LESSONS OF THE EUROPEAN CRISIS FOR REGIONAL MONETARY AND FINANCIAL INTEGRATION IN EAST ASIA Ulrich Volz, German Development Institute 8 August 2012, United Nations Economic and Social Commission for Asia and the Pacific, Bangkok Overview 1. Introduction 2. 3. Lessons for East Asia 4. Conclusions
Introduction Europe currently faces a severe crisis The debt crisis in several member states of the euro area has raised doubts on the viability of European Economic and Monetary Union (EMU) and the future of the euro Was European monetary unification a bad idea? While the launch of the euro in 1999 created a lot of interest in regional monetary integration and even monetary unification in various parts of the world, including East Asia, the current crisis has had the opposite effect, even raising expectations of a break-up of the euro area Crisis has highlighted the problems and tensions that will inevitably arise within a monetary union when imbalances build up and become unsustainable Introduction The objective of this presentation is twofold: To review the causes of the European crisis and explain why the crisis of a small member accounting for less than 3% of the euro area s GDP could cause so much havoc To draw lessons that East Asian countries can pick up from the current Europe sovereign debt crisis so they can pursue further successful development and economic integration in the region
Overview 1. Introduction 2. 3. Lessons for East Asia 4. Conclusions What happened? The Greek tragedy and how it spread over to Portugal, Ireland, Italy and Spain ( PIIGS : Portugal, Ireland, Italy, Greece, Spain) Underlying causes of the crisis Country-specific problems Banking crisis fuelling sovereign debt crisis and vice versa Mispricing of risk and misallocation of capital Imbalances in the euro area Lack of coherent and credible crisis response by European governments
What happened? 5 Nov 2009: George Papandreou's new Socialist government says the 2009 budget deficit will be 12.7% of GDP more than double the previously published figure 8 Dec 2009: Fitch Ratings, which had cut Greece to A- when the higher deficit was revealed, cuts Greek debt to BBB+, the first time in 10 years it has been rated below investment grade 16 Dec 2009: Standard & Poor's cuts Greece's rating by one notch, to BBB-plus from A-minus, saying the austerity programme is unlikely to produce a sustainable reduction in public debt 22 Dec 2009: Moody's cuts Greek debt to A2 from A1 over soaring deficits The revelation of the real Greek fiscal situation at the end of 2009 raised serious doubts on the country s ability to repay its debt Rating downgrades and rising interest rates made it ever more difficult for the government to refinance itself, creating a downward spiral for the Greek economy Bail-out by other European countries and IMF failed to restore trust in Greek economy Greek crisis has also raised concerns over debt situation of other periphery countries of the euro zone Rising borrowing costs for several members of the euro area (the PIIGS) as trust in their ability to repay vanishes Increased focus on structural/competitiveness problems of PIIGS and imbalances within the euro area
10 year government bond yields, January 2007 January 2012 Source: Datastream Sovereign Credit Default Swaps, December 2007 January 2012 Source: Eurostat
Underlying causes of the crisis Country-specific problems Banking crisis fuelling sovereign debt crisis and vice versa Mispricing of risk and misallocation of capital Imbalances in the euro area Lack of coherent and credible crisis response by European governments Causes of the crisis: Country-specific problems Greece: Desolate public finances due to a dysfunctional fiscal system, a massively oversized (and inefficient) public sector, and endemic corruption Ireland: Banking crisis! In September 2008 the Irish government guaranteed all outstanding obligations of the Irish banking system as a reaction to the Irish banking crisis (these were initially 400bn. but have increased to 440bn.) Ireland did not have a fiscal or debt problem before the crisis! Spain: Burst of housing bubble Spain did not have a fiscal or debt problem before the crisis either
Causes of the crisis: Banking crisis fuelling sovereign debt crisis and vice versa Government bail outs of banking systems in the course of the global financial crisis has increase public debt Fiscal positions worsened as economies contracted and governments responded with anticyclical policies Between 2007 and 2010, the debt to GDP ration of the Eurozone increased from 66.3% to 85.4% Governments failed to recapitalise banks swiftly Sovereign risk has increased and worsens bank s assets Further bail outs (of banks and states) make things worse Vicious circle set in motion Public debt as % of GDP, 1995-2010 Source: Eurostat
Public debt as % of GDP, 2007-2010 Source: Eurostat Credit default swap spreads of euro area (basis points, weighted by gross debt, excl. Greece), 2008-2012 Source: IMF
Causes of the crisis: Mispricing of risk and misallocation of capital Sovereign risk of the PIIGS was priced almost the same as German debt, not least because the Eurosystem (the ECB and the national central banks of the Eurozone) treated the sovereign debt instruments of the Eurozone central governments as risk-free collateral when these were offered as collateral for repos and other collateral financing trades Big drop in real interest rates in the periphery countries Low interest rates in PIIGS after entry into the euro area and inflowing capital fuelled unsustainable developments, including excessive credit dynamics and real estate bubbles in Spain or excessive fiscal spending in Greece 10-year government bond yields (% per annum), October 1990 December 2011 Source: Eurostat
Causes of the crisis: Imbalances in the euro area Divergences in current account balances across the Euozone have mostly gone hand in hand with divergences in price competitiveness The domestic booms resulting from low interest rates and capital inflows, in conjunction with existing labour market rigidities, led to large wage increases in excess of productivity growth, triggering a loss in price competitiveness and thereby impairing export performance Higher growth of inflation, wages and unit labour costs in PIIGS Appreciation of real effective exchange rates of PIIGS Loss of competitiveness of peripheral members of the euro area (PIIGS) vis-à-vis the core countries (esp. Germany) Current account deficits of PIIGS Average annual wages (in 2009 USD, constant prices), 1990-2010 Source: OECD
Unit labour costs (OECD index base year 2005=100), 1990-2010 Source: OECD CPI (differential over Germany CPI, in %), 2001-2010 Source: IMF
Real effective exchange rates based on relative unit labour costs, 1990Q1-2011Q1 Source: IMF Current account (quarterly data, in million USD), 1990Q1-2011Q1 Source: IMF
Causes of the crisis: Lack of coherent and credible crisis response by European governments European leaders were caught wrong-footed as they believed that a balance of payments crisis was impossible within a monetary union No crisis resolution mechanism in place the European Financial Stability Facility (EFSF) had to be created in midst of crisis (following decisions taken by members states on 9 May 2010) No coherent crisis response strategy from European governments and weak Commission Differing opinions and open diversions between creditor and debtor countries regarding a crisis solution strategy have further increased panic in the markets
Overview 1. Introduction 2. 3. Lessons for East Asia 4. Conclusions Lessons for East Asia Five lessons Don t rush with monetary integration! Rethink costs and benefits of international financial integration! Bolster crisis prevention and resolution mechanism before crisis hits! Strengthen surveillance and monitoring of regional financial markets! Recapitalise banks swiftly after crisis!
