by Sara Eisen
The troika has relied on two measures to buy time for Italy and Spain. The first is the ECB’s three-year, long-term refinancing operation (LTRO). The LTRO immediately relieved pressure on Italy and Spain in the sovereign bond markets, with banks using the ECB’s cheap financing in part to buy domestic sovereign debt. This was particularly the case in Italy, where banks were so exposed to Italian sovereign debt that they chose to double down on it, taking advantage of the cheap loans and using the LTRO to pick up more Italian debt, in the hope of reducing the chances of Italy’s undergoing a debt restructuring.
Given that the euro crisis is, at its very core, a balance of payments and growth crisis, the ECB’s three-year LTRO is a game changer only if it can help rebalance the eurozone economies through an adjustment in real effective exchange rates, or if it can significantly improve the periphery’s growth prospects. The LTRO will help to smooth out the deleveraging process that eurozone banks are undergoing. This means that the severity of the credit crunch that might have occurred without the LTRO will be mitigated. However, banks are unlikely to use liquidity from the LTRO operations to lend, and consequently the degree to which the LTRO will support growth is limited.
The LTRO succeeded in suppressing sovereign bond yields for Italy and Spain in the immediate term. If investors once again shun Italian and Spanish sovereign debt, the ECB is likely to offer additional LTROs or other extraordinary operations. However, there are limitations to how many LTROs can be offered and how much take-up there can be. Some members of the ECB’s governing council have expressed opposition to further LTROs, and ultimately ECB president Mario Draghi is likely to come into conflict with the German central bank, the Bundesbank, which is extremely wary of these types of operations that cause the ECB’s balance sheet to balloon.
Furthermore, banks must provide collateral in exchange for liquidity from the LTROs. While the collateral requirements have been significantly widened, banks will eventually run out of qualifying collateral. And while the LTRO differs in many ways from the sort of quantitative easing (QE) programs that the United States and the United Kingdom have embarked on, there are some parallels. Specifically, limited liquidity does not solve solvency issues (although unlimited liquidity can), and with each round of LTROs, we expect the relief in pressure on peripheral bond yields to be milder.
Ultimately, the relief in the peripheral sovereign bond markets resulting from the LTROs will be undermined by real, hard economic data. The Italian and Spanish governments are implementing austerity measures and have announced ambitious structural reform programs. In the short term, both austerity and structural reforms undermine growth. Consequently, economic activity in Italy and Spain will slow sharply over at least the next year. This will cause the pressure on Italian and Spanish bond markets to return, with borrowing costs for both countries eventually becoming unsustainable.
The second measure the troika has relied on to buy time for Italy and Spain is a firewall to take the two countries out of the bond markets once the LTRO euphoria wears off and borrowing costs rise again. At the time of writing, the firewall is to be cobbled together between the EU bailout funds—the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)—and bilateral loans to the IMF. For the firewall to work, both its EU and its IMF elements must be large enough. This is far from guaranteed, and failure on this point could trigger a massive escalation of the crisis.
On the EU side of the firewall, there are currently two funds in place: the EFSF, which has around €250 billion in available funding, and the €500 billion ESM. The former is due to replace the ESM, but the only way to amass enough funds to cover Italy and Spain’s financing needs for a few years is to run the EFSF and the ESM concurrently. There has been some German reluctance to allow the two EU bailout funds to be additive, although Chancellor Merkel has indicated that Germany might allow this. On the IMF side, many countries have indicated their reluctance to contribute to a firewall until the eurozone devotes more of its own collective resources to solving its crisis.
If the three-year LTROs buy a year for Italy and Spain by suppressing their sovereign bond yields for that long, and if both countries were then to request official financing, the eurozone’s total firewall would be sufficient to take all the weaker eurozone countries out of the markets until mid-2015 at the latest. However, some official financing will need to be held back in case another eurozone country—such as Belgium—is in need of a bailout. Furthermore, some of the firewall would have to be earmarked to recapitalize Italian and Spanish banks should those two countries have to restructure their debt, as has been done in Greece (€50 billion of Greece’s second support package is earmarked to recapitalize its banks following PSI). Thus, not all of the firewall would be allocated to Italy and Spain, and we expect that both countries would have to return to the markets in late 2014 or early 2015.
It is unlikely that either government will have both succeeded in implementing deeply unpopular structural reforms and seen those reforms begin to support growth by late 2014. In Italy, an election in April 2013 is likely to produce greater political instability, which in turn could threaten to derail or significantly slow the implementation of structural reforms. In Spain, the property market has yet to find its bottom, and mortgage defaults will require the state to step in with further aid for the banks, requiring ever more austerity to try to regain control of the public finances. If Italy and Spain face unsustainable borrowing costs when the firewall runs out, they will need to avail themselves of either another bailout (from outside public funds) or a bail-in (recapitalizing from within). It is difficult to imagine where more funding could be found for a bailout, given that the firewall will have already included IMF money, and consequently Italy and Spain will probably be forced to undergo an orderly debt restructuring.
