Thursday, August 11, 2011

Is Euro one of the culprits in creating and protracting the latest European credit crisis?


Is Euro one of the culprits in creating and protracting the latest European credit crisis?
European union was formed in 1999 with the vision of creating “One Europe”.  Its objective was to increase the economic and political unity and financial integration thus leading to a sustained economic growth. One of the means employed for achieving this was to have a common currency – the Euro. The idea was to curb the costly currency conversion between European countries thus allowing free flow of money towards better business opportunities across the countries thus leading to harmony and prosperity.
Seventeen member states of the EU adopted the Euro. Additionally, few other countries in the central and eastern Europe, such as Baltic countries, pegged their currencies to the Euro thus linking their monetary policies to that of the EU central bank. This EU worked well for a decade, during which the member countries experienced rapid growth and high employment rates. However, the very environment created by Euro, which was initially congenial for growth, in the background fostered a credit bubble.  


How did that happen?

European union consisted of core countries (rich developed economies such as Germany, France etc) and periphery countries (poor growing economies such as Spain, Greece, Ireland etc).  The merger in EU created different effects for each of these groups. Historically, the public and the private institutions in the poor periphery countries had to pay 4-5% more interest (spreads) than their rich core counterparts on its bonds resulting in a higher cost of capital.  However, when Euro was introduced these spreads completely disappeared. Capital was made available for everybody at the same price. This brought an immediate tangible benefit in the shape of lower funding cost for governments, corporations and households.

The free capital flow not only fueled the demand for credit but also triggered a boom in asset prices and domestic demand. This increased money supply also resulted in a greater demand for imports and stimulated a rapid expansion in the non-tradable sectors such as real state and financial intermediation. The effect was rapid increase in wages and cost, which in turn affected the profitability of tradable sectors (such as manufacturing). Net result was that the higher costs negatively affected exports. 
Secondly, the rapid growth in non-tradable sectors further attracted bank and FII investment in it whereas low growth in the tradable sector resulted in a reduction of FDI investments. Increasing imports and decreasing exports resulted in current account deficit and inflation. And once the current account deficit started increasing, these poor countries became increasingly dependent on the foreign capital inflow to fund their deficit thus further increasing the risk of financial disruption incase the flow stopped.
The situation was somewhat different in the richer countries as they witnessed expansion primarily in the tradable sector during the same period. Thus their export to the GDP ratio increased whereas the periphery countries saw a decline in the same.

In the pre Euro regime, every country’s central bank controlled its currency, regulated local interest rates and credit conditions. However, with the euro, that power now rested with the European Central Bank (ECB); And ECB adopted a uniform policy.  Unfortunately, this one policy didn’t fit all. Low interest rates became suitable for core countries whereas it were too low for the “periphery” countries. At the same time, governments in the peripheral countries failed to effectively use the fiscal policies to control rising inflation and account deficit.

Additionally, Euro’s creation gave private investors a feeling of reduced risk. It was widely assumed that the strong core countries would protect the weak peripheral countries from any eventuality. Hence capital kept flowing in at a rapid pace resulting in further compression of interest rates. For example: In late nineties, rates on 10-year Greek government bonds averaged 9.8 percent, compared with 5.7 percent for similar German bonds. By mid 2000, Greek bonds fetched 4.3 percent, just above the 4.1 percent of German bonds. It is evident that the Euro helped in creating this credit bubble resulting in a higher account deficit and inflation.

This boom came to a sudden end when Lehman brothers filed for bankruptcy. Staring Sep 2008, all capital flows reversed. The most severe retrenchment was seen in the banking flows from the core countries. As risk aversion rose and equity markets sank, banks in the core countries faced capital shortage. In turn they curtailed their supply to the peripheral countries. This resulted in a sudden dip in investment and consumption in the periphery countries triggering recession. The loss in demand negatively affected government revenues too, thus further increasing government deficit and compounding the existing current account deficit problem.  Lack of capital further resulted in increased financing cost for both government and private sector.  Governments in these countries needed fund to sponsor their account deficit that was not available now. But no bank, government or private institution was willing to lend them. Thus what appeared to be a banking sector problem soon translated itself into a sovereign debt problem, pushing these economies to the brink of bankruptcy.

Did Euro impede recovery as well?

Once the credit bubble had burst, the euro impeded the economic recovery as well. The periphery economies needed money for recovery, which they found hard to find. There were few ways how the periphery countries could have crawled their way out of this recession. First, if they had the monetary policy under their control (independent currency) they could have printed more money and could have sponsored their debt as well as invested in infrastructure thus fueling demand. Second way out for these countries to recover from the financial crises, was to depreciate their currencies. This would have made exports and local tourism cheaper, creating more jobs. Here again, these countries couldn’t leverage this option as they were latched to the euro.

The problem now is that if any of those peripheral countries defaults, it would create a panic situation where investors may dump bonds of other periphery countries fearing failure in those countries as well. That could lead to sharp increase in interest rates and put more losses on European banks. A banking crisis now in turn will endanger the economic recovery. Thus the prime focus in Europe right now is to prevent any fragile peripheral economy from defaulting till those countries figure a way to handle their debts. And the cost for it is being bore by the core economies for now. Contrary to the intent, this very process makes the euro a source of contention, as countries shift blame as well as costs to others. Given Europe’s huge debts, the question is how long this model can sustain itself?