Lesson 1: Don t rush with monetary integration There is still a strong case for monetary and exchange rate cooperation in East Asia (e.g., Volz 2011) but overambitious monetary and exchange rate integration schemes will backfire East Asian countries are not ready for a regional exchange rate system, let alone monetary union A high level of political agreement and commitment is needed among countries to pursue successful monetary integration, as well as close macroeconomic and fiscal coordination Just like the crisis of the European Monetary System in 1992, the current crisis highlights the dangers that advanced monetary integration brings in the face of economic and political divergences Macroeconomic imbalances within any kind of fixed exchange rate system will cause problems at some point Lesson 1: Don t rush with monetary integration East Asian countries should pursue a very gradual approach to monetary integration that allows for much flexibility and room for adjustment Managed floating guided by currency baskets are one option to keep relative intra-regional exchange rate stability
Lesson 2: Rethink costs&benefits of int l fin. integration The European crisis highlights once again that international financial integration will not automatically lead to an efficient allocation of capital and that it can contribute to the development of unsustainable imbalances The Stability and Growth Pact s belief in the power of free markets to discipline governments was not warranted (under-/overpricing of risk) International (including regional) financial integration increases contagion risk Greek crisis triggered a full-blown European crisis Financial institutions engaging in cross-border activities increase systemic risk and pose a regulatory challenge East Asian countries should be careful with liberalising financial markets too fast Lesson 2: Rethink costs&benefits of int l fin. integration Regulatory architecture needs to keep pace with financial integration Close cooperation of national regulators needed From a certain level of regional financial integration a regional regulatory body is needed Macroprudential regulation to deal with capital inflows (especially in a monetary union where interest rate and exchange rate cannot be used)
Lesson 3: Bolster crisis resolution mech. before crisis hits Crisis prevention and resolution mechanism needs to be in place before the next crisis ASEAN+3 should increase efforts to improve regional financial architecture now There is no time for complacency in East Asia Risks are looming Capital inflows can reverse quickly Liquidity crisis can occur even if fundamentals are ok (e.g., Korea 2008) Make Chiang Mai Initiative Multilateralisation (CMIM) process fully functional asap Work out details of cooperation with the IMF if a big crisis hits, IMF support will be needed US$240bn. may not suffice Lesson 4: Strengthen reg. surveillance and monitoring Strengthen surveillance and monitoring of regional financial markets Crisis can spread quickly among closely integrated economies (remember the Asian crisis!) Effective surveillance and monitoring is the best crisis prevention Strengthen ASEAN+3 Macroeconomic Research Office (AMRO) More resources need to be devoted to regional financial surveillance Risks of capital inflows need to be managed Regional approach (in addition to global efforts) to volatile capital flows is needed In an integrated region (world) no country can do it alone Consider Asian Financial Stability Dialogue
Lesson 5: Recapitalise banks swiftly after crisis Respond swiftly to banking crisis with swift recapitalisation of banks Undercapitalised banks need to be recapitalised quickly, otherwise they will hold back economic growth and increase risk of new crisis outbreak Europe has set negative example in this respect Negative Japanese experience with too slow clean-up after banking crisis should have been a warning Europe seems to be following Japan Overview 1. Introduction 2. 3. Lessons for East Asia 4. Conclusions
Conclusions European crisis highlights what can go wrong in terms of regional financial and monetary integration It is wrong to conclude that European monetary union was a flawed idea, but the vulnerabilities have become obvious now and ought to be addressed The crisis holds important lessons for East Asia and these should be taken seriously East Asia needs more regional monetary and financial cooperation, not less! Regional financial and monetary cooperation need to keep pace with integration of the real economies of East Asia Cooperation on the regional level as complement to global cooperation As seen also during the Asian crisis, crises can spread quickly The region needs to have adequate response mechanisms in place The time to strengthen crisis response mechanisms is now! MIT Press book & ADBI Working Paper
Thank you for your attention! ulrich.volz@die-gdi.de