This presentation analyzes the sources of the eurozone crisis, policy responses, and solutions. It also shows a debt sustainability analysis for Greece, Ireland, Italy, Portugal and Spain.

1. Eurozone Crisis:
Policy Responses & Solutions
Lalith Samarakoon
Department of Finance
University of St. Thomas
Presentation at
Freeman Center for International Economic Policy
Humphrey School of Public Affairs, University of Minnesota
Nov 20, 2012

2. Three Inter-related Crises
2
Debt Crisis
Fiscal
Crisis
Banking
Crisis

3. Banking Crisis: Sources
• Credit freeze
• U.S. Subprime crisis froze international money markets, dried up
liquidity and low-cost short-term foreign borrowings.
• Exposure to U.S. Subprime assets
• Banks had invested in sub-prime assets.
• Exposure to domestic real estate bubble
• Excessive exposure to domestic property bubbles.
• Exposure to euro-zone government debt
• Exposure to sovereign debt of other eurozone countries.
• Capital flight (from Greece, Spain, Italy) to other countries.
3

4. Banking Crisis: Irish and Spanish Property Bubbles
4
Capital
Bonanza
(Short-term,
Foreign)
Excessive
Property
Lending
Speculative
Demand &
Property Bubble
Credit Freeze
(2008 U.S.
Subprime)
Property
Bubble Burst
Loan Losses
& NPLs
Bank Runs ,
Withdrawals,
Capital Flight,
Liquidity Crisis

5. Banking Crisis: Eurozone Property Bubbles
5
Country % Increase
from 1997 to
peak
% Decline
from peak to
2011
Ireland 268 -34
Spain 192 -16
Greece 148 -17
Eurozone 78 -1
Italy 72 0.4
Portugal 49 -0.2
PIIGS 146 -13
• Property prices rose by an
average of 146% in PIIGS.
Sources: ECB

6. Banking Crisis: Loss of Credibility of Greece
• Sudden loss of credibility: Greece announced that its budget deficit had
been under-reported and made significant an upward revision to 2008
and 2009 data. (October 2009)
• Sudden collapse of funding sources: Greece was cut off from Euro
interbank market and international bond markets.
• Rating agencies downgrade Greek debt
• Sovereign spread increased rapidly.
• Bank liquidity problems
• Banks faced deposit withdrawals and raised deposit rates (mainly
time deposits) to counter deposit leakages.
• Lending rates increased due to higher borrowing and deposit rates.
• Lending declined.
• Bank capital problems
• Banks faced increasing loan losses, particularly consumer loans. 20%
or €48b non-performing loans as of Aug 2012.
• Bank’s suffered losses in Greek government bonds due to loss of
market value and then pubic debt restructuring.
6

7. Fiscal Crisis: Output Plummeted
7
• Output plunged by more than
8% over 4 years.
Country Pre-crisis
Average
Growth
(1999-2007)
Post-crisis
Cumulative
Drop
(2008--2012)
Greece 4.0 -18.6
Ireland 6.4 -6.5
Italy 1.5 -6.7
Portugal 1.8 -6.1
Spain 3.7 -4.3
Eurozone 2.3 -1.0
PIIGS 3.5 -8.4

8. Fiscal Crisis: Budget Balances Deteriorated
8
• Ireland and Spain ran
surpluses before the
crisis.
• Italy had a primary
surplus but overall
deficit.
• Greece and Portugal had
persistent deficits.

