Portal to the Economy of the Euro

FINANCE

This sections reviews the monetary policy of the ECB and various financial variables in the euro zone.
This is followed by a review of fiscal policy, the various bailout funds and government debt.

Governing Council meeting of 4 Aug: markets stressed, liquidity boosted

The ECB's latest Governing Council meeting was held against a background of renewed severe tensions in the financial markets as contagion spread with the bonds of Italy and Spain in particular coming under intense selling pressure.

The ECB responded with emergency measures boosting liquidity. Banks were offered one 6-month loan (10 Aug'11 to 1 Mar'12), three 3-month loans in addition to its regular Main Refinance Operations which are to run "for as long as necessary...and at least until 17 Jan'12". All are under the fixed rate tender with full allotment procedure, meaning that banks can borrow as much as they want.

The ECB also resumed its bond purchase programme SMP, after being out of the market for 18 weeks. In an effort to calm markets the ECB subsequently extended its purchases to Italian and Spanish government bonds after these two countries undertook to tighten fiscal policy further and accelerate structural improvements. The move was opposed by the Bundesbank and, reportedly, by three other Governing Council members.

In the previous, 7 July, meeting, interest rates were raised by 25 basis points. This followed the 7 Apr'11 meeting when the ECB increased its interest rates also by 25 basis points. The main refinance rate thus stands at 1.5% and this is the rate the banks will pay for their loans (except in the unlikely event that rates are raised during this period).

ECB's main interest rates to stabilise at 1.5%

The rate rises aimed to demonstrate the ECB's concern about inflation being above target. At the time President Trichet said that this was not to be seen as

the beginning of a series of rate hikes, but he also said that inflation risks are still on the upside and that monetary policy was still accommodating. This was taken as implying that rates could go higher still.

After the latest financial market tensions, weak growth indicators and deceleration of inflation, another rate hike appears a long way off. If current trends in growth and inflation persist the ECB is more likely to cut rates than to raise them.

Standard and non-standard monetary measures

The ECB makes a distinction between "standard" monetary measures, which concern interest rates and are designed to deliver price stability, and "non-standard" measures, which concern liquidity provision to the banking system to ensure that the (in the words of the ECB) "monetary policy transmission mechanism functions correctly", i.e. to alleviate the sovereign debt crisis.

It was already made clear earlier that the persistence of the sovereign debt crisis would not prevent the ECB from raising interest rates to contain inflation.

Phasing out the extraordinary measures

The ECB remains keen to phase out the extraordinary measures in force to support the banking system. The ECB regularly expresses concern that some banks continue to be so heavily dependent on borrowing from it.

The intention still is to return to standard operating procedures sometime in the foreseeable future. The ECB will then again conduct its refinancing operations through the variable rate tender system, with the ECB deciding on the amount of liquidity provided and the market setting the interest rate. A long period of calm in the financial markets will be required before such a move can be undertaken.

A rejuvenated Governing Council to be more hawkish?:

Nearly one third of the 23 member Governing Council is leaving this year, being replaced by mostly younger persons. President Trichet (69) will retire end Oct'11, to be replaced by Italy's Mario Draghi (63). He may wish to burnish his anti-inflation credentials, coming from a country with a past of high inflation and deep budget deficits.

New Bundesbank President Jens Weidman (43) has signalled he will pursue the same anti-inflationary path as his predecessor and mentor Axel Weber (54).

Belgium's new central bank governor, Luc Coene (64), has in interviews struck a more hawkish tone than his predecessor Guy Quaden (66). Other changes among the central bank governors are Josef Bonnici taking over from Michael Bonello (Malta) and in Netherlands Klaas Knot (44) has taken over from Nout Wellink (67). Estonia's Andres Lipstok (54) joined the Council at the start of the year.

On the ECB's Executive Board Belgium's Peter Praet (62) replaced Gertrude Tumpel-Gugerell (59). Lorenzo Bini Smaghi (55) may have to retire early to make way for a representative from France once Trichet leaves.

Background:
ECB's 10 May'10 measures: Policy moved back to stimulation
Enhanced capability of intervention in crises

A major shift in policy was announced Monday 10 May'10. During the previous week financial markets were increasingly unsettled by the euro zone's rapidly deepening sovereign debt crisis, ending the week in turmoil.

The debt problems of Greece spread to other deeply indebted euro zone countries, obliging the ECB to reverse its planned gradual withdrawal of unlimited cash support. Banks in Greece, Ireland, Spain and Portugal were heavily dependent on this facility and may have faced illiquidity should this source have dried up.

After the ECB left its policy stance unchanged at its 6 May'10 policy meeting, markets plunged, interbank lending started to freeze up and the financial situation risked moving out of control (similar to the aftermath of the Lehman Brothers bankruptcy). The ECB had to act. 10 May brought a dramatic volte-face. Policy was moved back to stimulatory.

Though initially viewed as disorderly, last gasp panic measures lacking unanimity, the ECB, by specifically granting itself the power to buy securities in the markets, became a credible purchaser of last resort for the securities of the governments in financial difficulties. This has greatly enhanced its ability to intervene in crises situation

Securities Markets Programme (SMP): private and public securities bought by the euro zone's central banks on behalf of the ECB in the markets ("quantitative easing"). The two German members on the Council opposed the measure.

