A Tough Ordeal for the Euro: The collapse of the currency bubble was inevitable

Faculty Fellow, RIETI

In Greece, a change of government in October 2009 brought to light grave deficiencies in the compilation of fiscal statistics and the country's fiscal deficit was revised sharply upward. The fiscal credibility of Greece was lost. Not only did this develop into a major fiscal crisis in the country, it also gave rise to concern that the crisis would spread to other PIIGS (Portugal, Ireland, Italy, Greece, and Spain) countries, causing a rapid plunge in the value of the euro.

When we look at the movement of the euro since its inception as a settlement currency in 1999 ( chart ), we can see that it continued on an upward trend for several years following the 2001 collapse of the information technology (IT) bubble in the United States. In particular, the euro strengthened after September 2005, namely in the period in the run-up to the global crisis. This occurred because the European Central Bank (ECB) was slow to switch to an easing stance. While the U.S. Federal Reserve began to ease monetary policy in response to the outbreak of the subprime mortgage loan problem, the ECB remained focused on containing inflation until the bankruptcy of Lehman Bothers on September 15, 2008.

Exchange Rates of the Euro Exchange Rates of the Euro

This led to a build-up of U.S. dollar-carry trades with investors borrowing funds in the U.S. dollar and buying the euro-denominated assets offering higher returns. Massive fund inflows drove up the value of the euro, which in turn led to the further acceleration of fund inflows. The euro continued to rise in value despite the fact that European financial institutions were directly hit by the U.S.-triggered financial crisis as they were saddled with massive amounts of subprime mortgage-backed securities. The appreciation of the euro was nothing but a case of a bubble detached from underlying economic fundamentals. The burst of the euro bubble was a matter of inevitability.

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The euro bubble collapsed twice. The first collapse began about a month before the failure of Lehman Brothers. Amid growing uncertainty over the degree of European financial institutions' exposure to subprime mortgage-backed securities, default risk for those financial institutions - or counterparty risk assumed by those on the other side of transactions - heightened. As a result, some European financial institutions failed to maintain sufficient U.S. dollar liquidity and the euro fell sharply against the U.S. dollar. Subsequently, the ECB managed to end the downward spiral of the euro by securing the provision of the U.S. dollar from the U.S. Federal Reserve to itself through a currency swap agreement and providing U.S. dollar liquidity to financial institutions in Europe.

However, in the wake of the Greek fiscal crisis in October 2009, the euro began to crumble once again. But in terms of Gross Domestic Products (GDP), Greece accounts for only 2.7% of the 16 eurozone countries. Indeed, the renewed decline of the euro was triggered, not by the fiscal crisis of this modest economy, but by the fear that the Greek crisis could spread to other PIIGS countries. The combined GDP of the five PIIGS economies accounts for 35% of the GDP of the eurozone. Another problem brought to the surface was disarray among the eurozone countries over how they should handle the Greek crisis. The discord, observed notably between Germany where the government worries more about angering taxpayers and France where banks' exposure to Greek sovereign debt is the largest, stems from the fact that the eurozone economies are not fiscally unified.

In the first place, much of the Greek fiscal problem was already there when the country adopted the euro. The Maastricht Treaty, which created the European Union, requires member countries to fulfill a set of convergence criteria (inflation rates, exchange rate, long-term interest rates, government deficit, and government debt) as a precondition for adopting the euro. In particular, annual government deficit must not exceed 3% of GDP and government debt must be kept to 60% of GDP or below. Greek fiscal deficit and government debt respectively stood at 3.7% and 114% of GDP in 2000, the year before the country joined the eurozone, meaning that Greece was in breach of the convergence criteria from the very outset. After that, the country only once, barely managed to meet the fiscal deficit criterion, bringing down its deficit to GDP ratio to 2.9% in 2006 compared to the 3% ceiling.
Under the influence of the global financial crisis and the subsequent global recession, the combined deficit of the 16 eurozone countries, measured as a percentage of GDP, more than tripled from 2% in 2008 to 6.3% in 2009. By country, the fiscal deficit to GDP ratio for Greece stood at 13.5 in 2009, compared to 14.3% for Ireland, 11.2% for Spain, and 9.4% for Portugal. Thus, Greece is not alone having a high ratio, indicating the possibility of the crisis spilling over to those other PIIGS countries.