9. Primary & Overall Balances Worsened
9
Country Pre-crisis
Overall
Balance
2007
Post-crisis
Overall
Balance
2012
Pre-crisis
Primary
Balance
2007
Post-crisis
Primary
Balance
2012
Spain 1.9 -7.0 3.0 -4.5
Ireland 0.1 -8.3 -1.0 -4.4
Eurozone -1.0 -3.0
Italy -1.6 -2.7 3.1 4.0
Portugal -3.2 -5.0 -0.6 -0.7
Greece -6.8 -7.5 -2.0 -1.7
PIIGS -1.9 -6.1 0.5 -1.5
• Overall deficit increased
by 8 percentage points.
• Primary balance declined
by 2 percentage points.
• Factors
• Lower revenue due to
recessions & cyclical
taxes
• Higher spending due
to automatic
stabilizers
• Higher interest costs
due to more debt

10. Debt Crisis: Public Debt Increased
10
• Decline in growth, rise in
budget deficits, banks rescues
& recapitalizations & bailouts
increased debt by 47%.
Country Pre-crisis
Debt (%)
(2007)
2012 Debt (%)
& Increase (%)
(2007--2012)
Greece 107 144 (34)
Italy 103 126 (22)
Portugal 68 118 (72)
Eurozone 66 92 (38)
Spain 36 76 (109)
Ireland 25 112 (348)
PIIGS 68 115 (47)

11. Sovereign Bond Yields Increased
11
Country Yield %
(Dec
2008)
Yield %
(Nov
2012)
Greece 5.08 17.61
Ireland 4.57 4.72
Italy 4.47 4.93
Portugal 4.00 8.79
Spain 3.86 5.83
Germany 3.05 1.30
• Yields rose. But have
declined significantly
since the peak except for
Greece & Portugal.

12. Social Costs: Unemployment Increased
12
Country Pre-crisis
(2007) Rate
(%)
(2007)
Post-crisis
(2012)
Rate (%) &
Increase
(Points)
Greece 8 24 (16)
Spain 8 25 (17)
Portugal 8 15 (7)
Eurozone 7 12 (5)
Italy 6 11 (5)
Ireland 5 15 (10)
PIIGS 7 18 (10)
• Jumped by 11 percentage
points over 4 years.
Sources: Eurostat, ECB & IMF

13. Reponses
13
Bank
Liability
Guarantee
Bank
Recapitaliza-
tion &
Nationalization
Asset
Support
Schemes
Liquidity
Support
Bailout
Programs
Debt
Restructuring
Structural
Reforms

14. Bank Liability Guarantees
• Purpose: State guarantee of liabilities of banks to restore confidence in
banks and prevent bank runs and a liquidity crisis.
• Irish blanket liability guarantee: guaranteed all deposits and debts of the
six largest in Sep 2008 (€485b, about 319% of GDP).
• Policy discussion
• Helped stabilize the banking system
• Socialized private debt
• Increased sovereign debt burden
14

15. Bank Recapitalizations & Nationalization
• Purpose: Prevent bank solvency crisis.
• Instruments: common shares, preferred shares and other hybrid
instruments
• Examples:
• Ireland: Anglo Irish, Nationwide Building Society, Allied Irish
(AIB), BOI, EBS Building Society
• Spain: Savings banks (Cajas); Bankia
• Policy discussion
• Restored bank solvency.
• Potential losses to tax payers.
• Increase public debt load.
15

16. Asset Support Schemes
• Purpose: ensure financial stability of banks by either removing impaired
assets to a bad bank or insuring against losses
• Asset removal schemes (Bad banks)
• Ireland: National Asset Management Agency (NAMA) acquired bad
assets worth €74b at an average haircut of 57% through bond for loan
swap.
• Spain: bad bank being set-up with part funding by bailout fund.
• Policy discussion
• Stabilized bank balance sheets
• Difficult to value, overpayment to buy bad assets
• Socialized private debt, taxpayers bear losses
• Increased public debt
16