Reportedly a number of national central banks already started buying government bonds in the markets on 10 May'10. In that week (week 19) bond purchases totalled EUR 16.5bn. Since weekly purchases have tailed off, though they briefly rose again after the Irish bail out. So far in 2011 the ECB has made virtually no additional purchases.
These purchases are "sterilised". ECB invites banks to deposit cash with it for one week periods (replacing overnight deposits with the ECB with one-week term deposits) to offset the rise in the money supply resulting from the bond purchases. This is little more than a symbolic move as the ECB continues to meet in full banks' demand for liquidity.
Hence the ECB claimed that monetary policy was "unchanged" and the measure did not constitute "quantitative easing". It stressed that the securities purchases were to address dysfunctional markets, not to assist the heavily indebted countries.
Unlimited liquidity provision: ECB reactivated its unlimited fixed rate liquidity provision to the banks with various maturities to ensure banks had access to funds during the crisis.
Liquidity swap lines: USD swap lines with US Federal Reserve reopened to provide ECB with as many USD as it requires for lending on to euro zone banks. Swap lines were also activated with other central banks and subsequently prolonged to 1 Aug'11.

Note 29 Jun'11: as part of measures to cope with potential Greek debt default dollar swap lines between major central banks have been extended to Aug'12

Background swap lines: Through the swap arrangements, put in place in Dec'07, the US Federal Reserve offered dollars to foreign central banks in exchange for their currencies. They take the form of repurchase arrangements against suitable collateral. The dollars were then lent on in their domestic markets, enabling firms access to dollars at a time when the normal financial channels shut down. At the peak in Oct'08 European banks took USD170bn through this channel, mostly in order to repay dollar loans taken out when US interest rates were exceptionally low.

Emergency Liquidity Assistance (ELA): little known

The little known ELA facility allows national central banks (NCB) to provide funds to domestic financial institutions in financial difficulty over and above the liquidity provided by the ECB's regular refinancing operations. These operations are separate from the Eurosystem, but the ECB's Governing Council can with a ⅔ majority oppose the granting of further ELA, if, for instance, it considers the emergency assistance provided constitutes monetary financing.

The assistance provided is supposed to be temporary and to an illiquid but solvent financial institution. The lending is not subject to ECB collateral requirements. Thus a bank can present its NCB collateral which would not be acceptable by the ECB (but which would be acceptable by the NCB).

Some known examples of provision of ELA are by the National Bank of Belgium and the Bundesbank during the Sep-Oct 2008 financial crisis. The Central Bank of Ireland has provided ELA to some Irish financial institutions since 2009 and the amounts have grown substantially in the course of 2010. (see Buiter)

Intra-eurosystem lending: rising rapidly

Under the eurosystem TARGET2 payment system when a banking retail transaction results in a debt between banks located in different euro zone countries which is not cleared in the interbank market, the debt creates a claim between the respective national central banks (NCB).

If for example a company decides to move its deposit from an Irish bank to a German one (because of doubts about the Irish bank's solvency), and the German bank is unwilling to accept payment in the form of a claim on the Irish bank, the debt is settled via the respective NCBs. The Bundesbank acquires a claim on the Central Bank of Ireland (CBI). See Whittaker

The outstanding claims and liabilities of all national banks are transferred to the ECB at the end of the business day, where they are netted out. The Bundesbank's claim against the CBI then becomes a claim against the ECB.

As the sovereign debt crisis intensified deposits not only fled Irish banks, but also Greek, Portuguese and Spanish banks. Germany was the major recipient of these funds, followed by Luxembourg and Netherlands. Besides the loss of deposits, the growth in eurosystem lending results from banks unable to refinance maturing debt and unable to access the interbank market.

The banks which lose deposits or are unable to access the interbank market replenish their liquidity by borrowing from the ECB under the normal repo operations against collateral. Under the current full allotment system the ECB fully meets all demands for liquidity. Those banks lacking acceptable collateral may borrow from their NCB under ELA described above.

Note that the monetary base in the euro zone does not increase as the banks receiving the deposits make a corresponding reduction in their borrowing from the ECB.

Eurosystem lending has risen rapidly, amounting to EUR457bn end-2010 (up from EUR80bn end-2006). The major creditors end-2010 were the Bundesbank (EUR326bn), followed by the central banks of Luxembourg (EUR68bn) and Netherlands (EUR41bn). The major debtors were the central banks of Ireland (EUR146bn), Greece (EUR87bn), Portugal (EUR60bn) and Spain (EUR51bn). See Bundesbank p 34-35

Some commentators have erroneously viewed this as, for instance, Germany through the Bundesbank lending EUR325bn to other central banks in the eurosystem. And, for instance, the CBI borrowing EUR146bn from the eurosystem to support its banks. All at the modest interest rate of 1% (up to Apr'11). In fact the lending is done by the ECB and if, say the CBI, defaulted the loss is born by the ECB (and ultimately by the NCB according to the ECB's capital key). See Storbeck

The imbalances in the eurosystem will decline once the sovereign debt crisis is resolved. The ECB has called on the governments of the indebted peripheral countries to recapitalise and restructure their banks so that they can return to the interbank market and reduce their reliance on ECB funds. But banks naturally have so far preferred the cheap and readily available funds from the ECB.

After subsiding in 2009, the ECB's balance sheet resumed its uptrend in H1'10 as the ECB responded to the deepening euro zone sovereign debt crisis.

During most of H2'10 the ECB's balance sheet receded again as banks repaid the large 1-year loans extended in H2'09 without being fully replaced by new loans (of shorter duration). The ECB's net lending to banks was in decline.

The ECB's balance sheet again briefly rose towards end-2010 as the Irish debt crisis unfolded and as the sovereign debt of other euro zone countries came under pressure. The ECB raised its purchases of Irish, Portuguese and Spanish bonds.

Early this the year the balance sheet shrunk again as the last of the long term loans were repaid. But as the debt crisis worsened again in mid-year the balance sheet again rose as the banks borrowed more from the ECB.

Also the ECB's Securities Market Programme, under which the ECB bought securities in the secondary markets (and which was in abeyance for 18 weeks), was again activated with large scale purchases of Italian and Spanish bonds.

