Greece’s economy is sluggish, and has been since the start of the crisis. What is more, the country’s high unemployment rate – 26.7% as of 2014 – is making growth difficult. “Greece should get enough help so that the government can start investing in infrastructure and can have a good old-fashioned Keynesian recovery,” says Mr Sterne at Oxford Economics. “It is about reversing 50% youth unemployment over several years, which [equates to] losing a generation.

“I understand the German perspective, which is ‘you screwed up so you have to pay’, but that is not how an optimal currency union works. There have to be fiscal transfers from the rich north to the stricken south on a major scale.”

In 2014, Greece’s economy saw its first annual expansion since 2007, when its GDP increased by 0.9% thanks to growth in the economy in the third and fourth quarter of the year, according to Oxford Economics. An increase of 1.7% is forecast for 2015.

Radical undercurrents 

Growth has slowed across the eurozone, as austerity plans have been implemented, not just in Greece and other crisis-stricken countries, but even in the currency zone's strongest economy, Germany. GDP growth in the eurozone came in at just 0.8% in 2014, according to the Organisation for Economic Co-operation and Development (OECD), with forecasts only slightly higher in 2015 at 1.1% and at 1.7% in 2016.

It is this slow economic growth and, in some countries, high rates of unemployment that have caused the rise in support for radical parties on both the left and right of the political spectrum, as well as of anti-integration protest parties.

Syriza’s victory in the Greek election has set a precedent in the region. Spain, another country stricken by high unemployment (24.6% in 2014), will go to the polls for its next general election in December 2015. Since early 2014, its left-wing, anti-austerity party Podemos has seen a strong rise in support. According to polls conducted by public research institute SigmaDos, at the end of January, following Syriza's victory in Greece, Podemos was attracting 26.3% of the Spanish vote, making it the second largest party by share of the vote behind the People’s Party with 27.1%.

“The euro itself has had a very major role in the rise of populist right-wing and left-wing politics, and I am pretty sure that few of these parties that are now coming to the fore in the periphery, be it in Greece or Spain, would have ever gotten that far if it hadn’t been for the euro,” says Mr Sterne.

Germany’s recent addition to the political landscape, called Alternative für Deutschland (AfD), meanwhile, underlines Mr Sterne’s statement as it has made opposition to the euro its overarching programmatic theme. AfD calls for the break up of the eurozone and a reintroduction of the deutschmark. While the protest party has not yet obtained any seats in the Bundestag, it has sent seven members to the European Parliament, as a result of elections in May 2014. A monthly political survey conducted by opinion research centre Infratest-dimap placed AfD as the fifth most popular party in the country, attracting 6% of the German vote in a February 5 opinion poll.

“The way forward is to try to break the adverse feedback between the state of the economy and public attitudes towards European integration, by implementing economic policies and institutional reforms to increase real incomes and reduce inequality in a meaningful and sustained way,” says Mr Papademos. “Then – if growth is strengthened and unemployment is reduced – the strength of these parties will be mitigated. If this does not happen, there is a serious risk of a weakening of the European integration process and of the eurozone itself. I don’t expect this risk to materialise but we have to be vigilant and implement appropriate policies and reforms to prevent it.”

Eurozone

Bad publicity

In the unlikely event that Greece and its creditors in the eurozone do not come to an agreement and Greece leaves the common currency, this would not only impact Greece’s economy and the economies of existing eurozone members, but also those EU members still aspiring to enter the currency union. “Think about the impact on other European countries still seeking to enter the eurozone, should Greece exit,” says Mr Georgikopoulos. "How sceptical would they be if they saw that one of the member countries had left?”

There are seven current EU member states committed to introducing the euro: Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania and Sweden. 

On January 1, 2015, Lithuania became the 19th country to join the eurozone, 13 years after it first pegged its former currency the litas to the euro. “Lithuania was the last remaining small economy where a compelling case for euro-accession could be made,” says Alexander Lehmann, lead economist for central Europe at the European Bank for Reconstruction and Development. “When you think ahead, there are few other obvious candidates: Romania and Bulgaria have yet to overcome deep structural problems, while Poland and Hungary have much more advanced economic structures, but are also facing political obstacles.