17. Liquidity Support
• Purpose: Improve market liquidity in public and private debt securities market.
• Instruments
• Covered Bond Purchase Program (CBPP) - June 2009 – Oct 2012
• Buy eligible covered bonds from banks in the primary and secondary markets.
• Securities Market Program (SMP) – May 2010 – Sep 2012
• Buy eligible bonds issued by eurozone
• governments and public entities (secondary market) and private entities
(primary and secondary markets).
• Long-term Refinancing Operations (LTRO) – Dec 2011 & Feb 2012
• Long-term credit (up to 3 years) on the basis of collateral. €1,047b
• Emergency Liquidity Assistance (ELA) – Life Support – Since 2008
• Credit line to NCBs to provide emergency funds to banks that cannot put up
acceptable collateral to ECB for regular refinancing (Greece, Ireland,
Germany, Belgium). €233b
• Policy discussion
• Helped lower & stabilize sovereign bond yields
• Provided liquidity for banks to continue to lend
• Helped finance budgetary and debt repayment needs (via ELA)
• Risks of ELA borne by the NCBs and hence the government.
17

18. Bailout Programs
18
• Purpose: Provide loans by EU & IMF to help finance the budget deficit,
debt repayments and bank recapitalizations.
•€110b
•May
2010
Greece
•€85b
•Nov
2010
Ireland
•€78b
•May
2011
•€130b
•Mar
2012
Greece
• Bailouts are conditional on implementation of large austerity programs.
• Policy discussion
• Helped fund governments via budgetary support.
• Helped avert sovereign debt defaults & insolvency.
• Added to debt stock increasing the sovereign risk.
• Large budgetary adjustments in a short time span is infeasible.
• Austerity causing less growth, social unrest and political instability.
Portugal

19. Debt Restructuring
• Purpose: reduce Greek’s debt burden through debt reduction and
restructuring (March 2012, part of the second bailout) of privately-held
debt.
• Mechanism
• Debt swap: exchange old bonds for new Greek bonds worth 31.5% and
eurozone bailout fund (EFSF) notes worth 15% of face value of old bonds.
• Haircut: resulted in a 53.5% haircut and reduction of Greek debt from €350b to
€250b.
• Favorable terms: lower coupon: 2% (2012-2015), 3% (2015-2021) and then
4.3%, and longer maturity.
• Policy discussion
• Reduced the debt burden.
• Private investors, not the tax payers, took losses.
• Losses reduced capital base of Greek banks requiring recapitalization.
• Not adequate given the enormity of debt stock.
• Public investors were spared giving a bad signal to the market.
19

20. Structural Reforms
• Purpose: remove impediments to long-term growth by creating a more
efficient, competitive, flexible, market-oriented economy.
• Policy instruments
• Financial sector reforms (bank recapitalization, deleveraging, prudential capital
requirements, reorganization and downsizing of the banking sector, bank resolution
regime, strengthen banking regulations and supervision)
• Entitlement reforms (curtail entitlement and selected social security benefits)
• Labor market reforms (reduce minimum wage, reform unemployment benefit
system)
• Pension reforms ( increase in state pension age, curtail early retirement)
• Public administration reforms (modernize public administration & reduce
inefficiency)
• Increase competition in the non-tradables sector (electricity, transportation, and
telecommunications) & sheltered sectors (legal, medical and pharmacy )
• Privatization of government-owned enterprises.
• Policy discussion
• Needed reforms to address root causes of fiscal crisis.
• Needed reforms to increase competitiveness and growth .
• Takes a long-term to yield results.
20

21. 21
Solutions

22. Permanent Bailout Fund (ESM)
• Purpose: A permanent bailout fund with more capital to provide funds to
member states with financial instability.
• European Stability Mechanism (ESM) – Oct 2012
• Subscribed capital €700 b (€80b paid-in and €620b guarantees)
• Maximum lending capacity €500b. with a 40% cushion.
• Combined lending capacity of EFSF/ESM €700b.
• Issue bonds and other instruments in the market to fund its programs.
• Instruments of support
• Loans to a euro area member states in financial difficulties.
• Intervene in the debt primary and secondary markets.
• Act on the basis of a precautionary program.
• Provide loans to governments for bank recapitalizations.
• Policy discussion
• A more robust backstop to insolvency.
• Provide confidence to the investors.
22