(In Dec'10 the ECB saw itself forced to double its capital to protect it from potential losses on the securities it holds in refinance operations and the securities it buys outright in the markets.)

Background: in crisis ECB lender of first and only resort

During the worst of the 2008 financial crisis, when there was no lending between banks (interbank lending being unsecured), banks dealt with the central bank: they borrowed from the ECB and deposited record amounts of cash with it.

Trading with the central bank replaced interbank trading. Rather than the lender of last resort, the ECB became lender of first and only resort. This accounted for the steep rise in the ECB's balance sheet in Q4'08.

This diminished in the early months of 2009 as liquidity gradually began to flow back from the ECB to the money market. In mid-Jun'09 refinance operations amounted to EUR611bn, down from a peak of more than EUR840bn at the turn of the year. The deposit facility declined over the same period from more than EUR300bn to EUR11bn.

Following a massive liquidity injections on 24 Jun'09 the ECB's balance sheet total again shot up to EUR1 997bn on 26 Jun'09 (from EUR1 719bn in prior week), just below the peak of EUR2 089bn at the start of 2009.

Refinance operations reached a new record of EUR897bn. Initially much of this money (EUR316bn) flowed back to the ECB in the form of deposits. Net lending to credit institutions thus amounted to EUR581bn.

Subsequently the balance sheet total shrunk again as the financial crisis abated and the ECB made a tentative start to normalise the situation.

The financial stress caused by the escalating Greek debt crisis, however, led to the renewed expansion of the ECB's balance sheet. Refinance operations rose and banks again deposited large sums with the ECB. Bond purchases by the ECB started in May'10 and added to the uptrend in the balance sheet.

Many smaller banks in the countries hardest hit by the sovereign debt crisis have reportedly been shut out of the interbank money market and were again fully reliant on the ECB for their liquidity requirements. In Jun'10 the ECB's balance sheet reached a new peak.

It declined subsequently as banks repaid the large loans taken out in 2009 without fully replacing them by new loans.

The broad money supply is rising, though modestly and fitfully. On a y/y basis the money supply M3 (s.a.) rose by 2.0% in Jul'11, fractionally up from 1.9% in the prior month.

On a m/m basis (s.a.) M3 rose by EUR21bn in Jul'11, after rising by only EUR3bn in Jun'11 (s.a.). In spite of the irregular monthly movements, the underlying trend so far this year is sideways.

The growth in the narrow monetary aggregate M1 continues its deceleration after shooting up in 2009. In the year to Jul'11 the rise in M1 came to 0.9% (down from 8.2% in the year to Jul'10).

In Jul'11 loans to the private sector rose by 2.4% on the year. On the month they rose by EUR10bn (adjusted for sale or securitisation they rose by 2.6%). (details below).

It may be noted that virtually throughout the euro zone first ten years its broad M3 money supply grew faster than its reference value ("target"), accumulating liquidity on the way. The ECB considers that "excess" monetary balances were built up. It considers that M3 growth would be stronger in the current recovery phase were it not dampened by the unwinding of accumulated liquidity.

According to anecdotal evidence companies held unusually large amounts of cash during the recession.

The granting of bank loans to the private sector, after diminishing dramatically in H2'08, moved erratically in 2009, recovered in the spring of 2010 but again lost momentum towards year end. So far in 2011 the trend has been irregularly downwards. (The chart above shows loans as 3-month averages, to iron out the most erratic monthly fluctuations.)

Many of the loans go to financial companies (mostly investment companies, including private equity firms and hedge funds) rather than the "real sector" (households and non-financial corporations).

Loans to households were being granted at a steady rate averaging EUR12bn per month in 2010, strengthened early in 2011 only to again weaken in mid-year. The average so far this year is EUR11bn. These loans are almost entirely for house purchases, not for consumer credit. Banks prefer to lend for house purchases as the risk is lower.

Loans to non-financial corporations, the "real" sector, remained weak in H1'10, but rose in some months in H2'10. The ECB's earlier massive injections of liquidity into the banking system thus brought little (net) lending by the banks to non-financial companies.

In 2010 loans to non-financial companies averaged -EUR2bn per month. Jan-Jul'11 brought increases averaging EUR10bn, a modest improvement.

Bypassing the banks: Reportedly many companies were flush with cash and did not need to borrow. This is in part a consequence of the extraordinary situation late in 2008 when the money markets ceased to function, depriving companies of liquidity. As a precaution companies raised their cash reserves by cutting costs, investments and personnel.

As a consequence of the prohibitive costs and onerous conditions of obtaining bank loans, companies are also had greater recourse to the equity and bond markets. Reportedly they found it increasingly easy to raise large sums. Even high-yield bond issues again found buyers in H1'11.

Bank lending survey: The ECB’s Jul'11 quarterly bank lending survey (published 28 Jul'11) showed that banks' lending standards were tightened further in Q2'11, but only modestly (and by less than in Q1'11).

For enterprises the tightening resulted from a more pessimistic assessment of the economic situation and of risk. There was only a modest increase in the demand for loans. (In Q1'11 there was a quite strong increase in demand for working capital as well as for investment). For Q3'11 the banks expect that their lending standards will be tighten a little further. Only a subdued rise in the demand for loans is expected.

For households the demand for consumer credit declined at an accelerating rate in Q2'11. A further, but smaller, decline is anticipated for Q3'11. The demand for housing loans is also in retreat.

Some background: bank loans to private sector

In the euro zone, unlike in the US, bank loans are the most imported source of external financing. Of these 48% typically go to households (3/5 for house purchases, 2/5 for consumer credit and other) and 44% go to non-financial corporations. This can be viewed as the "real" sector of the economy.

The remaining 8% go to financial companies (insurance companies, pension funds and other financial intermediaries other than banks).

