The crisis risks EU’s expansion into Eastern Europe and the prospects of the euro as an international reserve currency
Bloomberg 22 February 2010
The crisis stalking the euro economy began with a footnote.
When the European Union predicted in 1997 that Italy’s budget deficit would exceed the threshold to qualify for the single currency, it buried in the fine print the observation that with ‘additional measures’ the Italians could pass.
They did, thanks to a one-time tax and a yen-denominated swap. It was an early example of the balance sheet fiddling deployed since then by countries eager to share the benefits of a US$13 trillion market and lower borrowing costs, yet unwilling to cede control over their budgets, wages and welfare systems.
Now Greece, by setting a standard for fiscal creativity, has exposed the flaws in Europe’s hybrid of monetary union and fiscal indiscipline. The crisis risks extending the euro’s 6 per cent slide against the US dollar this year, its expansion into eastern Europe and its prospects to challenge the US dollar as an international reserve currency.
Greece’s fiscal tragedy ‘reveals a lot of things that people didn’t want to look at, such as the lack of economic governance of the euro zone’, said Pervenche Beres, a French member of the European Parliament who is sponsoring a resolution calling for tougher financial regulation. ‘If Greece falls apart, everything would fall apart. Nobody should allow this.’
Harvard University’s Martin Feldstein was among economists who have cautioned since the currency debuted in 1999 that divergent economies couldn’t fit under a single roof. The union was led by a Germany that consented to give up its deutsche mark as long as the rest of Europe embraced the German aversion to debt that took hold after two world wars.
Instead, each country went its own way: Germany, paced by such manufacturers as Volkswagen and Siemens, parlayed caps on labour costs and the elimination of exchange rate risks into economic ascendance. Wolfsburg-based Volkswagen’s European sales rose 16 per cent from 2006 to 2008 while domestic sales shrank 3 per cent. Siemens, based in Munich, boosted the European share of its revenue to 41 per cent in 2009 from 32 per cent five years earlier.
German unit labour costs fell from 2004 through 2006 and rose only 2.2 per cent in 2008, the year of the latest Eurostat figures. Labour costs jumped 4.3 per cent that year in Spain, 3.9 per cent in Greece and 3.4 per cent in Portugal.
The outcome was a skewed European economic map, with imbalances such as Spain’s current account deficit of 9.6 per cent in 2008 set against Luxembourg’s surplus of 5.5 per cent. The intra-European mismatch resembles the divergences that sent the Italian lira plunging 40 per cent against the mark between 1992 and 1995.
Greece, Spain and Portugal, buoyed by European Central Bank interest rates that never rose above 4.75 per cent, rode a debt-fuelled housing boom that went bust after Lehman Brothers’ collapse unleashed a global financial crisis.
The shelter the euro provided Greece began to weaken. The government in Athens paid as little as eight basis points, or 0.08 percentage point, more than Germany to borrow on Feb 18, 2005. The gap reached 396 basis points last month and currently stands at 334.
While the euro’s newness puts it at a heightened risk for shifting investor sentiment, doomsday scenarios of breakup are unfounded, said Simon Ballard, a credit strategist at Royal Bank of Canada in London.
‘Joining the euro is like frying an egg: once it’s fried you can’t put it back in the shell,’ Mr. Ballard said.
Investors pushed the euro down to a nine-month low of US$1.35 on Feb 12 as the Greek crisis unfolded.
The currency remains above its inaugural level of US$1.17 and is still overvalued by 16 per cent against the US dollar, according to a Bloomberg index of purchasing power parities.
The US$1.35 low was breached on Friday as the dollar rose to US$1.3466 per euro after the Federal Reserve on Thursday raised the discount rate charged to banks for direct loans for the first time in more than three years.
Signs that Greece was an uneasy fit in the monetary union first emerged in 2004 when the government of Costas Karamanlis disclosed that its socialist predecessor had cheated on its euro-entry exam in 2000. It published phoney data claiming the deficit was less than one per cent of gross domestic product.