23. ECB Bond Buying Program (OMT)
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me,
it will be enough“ ECB President Mario Draghi (July 26, 2012).
• Purpose: Buy sovereign bonds in secondary market to lower yields and thereby
long-term interest rates.
• Mechanism
• Outright Monetary Transactions: buy short-dated (1-3 year) bonds. Unlimited.
• Condition: Must ask aid from bailout fund and agree to conditions.
• Creditor treatment: ECB parri-passu with others.
• Sterilization: liquidity to be fully sterilized (OMT is not QE).
• Policy discussion
• Help lower bond yields and funding costs
• Lower interest rates might boost investment and consumption.
• Gives the option of rollover or restructuring.
• Limited effect due to high unemployment, weak consumer confidence and growth.
• Does not address budget deficit and debt
23

24. Banking Union
• Goal: Establish unified banking supervisory, deposit guarantee and resolution system
to minimize systemic risks and create a stable banking system.
• Ingredients
• Single Supervisory Mechanism (SSM)
• ECB to supervise all banks based on a single rulebook
• Banks receiving public support – Jan 01, 2013; Systemically important banks
July 01, 2013; All other banks – Jan 01, 2014
• Standardized Deposit Guarantee Schemes (DGS): Harmonization and
simplification of deposit guarantee systems, funded by banks.
• Recovery and resolution of banks: A common framework funded by banks.
• Policy discussion
• Reduce the occurrence and magnitude of bank failures
• Protection of deposits provides confidence and stability
• Resolution framework will make bank restructuring more efficient and less
burdensome to the state
• Reduce the exposure of states to bank bailout costs.
• Delink the bank insolvency from sovereign insolvency,
• Need to unify different national regulations and system (implementation issues)
24

25. Fiscal Union
“ If we want to re-establish trust in the eurozone, countries must pass a part of their sovereignty
to the European level,“ Mario Draghi, Oct 28,2012, Der Spiegel
• Goal: create an effective mechanism for budgetary control and supervision
and debt management
• Ingredients
• Common fiscal authority: Super-commissioner to supervise budgets and have
veto power over national budgets (German Finance Minister Wolfgang
Schaeuble).
• Central Eurozone budget (Rompuy, the president of the European Council
proposal, Oct 2012) to fund national operating deficits with binding contracts
with member states (fiscal transfer scheme to deal with asymmetric shocks).
• Fiscal solidarity instruments (Rompuy): Jointly issued Treasury bills, Eurozone
bonds.
• Policy discussion
• Need effective control of budget deficits and debt.
• Practical mechanism is the key – 3%/60% rule did not work.
• Need to establish comprehensive fiscal management and supervision
25

26. Debt Relief Proposals
• Debt forgiveness or reduction (IMF)
• Euro-zone governments to forgive or take a haircut on their Greek debt
(Official-Sector Involvement - OSI).
• Debt rollover (ECB)
• Rollover the debt held by public creditors such as ECB (ECB)
• Does not reduce debt level.
• Debt redemption fund (Rompuy)
• State debt in excess of the 60% to be pooled and paid off over a 20-
years.
• Debt buyback (Euro-zone Finance Ministers)
• Buyback debt held by private investors (€63b) and NCBs (€12b) at a
discount.
• What is the funding mechanism?
26

27. Debt Sustainability Analysis
• Government budget constraint
• Budget constraint in terms of GDP ratios
• Debt accumulation (change in debt)
27
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Bt -1 = debt at t-1
PBt = primary balance (-surplus/+deficit)
it = nominal interest rate
bt = debt-to-GDP ratio at time t
bt -1 = debt-to-GDP ratio at time t-1
pbt = primary balance-to-GDP ratio at t
(-surplus/+deficit)
it = nominal interest rate
gt = nominal GDP growth rate

28. Baseline: IMF Growth and Primary Balance Forecast
28

29. Baseline Debt Dynamics
• Baseline scenario:
• Debt will continue to
increase
• Unsustainable
except for Spain.
29

30. Negative Scenario: Baseline – 1% Growth, -0.5% Primary Balance
• Negative scenario:
• Debt will continue to
rise
• Unsustainable except for
Spain.
30

