Eurozone financial crisis
What is the eurozone crisis?
The eurozone crisis refers to the on-going financial difficulties within the euro area which were precipitated by the collapse of the global economy in 2008 and exacerbated by the record budget deficits of certain individual member states.
The eurozone is composed of the 17 member states of the European Union which have the euro as their common currency: They are – Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, Spain.
The euro was launched on 1 January 1999 as a virtual currency for cashless payments and accounting purposes; coins and banknotes were introduced on 1 January 2002.
EMU (Economic and Monetary Unification) is the process created to co-ordinate the economic policies of all EU member states in order to establish a common monetary policy and a common currency – the euro.
EMU was introduced in three stages:
Stage One began in July 1990 with the abolition of all internal barriers to the free movement of capital, goods, services and people within EU member states.
Stage Two began in January 1994 with the establishment of the European Monetary Institute (EMI) - the predecessor of the European Central Bank (ECB); technical preparations were also
carried out for the introduction of the euro, enforcement of fiscal discipline and enhanced convergence of economic and monetary policies. The ECB was established in 1998.
The final stage of EMU, Stage Three, began in January 1999 with the introduction of the euro and the irrevocable fixing of the conversion rates for the first 11 participating countries. The ECB became responsible for the single monetary policy of the euro area.
The United Kingdom and Denmark did not move to Stage Three as they had agreed an 'opt-out' clause which exempted them from adopting the euro. By January 2011 there were 17 participating countries. The remaining member states have yet to meet the criteria for joining the eurozone.
The objectives of EMU were enshrined in the 1992 Maastricht Treaty (Treaty on European Union) which requires member states to "regard their economic policies as a matter of common concern" and to "avoid excessive government deficits".
The Treaty also established the convergence criteria for states wishing to adopt the euro; these are - sustainable price stability, convergence of long-term interest rates, sustainable government finances, and participation in the exchange rate mechanism of the European Monetary System.
EMU was created to provide macro-economic stability within the euro area leading to sustainable long-term growth. A report published in May 2008 assessing the first decade of EMU concluded that although the former had been achieved, growth remained problematical.
The EC report 'EMU@10' found that overall EMU had been "a resounding success". It had secured macro-economic stability, boosted cross-border trade, financial integration and investment, and had led to the creation of almost 16 million jobs.
However, there had been "substantial and persistent differences" in macroeconomic performance across countries and a backlog in structural reform in several member countries. The euro area growth rate had been lower than expected, averaging around 2% per annum.
The EC's forecast for spring 2008 predicted a further fall in economic growth due to the on-going global economic slowdown and continuing turmoil in the financial markets. In the EU, growth was projected to decelerate from 2.8% in 2007 to 2% in 2008 and 1.8% in 2009. In the euro area, growth was forecast to slow down from 2.6% in 2007 to 1.7% in 2008 and 1.5% in 2009.
The Commission said the EU economy "holds up relatively well due to sound fundamentals", but conceded that "it cannot escape the global shocks unaffected."
By the autumn of 2008 the global economic slowdown had developed into a major global financial crisis. The EC predicted that GDP growth would "come to a standstill" in both the EU and the euro area, with several EU countries forecast to experience a technical recession – i.e. two consecutive quarters of negative quarter-on-quarter growth.
The Commission subsequently launched a major Recovery Plan to boost growth and restore confidence in the European economy, which included a 200bn euro fiscal stimulus within both national budgets (around 170bn euros) and EU and European Investment Bank budgets (around 30bn euros.).
Despite this stimulus many member states continued to experience severe difficulties, with some more affected than others due to country-specific factors.
Under the Stability and Growth Pact member states must not exceed a deficit to GDP ratio of 3% and a debt to GDP ratio of 60%.
In 2010, official EU figures showed that 14 of the 27 member states had government debt ratios higher than 60% of GDP (including the UK), with two countries above 100% - Greece 144.9% and Italy 118.4%. Government debt to GDP ratio for the EU 27 had risen from 74.7% in 2009 to 80.2% and for the euro area from 79.8% to 85.4%. Government deficit to GDP ratio was 6.6% for the EU27 and 6.2% for the euro area.
If a member state breaches the deficit ceiling, the excessive deficit procedure (EDP) is triggered. Under this procedure the Council issues recommendations to the member state concerned to rectify the situation within a specified time frame. If the member state fails to comply, the Council may then instruct the member state to take appropriate measures to reduce the deficit and may also impose penalties or fines. Once corrective action has been taken, the EDP for the member state is abrogated.
For some member states experiencing extreme financial difficulties, the EDP has proved inadequate and additional financial help has been provided in the form of loans. However, the Commission has insisted this step is only taken "as a last resort, to counter any risk of contagion and to safeguard financial stability in the euro-area."