EU reaction to news that Greece’s budget had never gotten below the 3 per cent ceiling showed how much power remains in national capitals. Greece went unpunished except for being told by the EU to tighten up its bookkeeping. At the same time, proposals to strengthen Eurostat, the bloc’s statistics watchdog, foundered on national opposition.
Germany and France helped ease the rules when they forced through the relaxation of the anti-debt ‘stability pact’ in 2005 after three years of deficits above the threshold.
Now, the question of who’s in charge looms larger than ever. After a decade of haggling, the EU appointed Herman Van Rompuy of Belgium as its first full-time president last year and enacted a new decision-making framework.
Mr. Van Rompuy’s powers are of persuasion only. He has a staff of 12, no sway over the EU’s 123 billion euro budget, and no vote on policy decisions, not even in case of a tie. Tensions over who calls the shots - all 27 leaders, or just the 16 using the euro currency? - further blur his role.
National governments continue to hold the purse strings. When Chancellor Angela Merkel went to Brussels recently to negotiate over a possible bailout for Greece, she was hemmed in by German high court rulings that bar a further transfer of power to the EU and by a domestic political uproar over helping a country that won’t help itself. ‘Not a single euro’ of German taxpayer money should go to Greece, Horst Seehofer, head of the Bavarian affiliate of Ms Merkel’s Christian Democrats, told a political rally in the southern city of Passau on Feb 17.
Added to German outrage was the disclosure that New York-based Goldman Sachs Group, Wall Street’s most profitable securities firm, helped Greece raise US$1 billion of off-balance sheet funding in 2002 through a currency swap that may have masked the deficit’s size.
What resulted, at the recent Greece-dominated summit in Brussels, was an EU pledge for ‘determined and coordinated action if needed’ to prevent a sovereign debt disaster from destabilising the economy, coupled with silence on what it would do.
As striking workers protested budget cuts in Athens, the EU declaration failed to shore up confidence in Prime Minister George Papandreou’s plan to shave the deficit by four percentage points in 2010 from an estimated 12.7 per cent last year.
Still, it would be a mistake to underestimate the EU’s resolve to aid Greece and prevent the fiscal rot from spreading, said Andrew Bosomworth, Munich-based head of portfolio management at Pacific Investment Management, which oversees the world’s largest mutual fund from Newport Beach, California. ‘The very strong words that came out of the European community last week are not words that I would bet against,’ Mr. Bosomworth said in a Feb 15 Bloomberg Television interview.
‘I don’t think the European Union is going to risk a repeat of Lehman within the monetary union.’ He declined to say how Pimco was investing.
The Brussels communique, negotiated by a group led by Ms Merkel and Mr. Van Rompuy, also sharpened the dividing line between the euro bloc and the rest of the EU. The leader of the largest EU country using its own currency, British Prime Minister Gordon Brown, wasn’t in the room.
‘The biggest single cleavage in the EU will increasingly be between those that belong to the euro and those that don’t,’ said Peter Ludlow, a historian and author of The Making of the New Europe. That leaves the euro’s further expansion to eastern Europe - after the EU took in ex-communist countries in 2004 - a potential casualty of the Greek fallout. Already in 2006, Lithuania felt the collateral damage: it was barred from the euro because of 3.5 per cent inflation, the first euro aspirant to be vetoed.
The next test comes with Estonia in April or May. Once a showcase economy with growth peaking at 10 per cent in 2006, the EU’s second-highest rate that year, the Baltic nation’s GDP plunged an estimated 13.7 per cent in 2009. Its bid to join the euro next year hinges on persuading the EU that the deficit won’t head back up after dipping to an estimated 2.6 per cent last year.
‘It will be more difficult for the potential new members to join,’ said Esther Law, emerging markets strategist at Societe Generale in London. ‘I expect them to be more strict with all the criteria and also to be more strict with the statistics.’ - Bloomberg
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The real victims of Greek tragedy
The crisis risks EU’s expansion into Eastern Europe and the prospects of the euro as an international reserve currency
Bloomberg
22 February 2010
The crisis stalking the euro economy began with a footnote.