In the first phase of the acute financial crisis (after the collapse of Lehman Brothers) bank lending to non-financial corporations expanded rapidly as firms drew down available credit lines, fearing that bank loans would be hard to obtain.

In a second phase lending declined sharply as demand for loans collapsed while at the same time banks anyway found it difficult to access finance and strived to reduce their balance sheets.

The ECB had hoped that through its massive liquidity injections it had created scope for the banks to raise lending to companies and households. The ECB believes that this "enhanced credit support" was the most appropriate way of promoting a recovery because of the greater reliance of business in the euro area on bank financing (in contrast to Anglo-Saxon countries).

According to the ECB banks account for 70% of company financing in the euro area, compared to only 20% in the US where companies issue commercial paper and corporate bonds to finance the majority of investments.

In spite of the massive liquidity injections lending continued to spiral downward. The decline would probably have been much more severe in the absence of the ECB measures. Constrained by inadequate capital and restrained access to finance as well as burdened by impaired securities on their books, banks became particularly risk adverse, inclined to reduce rather than expand lending.

The decline in bank lending was also in part due to companies requiring less working capital as the recession deepened. Subsequently, as banks' lending criteria tightened substantially, companies increasingly resorted to stock and bond markets to secure capital. Moreover companies hoarded internally generated cash.

The decline in loans to households was led by a slump in lending for house purchases as the housing boom collapsed in a number of countries. Housing loans were also the first to recover and grew at a sustained rate in 2010. Banks favour these as safer. Housing loans can be collateralised and used to back covered bonds. Consumer credit, seen as more risky, remains in decline.

In the past bank loans to non-financial corporations have typically recovered one year after the upturn in the economy. If repeated in the current cycle they should have turned up in Q3'10. They did, but the rise was not sustained in Q4'10.

The failure of bank lending to recover fully may be due to both demand and supply factors. Bank lending surveys indicate that demand for bank loans from enterprises remains restrained while the banks have imposed increasingly severe lending standards.

The 3-month EURIBOR was on an uptrend in H1'11 as the ECB gradually withdrew liquidity from the money markets and raises interest rates.

The rate rose above 1.5% after the ECB hiked its main refinancing rate to 1.5% on 7 Jul'11. The EURIBOR continued its rise, exceeding 1.6% in mid-Jul'11. But early in Aug'11, as the sovereign debt crisis intensified again, and the ECB injected more liquidity into the banking system, the rate fell back towards 1.5%

Interbank lending is still hampered by the debt crisis. Banks' holdings of deteriorating debt of the deeply indebted euro zone governments is weighing on the interbank money market. Many banks remain dependent on the ECB for their liquidity needs.

USD LIBOR inched up again in early Sep'11 to just above 0.33%. The gap between euro zone and US money market rates shrunk, though still remaining wide, one reason why the EUR remains about stable against the USD in spite of the deepening euro zone debt crisis.

The overnight EONIA rate, which remained low for most of 2010 was on a steep uptrend in H1'11. The rate has been particularly volatile in recent months.

EURIBOR (Euro Interbank Offered Rate): is the (average) rate at which banks lend to each other in EUR in the euro zone. EURIBOR is tracked more widely than its London counterpart, the Euro LIBOR (London Interbank Offered Rate). EURIBOR is used as a benchmark rate for a wide range of assets and is the main gauge of unsecured interbank lending in euros.

The rate is a mix of interest rate expectations and of the willingness of banks to lend in the interbank market.

The rate plunged after the ECB drastically eased monetary policy in Oct'08. It reached its all-time low of 0.634% at the end of Mar'10. As the Greek debt crisis spread to other countries the rate rose steadily, reaching a peak of 0.905% early in Aug'10.

Initially the cost of borrowing in the interbank market rose as banks hesitated to lend to each other on concern that the financial health of some banks may be endangered by the sovereign debt crisis. Many European banks have a heavy exposure to the debt of Greece and other heavily indebted euro zone countries.

More recently reduced liquidity provided by the ECB has forced more banks to borrow in the interbank market. This pushed the EURIBOR higher. For instance the ECB's 1-year loan which expired 1 Jul'10, required banks to repay the EUR442bn they borrowed a year earlier. Liquidity in the euro zone became less ample.

As a result of the sovereign debt crisis many smaller banks in the countries hardest hit by the crisis have reportedly been shut out of the interbank money market and are entirely reliant on the ECB for their liquidity requirements. (Interbank lending is unsecured.)

EONIA (euro overnight index average): in 2009 the ECB's provision of unlimited liquidity to the financial system, through its fixed rate tenders, consistently pushed the EONIA rate significantly below the official ECB main refinance rate and towards the lower deposit rate, thereby breaking the normally close link between the EONIA rate and the ECB's main refinance rate (see above chart).

Monetary measures taken 2008-09 to counter the financial crisis and recession: no banks to fail, unlimited liquidity provided

ECB cut interest rates: the main refinancing rate of the ECB was cut seven times, bringing it down to 1% (from 4.25% pre-crisis). The ECB's deposit rate was cut to 0.25%.

Unlimited liquidity injections by the ECB: since 8 October 2008 full demands for refinancing were met at the fixed rate (“fixed rate tender procedure with full allotment”). Previously a fixed sum was made available for which banks put in bids. Three auctions were held where banks could borrow unlimited funds for up to 12 months at 1% (24 Jun'09, EUR442 demanded; 30 Sep'09, EUR75bn; 15 Dec'09, EUR97bn).

Qualitative easing: the standard of eligible collateral was lowered. Thus, to access ECB funds a greater range of securities could be presented by the banks as collateral.

