Overcoming the Debt Crisis and Securing Growth- Irreconcilable Challenges for the Euro-zone?

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1 Franco-German Conference Overcoming the Debt Crisis and Securing Growth- Irreconcilable Challenges for the Euro-zone? Cinzia Alcidi, CEPS May 3, 2010, Paris

2 Outline: General post crisis background Debt sustainability The cost of the fiscal adjustment Argentina: all over again? The reasons for a Euro Stability Fund Debt restructuring

3 Background: boom-bust cycle First stage: after the bust private debt becomes public debt Second stage of crisis: Increased probability of sovereign default

4 Euro Area: Private & Public Debt Euro Area Debt: first difference MA-4q 1000 Private Public EUR Billion 2000Q1 2000Q3 2001Q1 2001Q3 2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1

5 Risk of sovereign default Stability & Growth Pact was supposed to avoid the problem But it failed in imposing fiscal discipline in some countries Fiscal discipline may not be enough to prevent buuild up of imbalances

6 The case of GREECE Greek debt dynamics Actual value % GDP If deficit = 3% Reference year = 2000 If deficit = 0%

7 The case of SPAIN Spanish debt dynamics If deficit = 3% Actual value 45 Reference year = 2000 If deficit = 0%

8 Assessing sustainability: External sustainability External debt is serviced via exports, public debt by tax revenues Fiscal sustainability: compare interest rate to the growth rate =snowball factor

9 External debt burden (I) Greece Portugal Spain Italy Argentina (1999) Hungary (2008) Total Gross External 167 Debt as % GDP Total Gross External debt as % of Exports Government & MA gross external debt % of Tax revenue na* 138

10 External debt burden (II) 2009(q3) % GDP Greece Portugal Spain Total Gross External Debt: Government Monetary Authorities Banks Other sectors Net External debt Government & MA Private Source: National Central Banks

11 Changes in components of snowball factor GDP (nominal growth rates) Nominal interest rate Ireland Greece (?) (?) Spain Italy Portugal

12 Country Fiscal adjustment difficult (I): Simple Keynesian multiplier Keynesian multiplier: 1/(s+m) Excess deficit (actual %) Impact of fiscal adjustment on output, in % Greece Spain Ireland Portugal Italy

13 Fiscal adjustment difficult (II): Simple Keynesian multipliers high: low savings & low openness Low openness: exports cannot provide offset Risk premium on external debt additional shock to economy

14 The relative importance of access to foreign capital The importance of foreign savings in total capital available 0.0 Ireland Greece Spain Italy Portugal Ratio CA to total capital available (=CA +Gross National Savings)

15 Digression (I): is such adjustment possible? yes! Required primary surplus about 6% of GDP, i.e % correction. Similar required from Turkey (IMF 2001); Achieved by Scandinavians after crisis of 1990s. Belgium and Italy close to this benchmark in preparation of EMU.

16 Digression (II): Effect of the fiscal correction on debt takes time: Debt-to-GDP ratio often increases during the adjustment Interest rate important If Greece repeats the experience of early 90s debt-to-gdp could reach 1,5 will it be possible?

17 Conclusion for Greece: Fiscal adjustment is likely to lead to deep recession Sudden stop requires ultimately compression of consumption Main danger developing vicious circle with mounting popular resistance new Argentina?

18 A reminder: Argentina Two years and three IMF programmes from first trouble to default. Initially: No net external debt! But government had foreign debt (private sector foreign assets). Popular opposition to fiscal adjustment required to service foreign debt too strong Can it happen again?

19 Euro Stability Fund 1) Pre-empt the end game: Recognize sovereign default as possibility 2) Financing mechanism to limit moral hazard

20 ESF: Financing mechanisms Limit moral hazard Only countries that breach Maastricht criteria have to contribute: 1% of excess debt: actual debt (%GDP) 60% 1% of excess deficit: actual deficit (%GDP)-3%

21 Restructuring: Orderly default & haircuts Prepare for sovereign default and minimize its cost ESF could offer debt holders exchange of the debt, with uniform haircut, against claims on the ESF Haircuts: ESF would buy public debt of the defaulting country (only up to 60% of GDP?) ESF acquires claims against defaulting country Default on ESF means leaving euro and ultimately EU

22 Institutional aspects Surveillance, not just fiscal Professional independent staff Effective enforcement: If policy recommendations not followed, no access to funding from EMF.

23 Concluding remarks Systemic issue post credit bubble: Private debt tends to become public Required fiscal adjustment may be politically not feasible Stability and Growth Pact failed in preventing preparing public finance for this problem Policy should not only aim at preventing failure, but also to prepare for it

24 Thank you

25 Who can save Greece? Annual redemptions about 30 billion. With deficit 8 % GDP => financing need +/- 100 billion next two years. Assume reduction in risk premium of 200 bps (IMF and EU funding below market) Savings = 2 billion or 0.8 % of GDP! Only Greek tax payer saves Greece!

26 Private finanl Consumption as % of GDP 80 Germ any Ireland Spain Italy Portugal Greece % of GDP

27 Compensation of employees: general government % of GDP Irel and Greece Spain Ital y Portugal Germany France Euroarea

28 34 The social party (I) Social expenditure (social benefits and transfers) Italy Portugal Greece Spain Germany % of GDP

29 200 The golden age of consumption Private final consumption expenditure (2000 = 100) Ireland Greece Spain Portugal Italy Germany

30 Persistent Current Account Imbalances 4,0 0, ,0 % of GDP -8,0-12,0 Ireland Greece Spain Italy Portugal -16,0

31 Net and Gross National Savings (2007) % of GDP Irel and Greece Spai n Ital y Portugal 5.0

32 The degree of openness Import and Export (goods plus services) % of GDP Greece Ireland Portugal Italy Spain Germany France Import Export

33 Changes in the snowball factor Snow ball factor = interest rate minus growth rate Ireland Greece Spain Italy Portugal

34 Actual fiscal adjustment needs Actual (2009) primary balance % of GDP Primary surplus (% of GDP) required for sustainability Adjustment required for sustainability Ireland Greece Spain Italy Portugal

35 Debt: external and public Worsening of the debt sustainability Large fiscal adjustment required Is it feasible?

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