When the European Union predicted in 1997 that Italy’s budget deficit would exceed the threshold to qualify for the single currency, it buried in the fine print the observation that with ‘additional measures’ the Italians could pass.
They did, thanks to a one-time tax and a yen-denominated swap. It was an early example of the balance sheet fiddling deployed since then by countries eager to share the benefits of a US$13 trillion market and lower borrowing costs, yet unwilling to cede control over their budgets, wages and welfare systems.
Now Greece, by setting a standard for fiscal creativity, has exposed the flaws in Europe’s hybrid of monetary union and fiscal indiscipline. The crisis risks extending the euro’s 6 per cent slide against the US dollar this year, its expansion into eastern Europe and its prospects to challenge the US dollar as an international reserve currency.
Greece’s fiscal tragedy ‘reveals a lot of things that people didn’t want to look at, such as the lack of economic governance of the euro zone’, said Pervenche Beres, a French member of the European Parliament who is sponsoring a resolution calling for tougher financial regulation. ‘If Greece falls apart, everything would fall apart. Nobody should allow this.’
Harvard University’s Martin Feldstein was among economists who have cautioned since the currency debuted in 1999 that divergent economies couldn’t fit under a single roof. The union was led by a Germany that consented to give up its deutsche mark as long as the rest of Europe embraced the German aversion to debt that took hold after two world wars.
Instead, each country went its own way: Germany, paced by such manufacturers as Volkswagen and Siemens, parlayed caps on labour costs and the elimination of exchange rate risks into economic ascendance. Wolfsburg-based Volkswagen’s European sales rose 16 per cent from 2006 to 2008 while domestic sales shrank 3 per cent. Siemens, based in Munich, boosted the European share of its revenue to 41 per cent in 2009 from 32 per cent five years earlier.
German unit labour costs fell from 2004 through 2006 and rose only 2.2 per cent in 2008, the year of the latest Eurostat figures. Labour costs jumped 4.3 per cent that year in Spain, 3.9 per cent in Greece and 3.4 per cent in Portugal.
The outcome was a skewed European economic map, with imbalances such as Spain’s current account deficit of 9.6 per cent in 2008 set against Luxembourg’s surplus of 5.5 per cent. The intra-European mismatch resembles the divergences that sent the Italian lira plunging 40 per cent against the mark between 1992 and 1995.
Greece, Spain and Portugal, buoyed by European Central Bank interest rates that never rose above 4.75 per cent, rode a debt-fuelled housing boom that went bust after Lehman Brothers’ collapse unleashed a global financial crisis.
The shelter the euro provided Greece began to weaken. The government in Athens paid as little as eight basis points, or 0.08 percentage point, more than Germany to borrow on Feb 18, 2005. The gap reached 396 basis points last month and currently stands at 334.
While the euro’s newness puts it at a heightened risk for shifting investor sentiment, doomsday scenarios of breakup are unfounded, said Simon Ballard, a credit strategist at Royal Bank of Canada in London.
‘Joining the euro is like frying an egg: once it’s fried you can’t put it back in the shell,’ Mr. Ballard said.
Investors pushed the euro down to a nine-month low of US$1.35 on Feb 12 as the Greek crisis unfolded.
Overvalued currency
The currency remains above its inaugural level of US$1.17 and is still overvalued by 16 per cent against the US dollar, according to a Bloomberg index of purchasing power parities.
The US$1.35 low was breached on Friday as the dollar rose to US$1.3466 per euro after the Federal Reserve on Thursday raised the discount rate charged to banks for direct loans for the first time in more than three years.
Signs that Greece was an uneasy fit in the monetary union first emerged in 2004 when the government of Costas Karamanlis disclosed that its socialist predecessor had cheated on its euro-entry exam in 2000. It published phoney data claiming the deficit was less than one per cent of gross domestic product.