The loans, which must be repaid fully with interest, come with strict conditions attached including "detailed and demanding" policy programmes, with fiscal and structural adjustments set in place to ensure solvency in the long run.
The loans are provided via a number of sources. These include bi-lateral loans from member states; the European Financial Stabilisation Mechanism (EFSM); the European Financial Stability Facility (EFSF); the International Monetary Fund (IMF); and the Balance of Payments (BoP) Regulation for non-euro area member states.
The European Financial Stabilisation Mechanism was created in May 2010 and is a Treaty-based mechanism covering all EU member states. The EFSM allows the Commission to borrow up to 60bn euros on financial markets on behalf of the EU under an EU budget guarantee. The Commission then lends the proceeds on to the beneficiary member state. The EU pays no debt-servicing costs; the beneficiary member state repays the loan principal as well as all interest.
The European Financial Stability Facility was set up in June 2010. The EFSF issues bonds that are guaranteed by euro-area member states and then lends the proceeds on to beneficiary member states. Initially the EFSF was allowed to borrow up to 440bn euros; however, at a summit meeting of EU leaders in October 2011 it was agreed to boost the fund's lending capacity to around one trillion euros – a fivefold increase – using private market tools.
Loans have been provided to three member states so far: Greece, Ireland and Portugal.
Economic Adjustment Programme for Greece:
The financial problems of Greece have been, and continue to be, the most difficult to resolve.
In 2009 the European Commission said it was clear Greece faced "very substantial economic and fiscal challenges" and noted that "the sustainability of public finances in Greece draws the attention of financial markets and rating agencies." The EC promised to monitor the situation "very closely".
The Greek government said it was determined to restore sound public finances, but attempts to impose austerity measures to help reduce the deficit provoked strike action and riots on the streets. Nevertheless, Prime Minister Papandreou continued to insist that Greece would not default on its debts.
However, the financial situation deteriorated rapidly and in May 2010, a programme of financial assistance was agreed between the EC, ECB, IMF and the Greek authorities which would provide up to 110bn euros over a three year period, 80bn euros in bi-lateral loans by euro area member states and 30bn euros under a stand-by arrangement by the IMF.
First tranche disbursed May 2010 – euro area 14.5bn, IMF 5.5bn – total 20.0bn
Second tranche disbursed Sept. 2010 – euro area 6.5bn, IMF 2.5bn – total 9.0bn.
Third tranche disbursed Dec.10/Jan.11 – euro area 6.5bn, IMF 2.5bn – total 9.0bn.
Fourth tranche disbursed March 2011 – euro area 10.9bn, IMF 4.1bn – total 15bn.
Fifth tranche disbursed July 2011 – euro area 8.7bn, IMF 3.3bn – total 12bn.
The sixth tranche – euro area 5.8bn and IMF 2.2bn, total 8bn – scheduled to be disbursed in November 2011.
In July 2011, EC president Jose Manuel Borroso, following consultations with Prime Minister Papandreou, launched a Task Force to provide technical assistance for Greece, to help deliver the EU/IMF adjustment programme and accelerate the absorption of EU funds. The Task Force, which started work in September 2011, will focus on economic growth, competitiveness and employment, and will provide quarterly progress reports. The first report published in November 2011 showed "cautious optimism".
Following a euro area summit meeting on 21 July 2011, Commissioner Olli Rehn stated that Greece would receive the necessary financing to strengthen its public finances and competitiveness, including the lowering of interest rates and the extension of maturities of EU loans. He added that the offer from the private sector, as presented by the Institute of International Finance (IIF), for a voluntary private sector involvement to improve Greece's debt profile, was "an important contribution".
At a further summit in October 2011, EU leaders announced new measures to help Greece reduce its public debt to 120% of GDP by 2020. This included a 30bn euro contribution by euro-area member states to the PSI package, a new loan of up to 100bn euros from the EU and IMF and an agreement from banks and other creditors to write off 50% of Greek debt.
On 11 November 2011, Lucas Papademos, a former vice-president of the ECB, became the new Prime Minister of Greece. He heads a new, interim three-party coalition government – ostensibly a "government of unity." Further elections are expected in February.
The president of the European Council, Herman Van Rompuy and the president of the European Commission, Jose Manuel Barroso, welcomed the news, stating: "We have long stressed the need for a broad political consensus around measures to lift Greece out of this deep economic crisis." The statement added: "We reiterate that our European Institutions will continue to do everything within their power to help Greece - but Greece must also do everything within its power to help itself."