31. • Positive scenario:
• Debt will be lower
• But still high for Greece
and Portugal
31
Positive Scenario: Baseline + 1% Growth, + 0.5% Primary Balance

32. Debt Path: Reduce Debt Load to 100% of GDP
32

33. Debt Path: Reduce Debt Load to 80% of GDP
33

34. Debt Reduction Amounts
34
Country Current Debt (€b)
Reduction Needed (€b)
To 100%
GDP
To 80%
GDP
Greece 301 133 193
Ireland 180 21 57
Italy 1,982 517 914
Portugal 198 35 74
Spain 805 - -
Total 3,466 706 1,238

35. Summary
• Crisis of Credibility: need a credible plan rather than the reactive and
gradualist approach.
• Core vs. Periphery: core must lead with a comprehensive solution.
• Banking union: needed to create a stable banking system.
• Fiscal union: needed with a new set of fiscal rules and monitoring
mechanism. Fiscal Transfer Scheme is needed to absorb asymmetric
shocks.
• Austerity vs. Growth: need to balance. Pace of fiscal adjustment needs to
take a medium term approach rather than “front-loaded” adjustments.
• Debt sustainability: necessary to reduce the debt load to reasonable levels
to ensure fiscal sustainability. Need to balance economic and social risks
with moral hazard.
• Political and social instability: the biggest risk to success.
“It's not over until the fat lady sings,” Christine Lagarde, IMF Managing Director,
Nov 16, 2012 35

36. Appendix
36

37. External Imbalance: Current Account
37

38. Competitiveness Indicators: Price
38

39. Competitiveness Indicators: Cost
39

40. Credit Ratings
40

41. US Dollar vs. Euro
41

42. Credit Default Spreads
42
Country 5-yr CDS
(Basis
Points)
11/19/12
5-yr
CPD %
(Sep-
2012)
Greece 7186 90-99
Ireland 308
Italy 200
Portugal 618 36.5
Spain 350 29.5
Germany 31
• 5-year Credit Default
Spreads and Cumulative
Probability of Default
(CPD).

43. Country Bailout Programs
43
Country Date Amount
€ bn.
Features Fiscal Adjustments (Austerity): Revenue
increases and spending cuts
Greece May 2010 110 3-year
(2010-2013)
Deficit targets:
7.5% in 2011 (actual 9.1%)
5.2% in 2013
3% by 2014 (-7.5% actual in 2012)
Mar 2012 130 2-year
(2012-14)
Extended to
2016
Reduce debt
Debt swap (PSI)
120% by 2020 (actual 171% in 2012)
Ireland Nov 2010 85 3-year
(2011-2013)
Deficit targets:
8.6% in 2012 (actual 8.3%)
7.5% in 2013
3% in 2015.
Portugal May 2011 78 3-year
(2011-2013)
Deficit targets:
5.9% in 2011 (actual 4.2%)
5.0% in 2012 (actual 5.0%)
4.5% in 2013
2.5% in 2014
Total 403

44. 44
Fund Date Capacity (€b) Sources and Uses of Funds
EFSM May
2010
60b
(Backed by EU budget
and implicit member
guarantees)
Funding:
-Issue bonds and other instruments
in the market to fund its programs
Uses:
-Macroeconomic adjustment
programs (Greece, Ireland, and
Portugal, Ireland)
-Bank recapitalizations (Spain).
-Precautionary programs (credit line
to a non-program country to
overcome external temporary
shocks)
-Primary and secondary market
interventions.
EFSF June
2010
440b
(over-guarantee up to
165% or €720b)
ESM
(Permanent
bailout
fund)
Oct
2012
700b
(€80b paid-in and €620b
callable; Maximum
lending capacity €500b
with a 40% cushion.)
Eurozone Rescue Funds

45. 45
Governments and Elections