Quantitative easing: as traditional expansionary monetary policies had little traction in the recessionary environment, the ECB agreed to buy EUR60bn of covered bonds in the markets for cash. This is a very modest sum, reflecting unease about quantitative easing, associated with "money creation", "monetising the debt" or "printing money", eventually leading to inflation or even hyper inflation. As a result the ECB shunned the term "quantitative easing", preferring "enhanced credit support"

Government rescues: the national authorities stepped in to bail out Fortis and Dexia, two Belgian banks, and Hypo Real Estate a German company. In Nov'09 the German government bailed out WestLB bank. A sum of EUR200bn was made available for governments to directly re-capitalise their banks. National authorities stepped in to guarantee savings.

Governments guarantee interbank lending: up to EUR1trillion was made available in the euro area to guarantee interbank lending with the aim to allow interbank lending to resume.

Budget deficits by country 2010 as % of GDP (in brackets 2009 deficit) as calculated by Eurostat in April 2011
*Countries with deficits of less than 3%*	Countries with deficits of 3% to 8%	Countries with deficits exceeding 8%
Estonia + 0.1 (1.7) Luxembourg 1.7 (0.9) Finland 2.5 (2.6)	Germany 3.3 (3.0) Cyprus 5.3 (6.0) Malta 3.6 (3.7) Netherlands 5.4 (5.5) Belgium 4.1 (5.9) Slovenia 5.6 (6.0) Italy 4.6 (5.4) France 7.0 (7.5) Austria 4.6 (4.1) Slovakia 7.9 (8.0)	Portugal 9.1 (10.1) Spain 9.2 (11.1) Greece 10.5 (15.4) Ireland 32.4 (14.3)
	Euro area 6.0 (6.3) for comparison: UK 10.4 (11.4) US 11.2 (11.2)

Budget deficits: from quiescence to calamity

The euro zone entered the 2008-09 recession in an apparently sound fiscal position. The budget deficit for the area as a whole amounted in 2007 to a modest 0.7% of GDP. Substantial growth in 2003-07 permitted the government coffers to be replenished after being drained by weak growth earlier in the decade.

Deficits rose rapidly in 2008: to 2.0% of GDP. Initially it was hoped that the 2009 deficits could be contained within the 3% limit set by the Stability and Growth Pact. But as the severity of the recession became evident more and more fiscal reflationary measures were introduced and deficits soared. The "automatic stabilisers" further deepened the deficits as the recession curtailed tax inflows and boosted social support spending.

According to Eurostat's Apr'11 report the deficits of the euro area countries added up to a relatively bearable 6.0% of GDP in 2010, down from 6.3% in 2009. But the impact of the recession brought widely divergent country developments, triggering the sovereign debt crisis.

Sovereign debt crisis brings bailout mechanisms

It was decided late in 2009 by the EU leaders that fiscal policy in 2010 would remain supportive of the recovery and that a start would only be made in 2011 to rein in the budget deficits. But the sovereign debt crisis which erupted early in 2010 in Greece and then spread to other deeply indebted countries forced these countries to introduce restrictive measure much earlier.

The EU was thrown into its deepest crisis yet, necessitating emergency measures, much soul searching and fundamental changes in the EU's architecture. Bailout funds had to be created.

Deficits to shrivel

Steep declines in the deficits are expected 2011-12 as growth strengthens and restrictive fiscal policies are implemented virtually in all the euro zone countries. Deficits, according to the European Commission's spring 2011 forecasts, are expected to amount to only 4.3% of GDP in 2011 and 3.5% in 2012. Based on the more higher nominal growth forecasts of Euroeconomics the deficits may amount to only 4% of GDP in 2011 and 3% in 2012.

Gross debt by country 2010 as % of GDP (in brackets 2009 debt) as calculated by Eurostat in April 2011
*Debt below 60%*	Debt in 60% - 79% range	*Debt in 80% - 99% range*	*Debt* *exceeding 100%*
Estonia 6.6 (7.2) Luxembourg 18.4 (14.6) Slovenia 38.0 (35.2) Slovakia 41.0 (35.4) Finland 48.4 (43.8)	Spain 60.1 (53.3) Cyprus 60.8 (58.0) Netherlands 62.7 (60.8) Malta 68.0 (67.6) Austria 72.3 (69.6)	France 81.7 (78.3) Germany 83.2 (73.5) Portugal 93.0 (83.0) Ireland 96.2 (65.6) Belgium 96.8 (96.2)	Italy 119.0 (116.1) Greece 142.8 (127.1)
	Euro area 85.4 (79.3) for comparison: UK 80.0 (69.6) US 93

Government debt by country: from miniscule to perilously high

The reference value of the government debt-to-GDP ratio laid down in the Maastricht Treaty is 60% of GDP. Only five countries currently satisfy this criterion, all countries with small populations, three of them recent members. A further three come quite close while the remaining nine are well over the limit, two widely so.

Concerns about possible defaults of the most indebted countries have led to wide yield spreads between their government bonds and those of Germany.

The average government debt for the euro zone for 2010 (as calculated by Eurostat) is 85.4% of GDP, thus well over the reference value. This is up from a low of 66.2% achieved in 2007, the lowest result so far after a number of years of growth provided scope to "deflate" the debt.

The deterioration since then is due to the steep decline is tax revenue and the rise in support payments occasioned by the recession as well as the reflationary fiscal measures taken. The European Commission forecasts a further deterioration to 87.7% in 2011, a year expected by the Commission to show only moderate growth. By 2012 the debt is forecast to amount to 88.5%.

Greece stands out as the country with the heaviest debt and the second largest 2010 budget deficit (tables above). On the basis of unchanged policies Greece's debt will spiral out of control. Even under a severely restrictive fiscal regime only a slower rise in the debt can be achieved in the medium term. Doubts about whether Greece will be able to pursue such a restrictive course accounts for the pressure its bonds have come under A debt restructuring appears inevitable.

