Withdrawal Clause for Stabilizing the Euro

Faculty Fellow, RIETI

The euro, which was introduced to 11 countries of the European Union (EU) in early 1999, was introduced to Estonia, the 17th country to adopt it, early this year. Ever since the Lehman Shock in 2008, however, the euro has been in turmoil.

The EU sets the economic convergence criteria based on the Maastricht Treaty as the requirements for membership of the eurozone, including an inflation rate convergence to a low level, long-term interest rate convergence to a low level, and an upper limit to the ratio of government deficit and debt to GDP. In conjunction with these economic convergence criteria, particularly due to a rapid increase in government deficit and debt, several countries have fallen into a fiscal crisis, and now the euro itself is facing a crisis.

On the other hand, the EU has not stipulated a rule for withdrawing from the eurozone. Although the absence of the withdrawal clause works in favor of countries facing a crisis and contributes to maintaining solidarity among eurozone countries, it has been a disturbing factor for the euro itself.

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When the Greek fiscal crisis occurred, there was a concern that it might spread to other south European countries (Portugal, Spain, and Italy) and Ireland, which faced the largest ratio of fiscal deficit to GDP, second to Greece.

Consequently, when eurozone countries and the International Monetary Fund (IMF) decided to provide financial assistance to Greece in May 2010, the European Stability Mechanism (ESM) was established, along with the European Financial Stability Facility (EFSF), as a tentative measure in response to a possible spread of a fiscal crisis.

Despite such countermeasures, the concern became a reality as the Greek fiscal crisis spread to Ireland and Portugal. Then the Greek fiscal crisis recurred as though things had gone back to the beginning, and it was decided to provide the second bailout to Greece in July, 2011.

Following the first bailout to Greece (€110 billion in total from eurozone states and the IMF), it was decided to provide the approximately same amount, €109 billion, in the second bailout. Although there was no involvement of the private sector including private financial institutions in the first bailout, the portion of the second bailout which can not be financed by the public financial assistance was to be borne voluntarily by private financial institutions through debt reduction and other means.

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The debt reduction by the private sector was proposed by the Institute of International Finance, and 39 financial institutions of the world were involved in the proposal, including, primarily, European banks such as Deutsche Bank, BNP Paribas of France, HSBC of the U.K., and ING of the Netherlands, but also banks of Canada, Korea, and Kuwait (as of August 9). The total amount of their burden is expected to be on the order of €106 billion in terms of net debt (€135 billion in terms of total debt) from mid-2011 to mid-2020.

Despite its problems, such debt restructuring—by combining a moratorium and a haircut—is a shortcut to eliminating the excessive debt of the Greek government. At the same time, Greek fiscal consolidation, which is one of the conditions for the bailout from the IMF, must be steadily carried out. Otherwise, moral hazard (lack of the sense of ethics) can be encouraged on the part of the government and people of Greece.

Furthermore, regarding measures for Greek government bond restructuring, it will presumably be required to verify whether the haircut rate of 20% upon bond change and eurozone governments' bond buy-back rate of 61.43% are appropriate. If these haircut rates are insufficient for Greek fiscal consolidation, it is possible that financial institutions' assuming the burden at the expense of damaging their balance sheets may not result in the fundamental solution to the problem of Greek fiscal consolidation.

To begin with, no shortcut existed in the eurozone for eliminating excessive debt by debt restructuring until the EFSF was established. That itself was a factor which made the euro value unstable. In this sense, an expansion of the EFSF is necessary.

On the other hand, taxpayers of countries with fiscal soundness such as Germany are cautious about using their tax money to assist crisis countries lacking fiscal discipline. For this reason, it is another matter for concern whether the requisite ratification by eurozone countries will proceed smoothly for the scheduled expansion of the EFSF by the end of 2011.

In addition, unless the ESM is ratified by the parliament of each country by the end of 2012 or the beginning of 2013, the transition from the EFSF to the ESM scheduled on July 1, 2013 will also be delayed. In that instance, confidence will be lost on eurozone countries' policy responses and the euro itself. This is the reason why a cooperative scheme for a bailout is required within the EU.

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Due to a concern for fiscal crisis, the long-term interest rate of government bonds started to rise not only in PIIGS (Portugal, Italy, Ireland, Greece, and Spain) but also in France recently. On the other hand, the inflation rate is rising in some eurozone countries, and the European Central Bank (ECB) is facing a tradeoff in steering its monetary policy.

Figure: Long-term interest rate in major EU member states (Yield of 10-year government bonds)Figure: Long-term interest rate in major EU member states

Due to a sharp increase in the interest rate caused by the fiscal crisis, the ECB began to implement a measure to purchase government bonds of Italy, Spain, and other countries whose interest rates are rising significantly due to sovereign risk (government debt confidence crisis). From August 8 to 12, it newly purchased government bonds of eurozone countries worth about €22 billion, which was the largest weekly purchase in history. A government bonds purchase by the EFSF is also being considered.

A monetary policy is required to be run by taking into account both inflation concern in some countries and sovereign risk in other countries. Under such a circumstance, the ECB needs to buy government bonds (reduce the interest rate) of countries such as Greece whose sovereign risk is rising and, at the same time, to sell government bonds (raise the interest rate) of countries such as Germany in which inflation concern is rising, thereby appropriately inducing the interest rate in each country through a government bond swap operation.

I have conducted a joint study with Eiji Okano, Associate Professor at Chiba Keizai University, using a Dynamic Stochastic General Equilibrium (DSGE) model incorporating sovereign risk. According to the study, assuming that the interest rates of two countries in a monetary union are to be induced toward the same direction simultaneously, running a monetary policy targeting at inflation or sovereign risk reduction only sacrifices other targets. It was proved to be desirable to induce, instead, the interest rate of each country in accordance with its situation through the government bond swap operation mentioned above.

The establishment of fiscal discipline and the fiscal consolidation by tax increase and government expenditure reduction in countries facing fiscal crisis are the prerequisite for terminating the euro crisis. On the other hand, the absence of the rule for withdrawing from the eurozone is itself causing a loss of fiscal discipline and moral hazard.

If a country which has fallen in fiscal crisis withdraws from the eurozone and goes back to its own currency, it will result in a large depreciation in the value of its currency and, in turn, a large increase in the euro value, rapidly increasing its burden of euro-denominated government bonds. For this reason, letting a crisis country withdraw from the eurozone may make its fiscal condition fatal.

If the government and people of such a country understand that the country can fall into a situation which forces it to withdraw from the eurozone, the existence of the rule for withdrawing from the eurozone itself works as a mechanism for reducing moral hazard. A country lacking fiscal discipline would rather be expected to address fiscal consolidation seriously in order not to be forced to withdraw from the eurozone. Although it can be a double edged sword, it will contribute to stabilizing the euro.

It will be long before the euro crisis comes to an end unless the EU aims at recovering the economic convergence criteria for entering the eurozone mentioned at the outset by debt restructuring involving the private sector, the government bond purchase by the EFSF, and the government bond swap operation by the ECB, while ensuring fiscal discipline and reducing moral hazard in the above manner.

>> Original text in Japanese

* Translated by RIETI.

August 26, 2011 Nihon Keizai Shimbun

September 27, 2011