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The fiscal crisis could spread through the following channels. First, anticipating those countries with massive fiscal deficit to follow Greece into a fiscal abyss and hence a collapse in the prices of their sovereign bonds, speculators would rush to short-sell those bonds and the very actions of those speculators would bring about an actual bond price crash for the targeted sovereign bonds. This is what is referred as "self-fulfilling speculation."

Second, in case of a massive fall in the value of Greek government bonds, the weight of sovereign bonds of other countries in investment portfolios would go up, prompting investors to restore their portfolio balance by selling some of those sovereign bonds that have become overweight. As a result, the prices of targeted sovereign bonds would crash.

Third, if Greece defaults on its sovereign debt obligations, European financial institutions - those with massive holdings of sovereign bonds - would suffer a severe deterioration in their balance sheets and they would be forced to sell government bonds issued by countries with high sovereign risk.

Fourth, should Greece restructure its debt by having the repayment rescheduled and/or part of its debt forgiven, financial institutions would incur further losses and their need to sell high-risk sovereign bonds would increase further.

In order to prevent the spread of the Greek fiscal crisis, the crisis must be defused at its source, i.e. in Greece. At the same time, a mechanism must be put in place to block the transmission of the crisis in consideration of the contagion channels discussed above. The former of those two approaches refers to a 110 billion euro Greek bailout package from the EU and the International Monetary Fund (IMF). Just like conditionality attached to an IMF rescue package for addressing a traditional balance-of-payment crisis stemming from fiscal deficit problems, conditionality attached to the EU-IMF package for Greece calls for restoring fiscal soundness, regaining international competitiveness, and establishing a safeguard mechanism for ensuring financial stability. However, unlike the conventional IMF conditionality, the EU-IMF conditionality does not require the ECB to tighten its monetary policy.

While providing financial support to Greece, the EU also decided on the establishment of a European Financial Stabilization Mechanism, an emergency fund of maximum 500 billion euro. An additional 250 billion euro contribution from the IMF brings the total sum to a maximum of 750 billion euros. The European Financial Stabilization Mechanism is to support an EU member state facing severe difficulties caused by "exceptional occurrences beyond its control" comparable to natural disasters in accordance with provisions under the Treaty of Lisbon (which amended the Treaty on European Union and the Treaty on the Functioning of the European Union). A country that receives support under the mechanism is subject to IMF conditionality and fiscal surveillance by the EU.

Despite the establishment of those measures to prevent crisis contagion, the Greek fiscal crisis would spread to other euro economies unless PIIGS countries make tangible progress in improving their fiscal conditions. Meanwhile, if Greece fails to restore its fiscal stability, it would fall into a state of balance sheet insolvency whereby financial support to the country would be nothing but "oigashi" (forbearance lending), a term coined to describe Japanese banks' practice of continuing to lend to failing companies that have little - if any - chance of recovery. Thus, in the event of such a situation, the bailout of Greece would have to take the form of an outright reduction of liabilities through debt restructuring rather than financial support. But this would give rise to the concern that other eurozone countries might follow the same path, which might in turn cause further destabilization of the euro.

Even if the EU manages to avoid the contagion of the fiscal crisis by means of financial support, EU member economies will still need to coordinate fiscal policy, establish fiscal discipline, and implement measures to prevent moral hazard in order to ensure the sustained stability of the euro. In this regard, the aforementioned debt restructuring will contribute in the long run to the prevention of moral hazard on the part of banks as lenders.

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The banning of naked short-selling on government bonds, introduced by the German government in May, has caused a further decline in the value of the euro, contrary to the intended effect. Germany's solitary step to impose financial regulation without coordination with other euro governments highlighted disarray among the eurozone countries.

Germany's short-selling ban was intended to block one of the crisis contagion channels discussed above. But such a measure cannot be counted on to deliver its intended effect so long as the other channels remain open. Rather, given the fact that discord among EU member economies, which is attributable to the absence of fiscal unification, has been the cause of speculation, it is evident that the EU member states need to coordinate and act in concert in introducing capital control.

>> Original text in Japanese

* Translated by RIETI.

June 14, 2010 Nihon Keizai Shimbun

July 29, 2010