Economic Adjustment Programme for Ireland:
Ireland's debt crisis has its roots in a banking sector attracted to Ireland by a low corporate tax rate of 12.5% and a massive expansion of credit by the banks to fund a housing boom with hugely inflated house prices. When the housing market collapsed due to the global recession, the banks suffered phenomenal losses. The government's subsequent bailing out of the banks resulted in Ireland recording the largest budget deficit of all the member states (31.3% of GDP) in 2010.
Despite the government's best efforts to restore confidence in the economy the situation continued to deteriorate and in November 2010 the Irish authorities requested financial assistance from the EU.
The EC, IMF and ECB agreed a comprehensive policy package with the Irish authorities for the period 2010-13, including financial assistance of 85bn euros - 50bn euros to cover public finance needs and up to 35bn euros to cover banking assistance, including a contingency element.
67.5bn of the overall package (i.e. 22.5 billion each) will be shared equally amongst:
the European Financial Stabilisation Mechanism (EFSM);
the European Financial Stability Facility (EFSF), together with bilateral loans from the United Kingdom, Denmark and Sweden (together: 4.8bn);
the International Monetary Fund.
Half of the banking support measures (17.5 billion) will be financed by an Irish contribution through its treasury cash buffer and investments by Ireland's National Pension Reserve Fund (NPRF).
EU leaders attending the euro summit in July 2011 stated that they were "pleased with the progress made by Ireland in the full implementation of its adjustment programme which is delivering positive results."
Economic Adjustment Programme for Portugal:
From 2009 onwards concerns increased about the sustainability of Portugal's public finances, with repeated downgradings of the country's credit ratings, government debt rising to 93.3% of GDP and a banking sector increasingly dependent on the Eurosystem for funding.
As in Greece, government attempts to impose austerity measures were fiercely opposed by the public and the opposition. In March 2011, the minority Socialist Party government collapsed after parliament rejected a new austerity package and Prime Minister Jose Socrates resigned. However, the Socialists stayed on in a caretaker capacity until the June election and in April 2011 Mr Socrates officially requested financial help from the EU.
The loan agreement was approved by the EU Council on 17 May 2011 and by the IMF on 20 May 2011. The programme, which covers the period 2011-2014, will provide financing of up to 78bn euros .
Portugal's European partners will provide up to 52bn euros – up to 26bn under the EFSM and up to 26bn under the EFSF. The IMF will provide a loan of up to 26bn under an Extended Fund Facility.
The EU stressed that disbursement of the funding was conditional on the implementation of policy measures and achievement of targets agreed under the programme. At the euro summit in July 2011, EU leaders stated that Portugal "is making good progress with its programme and is determined to continue undertaking measures to underpin fiscal sustainability and improve competitiveness."
In September 2011, the European Commission adopted proposals to reduce interest margins and extend maturities for loans granted to Portugal and Ireland under the EFSM. The improved terms are expected to "enhance liquidity and contribute to the sustainability of both countries in support of their strong economic and reform programmes."
Measures agreed at the euro area summit meeting in October 2011 included plans for governments to provide guarantees for banks affected by the sovereign debt crisis. The guarantees will be co-ordinated at EU level and will allow banks to continue to provide the loans needed for growth and job creation.
The eurozone countries also approved measures to improve economic governance, with more co-ordination of economic and national budget policies and increased monitoring to ensure the measures are implemented.
The eurozone will also seek to strengthen the economic union, including exploring the possibility of "limited Treaty changes." A report on implementing the agreed measures is to be completed by March 2012.
From the moment former Conservative prime minister Edward Heath took Britain into the European Economic Community in 1973, EU opponents in the UK have campaigned to take Britain out again, and the current eurozone crisis has added fuel to their argument for leaving the EU.
In September 2011, a petition calling for a referendum on EU membership, signed by 100,000 people, was handed into Downing Street. The Commons subsequently debated a motion proposing that a national referendum be held on whether the UK should stay in the EU, leave the EU, or re-negotiate the terms of its membership.
All three of the main parties urged their MPs to vote against the proposal, arguing that the middle of an economic crisis was not the right time to hold a referendum. The motion was defeated by 483 votes to 111. However, despite the imposition of a three-line whip, David Cameron faced the largest ever Tory rebellion over Europe when 81 of his MPs supported the motion and two actively abstained.
For eurosceptics the crisis is seen as an opportunity for the re-negotiation of treaties and the repatriation of powers from Brussels and David Cameron, in a City of London speech, said he believed "we sceptics … have a right to ask what the European Union should and shouldn't do and change it accordingly" and that the crisis presented an opportunity in Britain's case "for powers to ebb back instead of flow away."
