European Sovereign Crisis, what s the Outcome? Gonzalo Rengifo June 2012 Mexico

European Sovereign Crisis, what s the Outcome? Gonzalo Rengifo June 2012 Mexico

1 Current situation

Eurozone (im)balances: a Small World Rising imbalances since the creation of the euro Eurozone current accounts (% Eurozone GDP) by major EMU member 1.6 %GDP Northern Europe to rest of the world euro Northern Europe to southern Europe 1.2 0.8 0.4 0.0-0.4-0.8-1.2-1.6 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Austria Belgium Finland France Germany Ireland Italy Netherlands Portugal Spain Greece 3

Fiscal Revenue for Advanced and Emerging Countries Fiscal revenue to GDP ratio in 2010 60.0 4 10.9 13.4 17.2 17.4 17.5 18.3 20.7 20.8 20.9 22.4 22.7 23.1 24.3 24.3 24.6 24.7 25.0 25.7 27.2 31.9 32.3 32.9 33.1 33.8 33.9 34.2 35.7 35.8 37.5 37.5 38.4 38.9 39.0 39.9 40.5 41.5 41.5 43.8 44.8 46.1 46.2 48.0 48.6 49.6 52.7 52.9 54.5 56.0 50.0 40.0 30.0 20.0 10.0 0.0 India Philippines Peru Taiwan Indonesia Thailand Venezuela Malaysia China Turkey Mexico Emerging South Africa Argentina Egypt Chile Brazil Korea Colombia United States Australia Switzerland Japan Romania Bulgaria Ireland Spain Russia Poland Advanced Canada New Zealand Greece Ukraine United Kingdom Portugal Czech Republic Germany Hungary Italy Netherlands Austria Belgium France Finland Sweden Denmark Norway

Debt-to-GDP Ratio: Developed Economies General government debt-to-gdp ratio: major advanced (21) economies 5 96.7 23.6 33.9 37.8 39.8 42.6 43.4 44.7 49.7 61.1 62.9 65.8 71.9 82.4 83.4 85.1 92.6 93.3 96.2 101.1 119.4 144.9 200.0 200 150 100 50 0 United States Australia Emerging New Zealand Sweden Switzerland Denmark Finland Norway Spain Netherlands United Kingdom Austria France Germany Canada Ireland Portugal Belgium Advanced Italy Greece Japan %GDP 2010 General Government Debt Maastricht Criteria (60%) Fitch criteria (80%)

Euro Countries: GDP Shares Eurozone countries: GDP in billion of euros and in percentage of total eurozone GDP Ireland; 153; 2% Portugal; 172; 2% Finland; 180; 2% Greece; 230; 3% Austria; 281; 3% Belgium; 346; 4% Germany; 2481; 27% Netherlands; 591; 7% Spain; 1062; 12% France; 1931; 21% Italy; 1547; 17% 6

Euro Countries: Public Debt Shares Eurozone countries: public debt in billion of euros and in percentage of total eurozone debt Finland; 80.5; 1% Ireland; 144.4; 2% Portugal; 161.0; 2% Austria; 205.9; 3% Greece; 333.7; 4% Germany; 2061.8; 27% Belgium; 340.7; 4% Netherlands; 369.9; 5% Spain; 641.9; 8% Italy; 1854.9; 24% France; 1591.2; 20% 7

Who Owes Money to Whom (USD Bn) 8

2 What has been done so far?

Central Government Fiscal Balance Central fiscal balances have generally improved. Eurozone on average better than the UK & the US Central fiscal balances: Italy, Spain & EFSF-3 countries Central fiscal balances: Eurozone (average), UK & US 5.0 %GDP, 12-month moving average 2.0 %GDP, 12-month moving average 0.0 0.0-2.0-5.0-4.0-10.0-6.0-8.0-15.0-10.0-20.0 07 08 09 10 11 12-12.0 07 08 09 10 11 12 Italy Spain Portugal Greece Ireland Germany Eurozone France UK US Source:, CEIC, Datastream, as at 25.02.2012 10