EU reaction to news that Greece’s budget had never gotten below the 3 per cent ceiling showed how much power remains in national capitals. Greece went unpunished except for being told by the EU to tighten up its bookkeeping. At the same time, proposals to strengthen Eurostat, the bloc’s statistics watchdog, foundered on national opposition.
Germany and France helped ease the rules when they forced through the relaxation of the anti-debt ‘stability pact’ in 2005 after three years of deficits above the threshold.
Now, the question of who’s in charge looms larger than ever. After a decade of haggling, the EU appointed Herman Van Rompuy of Belgium as its first full-time president last year and enacted a new decision-making framework.
Mr. Van Rompuy’s powers are of persuasion only. He has a staff of 12, no sway over the EU’s 123 billion euro budget, and no vote on policy decisions, not even in case of a tie. Tensions over who calls the shots - all 27 leaders, or just the 16 using the euro currency? - further blur his role.
National governments continue to hold the purse strings. When Chancellor Angela Merkel went to Brussels recently to negotiate over a possible bailout for Greece, she was hemmed in by German high court rulings that bar a further transfer of power to the EU and by a domestic political uproar over helping a country that won’t help itself. ‘Not a single euro’ of German taxpayer money should go to Greece, Horst Seehofer, head of the Bavarian affiliate of Ms Merkel’s Christian Democrats, told a political rally in the southern city of Passau on Feb 17.
Added to German outrage was the disclosure that New York-based Goldman Sachs Group, Wall Street’s most profitable securities firm, helped Greece raise US$1 billion of off-balance sheet funding in 2002 through a currency swap that may have masked the deficit’s size.
What resulted, at the recent Greece-dominated summit in Brussels, was an EU pledge for ‘determined and coordinated action if needed’ to prevent a sovereign debt disaster from destabilising the economy, coupled with silence on what it would do.
As striking workers protested budget cuts in Athens, the EU declaration failed to shore up confidence in Prime Minister George Papandreou’s plan to shave the deficit by four percentage points in 2010 from an estimated 12.7 per cent last year.
Still, it would be a mistake to underestimate the EU’s resolve to aid Greece and prevent the fiscal rot from spreading, said Andrew Bosomworth, Munich-based head of portfolio management at Pacific Investment Management, which oversees the world’s largest mutual fund from Newport Beach, California. ‘The very strong words that came out of the European community last week are not words that I would bet against,’ Mr. Bosomworth said in a Feb 15 Bloomberg Television interview.
‘I don’t think the European Union is going to risk a repeat of Lehman within the monetary union.’ He declined to say how Pimco was investing.
The Brussels communique, negotiated by a group led by Ms Merkel and Mr. Van Rompuy, also sharpened the dividing line between the euro bloc and the rest of the EU. The leader of the largest EU country using its own currency, British Prime Minister Gordon Brown, wasn’t in the room.
‘The biggest single cleavage in the EU will increasingly be between those that belong to the euro and those that don’t,’ said Peter Ludlow, a historian and author of The Making of the New Europe. That leaves the euro’s further expansion to eastern Europe - after the EU took in ex-communist countries in 2004 - a potential casualty of the Greek fallout. Already in 2006, Lithuania felt the collateral damage: it was barred from the euro because of 3.5 per cent inflation, the first euro aspirant to be vetoed.
The next test comes with Estonia in April or May. Once a showcase economy with growth peaking at 10 per cent in 2006, the EU’s second-highest rate that year, the Baltic nation’s GDP plunged an estimated 13.7 per cent in 2009. Its bid to join the euro next year hinges on persuading the EU that the deficit won’t head back up after dipping to an estimated 2.6 per cent last year.
‘It will be more difficult for the potential new members to join,’ said Esther Law, emerging markets strategist at Societe Generale in London. ‘I expect them to be more strict with all the criteria and also to be more strict with the statistics.’ - Bloomberg
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