However, the deputy prime minister, Nick Clegg, warned against any attempt to negotiate new treaties during the present crisis, insisting that the focus should instead be on the promotion of jobs and growth.
And although leaders at the euro area summit meeting in October 2011 indicated that the possibility of "limited" treaty changes could be explored in a bid to strengthen the economic union, EU leaders have made it clear this would not be an opportunity for Britain or any other member state to introduce further treaty changes.
Another area of controversy is a proposal by the European Commission to introduce a financial transactions tax (aka Tobin or Robin Hood tax) which would add a small tax (suggested 0.01%) to all financial transactions. The tax is intended to discourage speculators and short-term investors.
David Cameron is opposed to the tax because of the "massively disproportionate impact" it would have on the City of London, the centre of Britain's vital financial services sector.
And a report from the Institute of Economic Affairs has argued that, not only would the FTT be "counterproductive in Europe", but under this 'Robin Hood Tax', rather than taking from the rich (i.e. the banks) and giving to the poor, "the costs would ultimately be borne by consumers of financial products – future pensioners, mortgage customers and so on."
The prime minister has made it clear he could only support the tax if it were to be introduced globally, which seems unlikely.
Britain would also like the EU to make the European Central Bank an effective lender of last resort to help the struggling EU economies, but German Chancellor Angela Merkel has dismissed the idea.
Suggestions that the crisis will inevitably lead to a divided eurozone, split between the prosperous northern states and the troubled south, or, as advocated by President Sarkozy, a two-speed Europe with euro area countries accelerating and integrating more deeply and the remaining states on the periphery, have been rejected by the EC president and the German Chancellor.
President Barroso insisted "There cannot be peace and prosperity in the North or in the West of Europe, if there is no peace and prosperity in the South or in the East" and Chancellor Merkel said there would be "more Europe not less Europe."
President Barroso is also adamant that the whole of the European Union should have the euro as its currency. "Let us be clear," he said, "the Treaties don't define the euro area as something that is distinct from the European Union; the Treaties define the euro area as the core of the European Union."
"Belonging to the euro area or striving into the euro area should constitute European Union normality – not belonging to it is the derogation from the rule," he added. "It would be absurd if the part of our integration that is deepest on the substance would be lightest on the form."
EU autumn forecast 2011
All main indicators point to a stalled recovery with considerable downside risks.
No economic growth is now expected in the current and coming quarters. Consequently, GDP is forecast to grow at a rate of only ½% in the EU and the euro area in 2012. Some acceleration is expected in 2013, when growth is set to reach 1½% in the EU and 1¼% in the euro area. While growth rates will differ across the Union, no group of countries will remain unaffected by the slowdown.
Continued uncertainty in financial markets relating to the sustainability of public finances in some euro area economies as well as fears of contagion affecting the core euro area countries will contribute to subdued growth. The global economy's weakness, including of some of the most important partners for the EU, will reinforce this trend.
The forecast assumes that confidence will gradually return in the second half of 2012 underpinned by the implementation of policy measures that rein in the sovereign debt crisis.
Employment growth is expected to come to a standstill in 2012. The rate of growth of the economy projected to prevail over the forecast horizon is judged as insufficient to translate into any gains in the labour markets. Unemployment, therefore, is likely to remain at its current high level of 9.5%, but labour markets of member states will continue to fare differently.
Consolidation of public finances has made progress in 2011. Fiscal deficits for this year are projected to stand at 4¾% of GDP in the EU and just above 4% in the euro area. Deficits are forecast to come down and amount to just below 4% and 3½% of GDP in the EU and euro area respectively in 2012.
According to the forecast, the debt-to-GDP ratio will peak in the EU at around 85% in 2012, and stabilise in 2013. In the euro area, however, the debt ratio will continue to rise slowly and exceed 90% of GDP in 2012.
Thanks to lessening pressure from energy prices, inflation is projected to fall below 2% in 2012. The subdued economic activity and modest increases in wages are set to hold inflation in check during the forecast period.
Three main risks are identified as weighing on the EU and the euro area economy: continued sovereign-debt-related uncertainty, the weakness of the financial industry and the sluggish world trade. There is a possibility of negative dynamics: slower growth could affect sovereign debtors and this, in turn, could deteriorate the condition of the financial sector, which would be unable to support growth.
On the upside, an earlier-than-expected return of confidence could jump-start investment and private consumption. Moreover, an improvement in the external environment such as a resumption in global growth, could give new impetus to EU exports. Declining commodity prices would also contribute to more dynamic consumption.
The next forecast, an interim one, will be published in February 2012, followed by a full forecast in May 2012.
Source: European Commission – November 2011
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