The debts of Italy and (to a lesser extent) Belgium also are exceptionally high, but both countries have followed conservative fiscal policies during the recession and their 2010 budget deficits are relatively moderate.

When does a debt burden become unsustainable?
The example of Greece

It is difficult to pinpoint in advance when a country's debt burden becomes unsustainable. But its clear that it cannot rise forever. The debt burden is measured by the debt stock/nominal GDP ratio. The stock of debt rises as the government runs budget deficits while nominal GDP rises as the economy grows and the price level rises. If the debt rises faster than GDP, danger may lie ahead.

With a rising debt burden the financial markets may suspect at some point that the debt may become too large for the government to be able to meet its repayment obligations. As the risk of default rises the market will demand higher interest rates to compensate for the higher risk.

Higher interest payments raise the debt service payments, thereby worsening the budget deficit, further accentuating the risk and increasing the debt service payments, creating a vicious spiral which inevitable leads to default if no remedial action is taken. Even then fiscal restrictions may not reduce the debt burden if the measures reduce growth of the economy or lead to a recession.

Greece's debt ratio was stable for most of the noughties at around 100, not causing any concern. The yield spread between Greek and German 10-year bonds was in the range of 20 to 30 basis points.

The debt ratio jumped to 127 in 2009 and further to 143 in 2010. The steep rise in 2009 was due to the (global) recession deepening the budget deficit, the uncovering of hidden debt and declining GDP. Greece faced rapidly rising interest rates on its borrowing which further deepened the budget deficit.

Greece's partners in the euro zone and the IMF had to step in and provide it with the funds to cover its borrowing requirement for the 2010-12 years at an interest rate of 5%, well below what Greece would have had to pay in the markets. The government introduced severe austerity measures, but failed to meet its targets and the debt burden is rising further, to 166 in 2012 (according to the European Commission). This is so high that the financial markets consider a debt restructuring inevitable and the yield on 2-year Greek debt rose in May'11 to 24% and on 10 year Greek bonds to 16%.

The EUR110bn loan granted to Greece in 2010 will cover Greece's financial needs to mid-2012. In subsequent years its financial needs (repaying maturing loans, financing its running budget deficit) may amount to EUR60-70bn per year. With borrowing in the markets excluded Greece may receive further EU/IMF aid and/or reschedule its debts. Some funds may come from privatisations.

Problems abound. Granting Greece more funds is unpopular in the donor countries and may lead to voter revolt and moral hazard. The severe austerity regime imposed on Greece is leading to demonstrations in the streets and political turmoil. Debt rescheduling may have a devastating impact on the Europe's financial system as banks and other financial institutions (and the ECB) are major holders of Greek debt. A solution remains to be found.

Primary Budget Balance required to stabilise debt

A necessary condition to avoid a country's budget deficit "snowballing", i.e. deepening and eventually becoming un-financeable in the markets, is that the surplus on the primary budget, which excludes payment of interest, (S), should be at least as high as the difference between the nominal interest rate (r) and the nominal growth rate of the economy (g) times the ratio of government debt/GDP (D):

S ≥ (r - g) D

see De Grauwe

The formula has been applied to selected countries in the table right (Euroeconomics calculations).

The fiscal adjustments required are astronomical for Greece and mammoth for Portugal and Ireland. These countries also have deep external deficits. See also Gross and Alcidi, "Adjustment Difficulties and Debt Overhangs in the Eurozone Periphery", May 2011.

Primary Budget Balance required to stabilise debt as % of GDP
Selected country	r Nominal interest rate: 10-yr govt bond yield (%), average for May 2011	g Nominal GDP growth expected for 2011 %	D Government debt/GDP ratio*	S Required primary budget balance: % of GDP	Actual primary budget balance surplus (+), deficit (-) 2011* % of GDP	Required change to primary budget balance ** % of GDP
Germany	3.06	4.5	0.824	-1.2	0.4	-1.6
France	3.49	4.0	0.847	-0.4	-3.1	2.7
Italy	4.76	2.7	1.203	2.5	0.8	1.7
Belgium	4.21	4.5	0.97	-0.3	-0.4	0.1
Spain	5.32	2.0	0.681	2.3	-4.1	6.4

Greece	15.94	-3.5	1.577	30.7	-2.8	33.5
subsidised rate	5	"	"	13.4	"	16.2
Portugal	9.63	-1.5	1.017	11.3	-1.7	13.0
subsidised rate	5	"	"	6.6	"	*8.3*
Ireland	10.64	1.5	1.120	10.2	-6.8	17.0
subsidised rate	5.8	"	"	4.8	"	*11.6*

UK	3.49	3.7	0.842	-0.2	-5.5	5.3
US	3.15	4.5	1.200	-1.6	-7.1	5.5

* Source: European Commission, European Economic Forecast, Spring 2011 **This results from the previous two columns: the required primary budget balance and the actual (estimated) balance for 2011. Only in Germany does the actual balance exceed the required balance. In the other countries listed the two have to be added.

Germany: only in the case of this country (of those listed in the table) is the primary budget balance expected for 2011 (a surplus of 0.4% of GDP) larger than the primary budget balance required to stabilise the debt (a deficit of 1.2% of GDP). The latter is particularly low as the economy is growing in nominal terms faster than the interest rate it has to pay on its government debt.

France: expected nominal GDP growth exceeds interest rate on government debt, though by a relatively modest margin. To stabilise the debt a primary budget deficit no larger than 0.4% of GDP is required. The expected primary budget deficit for 2011 is 3.1% of GDP, a tightening of 2.7% of GDP will thus stabilise the debt.

Italy: the expected growth of nominal GDP falls well short of the interest rate and the debt is large, exceeding GDP. This calls for a primary budget surplus of 2.5% of GDP to stabilise the debt. But as a surplus of 0.8% of GDP is expected for the primary budget in 2011, only a tightening of 1.7% of GDP is required, less than in the case of France.