"Poland requires a constitutional change, for which currently there does not seem to be a political consensus, and in Hungary, of course, the record of recent reforms have complicated the situation in the banking sector. This indicates that a steady expansion of the eurozone now faces more challenges.”

Aside from its still-high, if falling, government deficit, Poland – the EU's strongest performing economy in the past year, with GDP growth of more than 3% – should not face too many barriers to joining the common currency area. Still, Poland’s minister of finance, Mateusz Szczurek, says that there is no roadmap to adopting the euro.

“The pros and cons of joining the eurozone have shifted over time, because Poland is a much more mature economy today,” says Mr Szczurek. “We have macroeconomic stability, access to funding, which is at par with, or better than, that of eurozone countries. That means the benefits of joining are not as great as we thought they were back in 2004.”

Poland on pause

The timing of further eurozone entries will likely depend on domestic and economic circumstances, according to Mr Papademos. “These countries will have to fulfil the convergence criteria required for euro adoption and also be confident that their economies can function within the eurozone in an efficient manner,” he says. “And I suspect that some of them would like to wait and see that the eurozone economy performs robustly and its growth is stronger and more sustained before making a decision.” 

This is certainly the position being adopted by Poland. “I am not going to set a date for when we are going to enter,” says Mr Szczurek. “First of all, we need to meet the nominal criteria, we need to make sure that we remain or are flexible enough, both in terms of possible fiscal space and macro-prudential regulation, and also, the eurozone itself must be confident that it is going in the right direction.”

Meanwhile, Romania is the only one of the seven remaining countries to have set a target to join the eurozone. It plans to enter by 2019, but a detailed roadmap is still pending.

A band-aid?

With the eurozone economy lagging, thanks to slow growth and rising concerns over deflation, the ECB finally announced a long-awaited programme of QE in January 2015. While larger than expected, the sovereign debt purchase programme, which will be running from March 2015 until at least September 2016, and allows the central bank to buy a minimum of €1100bn of sovereign debt of all member states, has still been accused of being half-hearted by many observers.

While the headline figure of 20% of assets, which are applicable for risk-sharing under the ECB, is already low, it translates into the ECB only buying 8% of all asset purchases directly, while 12% of purchases will be made by European institutions such as the ESM, which are backed by joint liability of the respective governments.

While debt from non-investment grade-rated countries can be bought – a relief for Cyprus and Greece – such countries need to be under a programme to be eligible. This leaves Greek securities vulnerable to market speculation over the future of its programme and its place within the eurozone.

And there is more bad news for Greece: a recent research paper by Morgan Stanley notes that the ECB will not hold more than 33% of each issuer and not more than 25% of each single issue in order to still allow normal market functioning, and to avoid having a blocking minority against a hypothetical debt restructuring in the future.

For Greece, that means there will be no additional purchases until some of the debt that the ECB holds has been redeemed, which, according to Morgan Stanley, is unlikely before July.

Further integration

A decision on the future institutional make up of the eurozone and the necessary reform has to be made sooner rather than later. The first decisions in response to the new Greek government’s confrontational course could come within weeks; should a compromise be reached, however, it could also take months of negotiations.

So far, both sides are digging in hard and there is a risk that disagreement could still culminate in a Greek exit from the eurozone – the impacts of which would reach far further than just the eurozone’s borders.

This uncertainty has to be put to bed through clear and decisive reform plans not only revolving around a common currency but a further integrated common economic union.

“Ultimately, economic convergence among countries cannot be only an entry criterion for monetary union, or a condition that is met some of the time,” writes Mario Draghi, president of the ECB, in a column on the website of the World Economic Forum on January 5. “It has to be a condition that is fulfilled all of the time. And for this reason, to complete monetary union, we will ultimately have to deepen our political union further: to lay down its rights and obligations in a renewed institutional order.”

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