Spanish Fiscal Policy 11

Italy & Spain debt/gdp Evolutions under Various Interest Rates Insert key message Italian debt/gdp simulated for various interest rates Spanish debt/gdp simulated for various interest rates 160 150 %GDP 154 140 120 %GDP 120 140 130 132 100 106 98 120 119 80 110 60 100 90 40 80 20 2010 2011 2012 2013 2014 2015 2016 2010 2011 2012 2013 2014 2015 2016 Interest rate at 5% Interest rate at 7% Interest rate at 10% Interest rate at 5% Interest rate at 7% Interest rate at 10% 12

Sovereign Debt Long and Short-term Scores Sovereign debt long and short-term scores for developed economies: a scatter diagram view Dynamic (short-term) Score 1.5 0.5-0.5-1.5-2.5 Greece Austria CanadaFinland France Italy United States Belgium United Kingdom Spain Portugal Japan Ireland Good long and short-term positions Norway New Zealand Germany Sweden Netherlands Australia Switzerland Denmark Bad long and short-term positions -3.5-3.0-2.0-1.0 0.0 1.0 2.0 3.0 Sustainability (long-term) Score 13

Euro Endgame: Multiple Equilibria Current state Monetary union Fiscal autonomy Euro breakup Fiscal integration National currencies One country opts out No Eurobond Small central fiscal authority Eurobond Strong central fiscal authority Rising number of new national currencies Increasing fiscal federalism Risk Scenario Main Scenario Source: 14

Solving the Debt Problem Four Ways Out High short-term cost / low long-term cost Low short-term cost / high long-term cost Solution Debt repayment Bail-out Sovereign default Monetization Debt solving mechanism Primary balance deficit reduction Bilateral agreements or supranational bail-out Official default and debt restructuration Central Bank Intervention to use the inflation channel to solve the debt problem Domestic consequences Lower economic nominal growth Social imbalances and conflicts between tax payers and public workers Loss of economic independence Limited if no access to the international market of capitals for an extended period Loss of the Central Bank s credibility Currency depreciation Weaker external demand coming from the indebted country Bilateral agreements: higher spreads for the country that funds the bail-out Sovereign crisis contagion Banking system crisis Competition on currency depreciation International consequences Possible social conflicts 15

EU/IMF Financial Aid Package Fiscal policy Monetary policy Greek package EUR 110bn Additional package EUR 720bm Unconventional monetary policy tools 80bn from EMU countries (funding according to countries quotas in the ECB s capital) 30bn from the IMF First loan tranche of 14.5bn was sent to Greece on 18th of May while second tranche of 9bn was sent on 9th of Sept. Total package covers Greek debt service until Dec 2012 (i.e. interest payments + principal but excluding primary deficits financial needs) 60bn available under the existing European Commission balance-of-payments lending facility (Funded and guaranteed by the 27 EU members) 440bn available through the creation of the European Financial Stabilisation Fund (EFSF) funded according to countries quotas in the ECB s capital and guaranteed by the 16 Eurozone members 220bn from the IMF Irish package: EUR85bn EFSM/EFSF/IMF: EUR22.5bn each Domestic sources: EUR17.5bn Portuguese package: EUR78bn EFSM/EFSF/IMF: EUR26bn each Remaining effective lending capacity: EUR575bn (Spanish debt service is about EUR350bn until Dec 2014) The EFSF pave the way towards a closer fiscal union in Europe Outright purchases in the Euro area public and private debt securities markets Reactivation of 1Y, 6-month and 3-month refinancing operations at fixed rate with full allotment Reactivation of liquidity swap lines with the Fed Outright bonds purchases of 165bn (as of Oct. 14th), absorbed with one-week fixed-term deposit 16