Belgium: Expected nominal growth of the economy just exceeds the interest rate, calling for modest primary budget deficit of 0.4% of GDP. The expected deficit is close to that, thus require almost no adjustment.

Spain: the growth rate is well below the interest rate but the deficit is relatively low. A primary budget surplus of 2.3% of GDP is required. The actual primary budget deficit this year is expected to amount to 4.1% of GDP, thus a correction of 6.4% is required.

Greece: the interest rate is sky high, the economy is shrinking and the debt is one-and-a-half times GDP. This calls for a primary budget surplus of 30.7% of GDP. As the primary budget is in deficit the total correction required is 33.5% of GDP to stabilise the debt, clearly an impossible task. In fact Greece does not pay the market rate for its funds, but the subsidised rate of the bailout fund of 5%This reduces the required correction to 16.2%. Still a mammoth task

Portugal: interest rates are less high than in Greece but the economy is also shrinking and the debt is high, slightly exceeding GDP. This calls for a primary budget surplus of 11.3% of GDP. With the primary budget in deficit in 2011, the fiscal adjustment required amounts to 13% of GDP. Portugal also does not pay the market rate. This reduces the required correction to 8.3%. Still a formidable task.

Ireland: interest rates are high, as is the debt, but the economy is growing. A primary budget surplus of 10.2 of GDP is required as well as the elimination of the 2011 primary budget deficit of 6.8%, a turnaround of 17% of GDP, a bigger task than for Portugal. Ireland also does not pay the market rate, but the subsidised rate of just under 6% of the bailout fund. This reduces the required correction to 11.6%.

UK: growth modestly exceeds the interest rate and a primary budget deficit of 1.6% of GDP would stabilise the debt. The expected 2011 primary budget deficit amounts to 5.5% of GDP, the correction required thus amounts to 5.3%.

US: growth is well ahead of the interest rate on 10-yr Treasuries, but the debt exceeds GDP and the primary budget is expected to show a deficit of 7.1% of GDP. This calls for a correction of 5.5% of GDP.

Mar'11 summits: euro zone leaders reach agreement in principle about measures to cope with sovereign debt crises

Result of summits was ahead of initial market expectations, but left some essential details to be agreed. Final agreement is now to be concluded in Jun'11. The measures will still require formal approval by all euro zone members.

Short term measures

Lower borrowing costs for countries unable to finance their budget deficits in the markets (excluding for now Ireland)
Increased financial backing for the current bail-out fund (European Financial Stability Facility, EFSF) agreed in principle, allowing it to use the full EUR440bn sum with AAA rating (rather than EUR250bn up to now) But no agreement yet on how this is to be achieved. For now the EFSF still only disposes of EUR250bn.
EFSF funds can be used to buy sovereign bonds in primary markets (i.e. when issued), but not in secondary market (as demanded by Greece) or from ECB (as demanded by the ECB). This should allow indebted countries to borrow at lower rates, but subject to the country entering into an austerity programme.
Greece was offered a one percentage point reduction in its borrowing costs from the bail-out fund (it had asked for two percentage points) and an extension of its repayment schedule to 7½ years (from 4½ years) in exchange for increased privatisations.
After acrimonious exchanges no relief was for now granted to Ireland as it refused to offer to raise its (ultra low) corporate tax rate. The issue to be revisited at 24-25 Mar'11 summit.

Long term measures

Agreement in principle about bailout fund (European Stability Mechanism) which in June 2013 is to take over from the current bailout fund (EFSF). The ESM is to draw on EUR80bn paid-in capital and EUR620 callable capital, enabling it to lend EUR500bn. This to allow the fund to have a AAA credit rating. The fund can be seen as creating a "transfer union", where the richer countries provide financial support for the weaker ones.

The initial timetable for paying in the cash contributions has been stretched out after objections from Germany. In the event of a crisis the payments would be speeded up, but no agreement yet on how.
The EMS to charge 200 basis points more than its funding costs for loans up to three years and 300 basis points for longer loans. ESM was to enjoy preferred creditor status and decide case-by-case whether private bond holders were to share cost of bailouts. But 20 Jun'11 it was decided that ESM loans are not to have preferred status over private creditors. Funds are provided subject to the recipient country taking corrective action (to counter moral hazard).
The "euro-plus pact", previously "competitiveness pact", received widespread acceptance after original Franco-German proposal was watered down. It aims to prevent future debt crises by harmonising budgetary, tax and social policies. The measures to be taken are voluntary (there are no sanctions) and are to be supervised by the European Commission. It is a general appeal for wage restraint, raising the retirement age, commitment to rigorous budget and labour market reforms as well as harmonisation of the corporate tax rate. Six non-euro zone countries have joined the pact. More are free to join later.
The member countries have also committed themselves to translate the provisions of the Stability & Growth Pact into national legislation and put in place national legislation for banking resolution. The debt stock is to be reduced by 1/20th annually where the existing debt stock exceeds 60% of GDP.
The euro zone heads of government are to meet once a year to verify progress. But all other EU countries are invited to join. This can conceivably be seen as a form of "economic government".

Comment

Markets were unimpressed by the result of the summits and euro sceptics were confirmed in their scepticism. Considerable progress was nonetheless made, progress which quite recently would have been considered unlikely.

The markets and the sceptics have focused on what remains to be done. Yet once the lacunae have been filled (by mid-year?), the euro zone may have erected a workable structure to grant de facto fiscal transfers to members unable to finance themselves in the markets. But this requires that the country receiving aid implements the austerity measures imposed.

BACKGROUND: from "No Bailout" to ESM bailout fund

The 2008-09 recession was so deep that the 3% deficit limit of the Stability and Growth Pact could be exceeded. The Pact allowed this if a country is “seriously threatened with severe difficulties caused by circumstances beyond its control”. But the European Commission and the ECB insisted that countries are expected to return to the strictures of the Pact as soon as possible.

The individual countries found themselves in widely differing positions (see table above). Already in 2009 it was feared that some countries could find it difficult to refinance their debt, even be forced to leave the euro zone. The yield gap between German government bonds and those of some other euro zone countries at such times widened alarmingly.

Though the euro zone has a "no bail out clause" the European Commission announced early in 2009 that a way had been found for the stronger euro zone countries to assist the weaker ones if needed (without providing any details). In fact the "no bail-out clause" allows bail-outs of a member country following "natural disasters or other exceptional occurrences beyond its control."

In 2009 Ireland was the worst affected. After the collapse of its property boom a startlingly steep decline in the inflow of tax revenues forced the Irish government to introduce severe austerity measures, for fear that the deficit could no longer be financed. The measures sufficed to calm the markets and Ireland was able to borrow at reasonably low rates.

Early in 2010 Greece moved into the firing line after its newly elected government revealed that the country's budget deficit was twice as deep as stated by the previous government. Greece was forced to follow the Irish example and introduced drastic austerity measures. In return Greece was granted substantial financial assistance by member countries.

As solvency fears spread to other deeply indebted south European countries, Spain, Italy and Portugal announced new austerity measures. In order to counter the intensifying pressures on the euro zone's financial system the EU drew up a EUR750bn package of measures during the week-end of 8-9 May'10 after intensive and divisive emergency negotiations (details below).

In spite of the huge amount involved the financial markets, after the initial euphoria passed, reacted with scepticism as many of the details of how the package would be applied were not specified. The package was a compromise between open-ended support favoured by France and much more restrictive support favoured by Germany. The divisions fuelled market scepticism.

To some this was the beginning of the creation of the "fiscal roof" the euro zone lacked. To others it was a temporary, three year, arrangement to tide over current difficulties. Either way the commitment of such a large sum of tax payers' money to financially assist weaker members was a demonstration of the cohesion of the euro zone. Germany in particular accepted that weaker euro zone members can access funds guaranteed by stronger members, a fiscal transfer mechanism of sorts.

Financial markets reacted with scepticism, fearing that the deeply indebted euro zone countries may fail to impose the required fiscal restrictions or that they may stifle growth. But in the course on Jun-Jul'10 the markets gradually accepted that these measures taken by the ECB and the EU defused the crisis. Meanwhile the European Commission set to work on proposals to address the euro zones debt issues.

The serenity was shattered by Ireland in the autumn of 2010 as the costs of bailing out its failing banks rose to astronomical level. A financial rescue package was negotiated with the EU and the IMF in Nov'10. Portugal in Apr'11 became the third country calling for a bailout.

European Union's financial support packages of May'10

European Financial Stability Facility (EFSF): Euro zone governments in May'10 created a "special purpose vehicle" (SPV) which could raise up to EUR440bn in the markets in the form of loans guaranteed by all euro zone countries.

The money is lent on in the form of bilateral 3-year loans from euro zone countries to euro zone countries in financial difficulties and subject to these countries implementing fiscal restrictions to contain their budget deficits under close supervision of the IMF and EU ("IMF conditionality").
EFSF funds may also be used to recapitalise banks.
When a country is drawing on the fund it will step out of its commitment with the guarantees of the remaining countries scaled up commensurately.
The fund is located in Luxembourg and headed by an official from the European Commission (Klaus Regling, a German national).
Initially it was hoped that if no country requests assistance (i.e. they can raise all they need in the markets), the fund may never be used. The mere existence of the fund, it was argued, may mean that it won't be needed. In fact Ireland is the first country to draw on it.
EFSF debt got a AAA credit rating. Initially the need for a cash buffer to maintain AAA rating reduced effective lending capacity to EUR230bn. But 20 Jun'11 effective lending capacity was raised to EUR440bn after countries raised their guarantees.
Japan undertook 12 Jan'11 to buy more than 20% of the bonds to be sold later in month to fund bailout for Ireland.

European Financial Stabilisation Mechanism (EFSM): A EUR60bn rapid reaction stabilisation fund was also created in May'10, controlled by the European Commission and modelled on, and in addition to, the "balance of payments facility" hitherto used to aid EU members not part of the euro zone.

The money is borrowed by the Commission in the financial markets and EU member countries only become liable if the disbursed money is not eventually paid back by the recipients.
The funds can be used for all EU members (not only those EU members not part of the euro zone) and was intended as a first line of defence in a financial crisis. (The second line of defence being the EFSF)
EUR5bn of 2.5% five-year notes were issued 6 Jan'11, the first instalment of financial aid for Ireland. The issue yield was 2.59% and elicited strong demand. The funds are lent to Ireland at 5.51%.

IMF contribution: The IMF contributes one euro to the aid package for every two euros contributed by the EU. On the assumption that the EU package amounts to EUR500bn (EUR440bn + EUR60bn), the IMF's contribution may amount to EUR250bn.

European Stability Mechanism (ESM): In Dec'10 the EU leaders reached agreement on a new permanent bailout vehicle, the ESM, to replace the EFSF in 2013. The ESM is subject to unanimity in decision making and its loans have preferred creditor status (but junior to IMF loans). The ESM is in the form of an amendment to the EU treaties and requires ratification by all 27 member states. (see above)

ECB Governing Council Meetings usually first Thursday in month in Frankfurt (other locations indicated) -
Q1 2011	Q2 2011	Q3 2011	Q4 2011	Q1 2012
13 January	7 April	7 July	6 October Berlin	12 January
3 February	5 May Helsinki	4 August	3 November
3 March	9 June	8 September	8 December