ECB Government Bonds Purchase Accelerating ECB interventions mainly focused on Italy, but to be continued with stronger commitment ECB Eurosystem securities market program-weekly and cumulated amounts 25'000 225'000 200'000 20'000 175'000 15'000 10'000 150'000 125'000 5'000 0 00.01.1900 04.06.2010 25.06.2010 16.07.2010 06.08.2010 27.08.2010 17.09.2010 08.10.2010 29.10.2010 19.11.2010 10.12.2010 31.12.2010 21.01.2011 11.02.2011 04.03.2011 25.03.2011 15.04.2011 06.05.2011 27.05.2011 17.06.2011 08.07.2011 29.07.2011 19.08.2011 09.09.2011 30.09.2011 21.10.2011 11.11.2011 bn bn 100'000 75'000 50'000 25'000 0 Weekly Amount (ls) Cumulated Amount (rs) 4 week moving average (ls) Source: Bloomberg,. Updated 2011-10-14 Fixed Income Outlook Quarterly conference call 17

EU/IMF Packages & Financing Needs for Countries at Risk Current lending capacity just enough to cover EFSF-3 & Spain until Dec. 2014 Debt servicing until Dec. 2014 for EFSF-3, Spain & Italy & remaining packages 1'200 843 Financing needs until Dec. 2014 (bn of ) 1'000 800 600 400 200 0 + EU/IMF remaining lending capacity, 575 168 Greece 42 Ireland 80 Portugal 431 + Portugal remaining package, 66 + Irish remaining package, 46 Greek remaining package, 37 Spain Italy 18

Euro Sovereign Risk Themes & risks to dominate the market in the short and long run Euro area Greece Ireland Portugal Spain Italy Main risks Euro breakup. Disorderly default from Greece triggering a round of contagion to other Eurozone countries and the whole banking sector. Disorderly default No stabilisation of the current negative fiscal balance trend Lack of growth endangering the current positive trend in terms of public finances adjustment Lack of growth Brutal adjustment of the real estate loans value on the banks balance sheets Lack of growth Government rates pushed significantly and structurally above 5% Our View The cost of the Euro breakup option is so high that the already started transfer between the strongest and the weakest countries will continue. More fiscal discipline and a painful adjustment process will lead to low growth over a 5 to 7 years cycle. Greece is bankrupt and by no mean can muddle through whatever the measures taken. Significant losses have to be taken through a set of orderly haircuts ultimately amounting to circa 70%. Ireland will have to resort to a second bailout plan in the coming months. The widely nationalised banking sector is still threatening dramatically public finances. An orderly default going forward can not be ruled out. Portugal can muddle through but will be highly dependant on the whole zone growth and the ECB monetary policy. Spain has made significant efforts on the fiscal front but a banking sector recapitalisation will be needed. The latter is manageable provided the real estate necessary adjustment is done gradually. Italy has already a primary balance almost at equilibrium. The stabilisation of its debt /GDP ratio is highly achievable especially with the newly decided fiscal measures. But the ECB then EFSF/ESM will have to maintain an active SMP to avoid contagion through government refinancing rates. Source: 19

Eurozone: Key Messages Recession in the Eurozone, no euro break-up but more fiscal federalism Eurozone contracted in 2011Q4. No collapse in 2012, the zone might even avoid a recession Germany is recovering, while Greece is entering into its 4th year of declining activity. Biggest risk remains a Greek downward spiral, notably in Spain: contracting activity lower fiscal revenues more fiscal austerity additional contraction in activity Inflation to decline: no reason for the ECB not to continue loosening conventional & possibly unconventional monetary policy Euro debt crisis: no euro break-up, but more fiscal integration EFSF/ESM not a solution for Spanish/Italian financing needs, only the ECB can afford it (monetization indirect QE) ECB further non-conventional monetary policy to depend on two conditions: a political commitment to fiscal federalism with credible fiscal rules (that will not be breached) Complete disorderly market conditions Greece, Portugal and Ireland to default orderly 20

3 What should be done?

Wrong Way 22

Right Way? 23

What Should Be Done? Surgery in Greece A wall ECB better than a firewall Control supranational (European) of the budgets of the euro area countries Lower interest rates in Europe Second phase: policies that promote growth consistent with the reduction of public expenditure 24

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