Like that of Greece, a debt restructuring in Italy and Spain would address the countries’ stock-of-debt issue, making them appear more fiscally sustainable and therefore giving them more time to try to address their flow-of-debt problem. This would require implementing structural reforms to open product and labor markets, unwind imbalances, and engineer an internal devaluation. If Italy and Spain manage to restructure their economies as well as their debt over the next five to ten years, they have a fighting chance of finding a path toward sustainable growth within the eurozone. But there is a high risk that their plans for structural reform will be sidelined or decelerated by social unrest, opposition from vested interests, or cyclical economic shocks. If this is the case, then Italy and Spain will face the same choice about returning to growth as Greece: either they could continue along the same path of austerity and retrenchment for a decade of depression, or they could choose to exit from the eurozone and return to growth much more quickly.
Why the Core Would Benefit from a Eurozone Breakup
Each of the eurozone’s weaker countries is likely to face a choice between prolonged retrenchment inside the single currency and an accelerated return to growth outside it. While this will be painful and messy, it is the lesser of two evils, not only for the weaker countries, but for the core countries in the eurozone as well.
The core countries have two main courses of action they could pursue instead of supporting the weaker countries while they restructure their debt and exit from the eurozone in a managed fashion. The first option would be to pull the plug on the weaker countries, cutting off their funding and letting them fend for themselves. This would be a disaster for all parties, causing the crisis to spread like wildfire to the core. It is clearly not on the table. The second alternative would be for the core countries to keep the peripheral countries on life support indefinitely, effectively turning the core-periphery relationship into an endless unhappy marriage.
To maintain such an unhappy marriage, the euro’s core countries would need to agree either to unlimited fiscal subsidies for the weaker countries through joint and several liabilities (such as eurobonds) or to fiscal transfers. But
eurobonds can emerge only after political union and a pooling of assets within the eurozone have been achieved. This is a long-term process, and there is very little chance that eurozone leaders could achieve this in the time frame necessary to keep the weaker countries in the common currency area. More likely, the eurozone’s unhappy marriage of core and periphery would involve creating a fiscal transfer union, or debt sharing, in which strong countries or states end up subsidizing weaker countries or states, as in the United States. This is an extremely risky and expensive venture, however.
Weaker countries would lack incentives to undergo the difficult and painful task of rebalancing their economies if they knew that they could turn to the wealthier eurozone countries for handouts instead. Transfers to the weaker countries are already vehemently opposed by the stronger, wealthier countries of the core. Furthermore, if the core countries were to provide all of the weaker eurozone countries with unlimited fiscal transfers, the core countries’ own balance sheets would become impaired, and they would end up requiring bailouts themselves.
While the introduction of eurobonds is too long-term a project to be completed in time to prevent the exit of some weaker countries from the eurozone, such exits from the periphery would make it easier for the remaining core countries to create joint and several liabilities in a common eurobond.
The euro’s core countries do not trust the fiscal responsibility of their peripheral counterparts. This was highlighted by the agreement of the fiscal compact, an initiative spearheaded by Germany to impose limits on the fiscal imbalances that eurozone member states are allowed to accrue. Eurozone leaders touted the fiscal compact as an early step toward fiscal union, but at the time of its agreement, it represented nothing of the sort. It was an attempt to get the weaker euro countries to mimic Germany’s fiscal dynamic, thereby placing the entire onus for adjustment on the periphery and ensuring that drastic fiscal adjustment would drive the eurozone’s weaker countries deeper into recession.
Given Germany’s obsessive insistence on fiscal responsibility as a pillar of the eurozone, the exit of weaker countries from the common currency area could provide the impetus for the stronger countries to move toward creating a true fiscal union. Currently, the core countries are unwilling to pool their liabilities with those of the weaker countries because of concerns that they will be subsidizing those countries forever and will therefore see their borrowing costs rise. But if the eurozone loses its weaker members, the smaller eurozone that would result would consist of countries with a greater reputation for fiscal responsibility. Such a change in the profile of the membership might lead the strongest, wealthiest countries to become less opposed to issuing eurobonds.
Smaller but Stronger
Eurozone leaders have said over and over again that they will do whatever it takes to protect the common currency. Most people have interpreted this to mean that eurozone leaders are committed to keeping all 17 current member states in the eurozone. But doing what is needed for the euro to survive is not necessarily the same as doing what is needed to keep all of its current members on board. Nor is continued participation in the single currency necessarily the best economic strategy for all of its current members.
Ultimately, the best solution for both the weaker and the stronger eurozone members may be to allow at least some of the former to abandon the common currency in an amicable divorce. Trying to muddle through together may make matters worse rather than better for all concerned. Even if eurozone leaders manage to buy enough time so that the common currency survives the current crisis intact, regular boom-and-bust business cycles indicate that there will be another fiscal or financial shock in the eurozone over the next decade. Without a fundamental unwinding of imbalances in the eurozone and the creation of an optimal currency union with fiscal transfers or pooled liabilities, the next fiscal shock is likely to see the eurozone back in crisis. Similarly, decisive action is required to restore economic growth within the weak peripheral countries.
The exit of the weaker states from the common currency area would achieve both of these aims, giving the periphery the flexibility to return to growth quickly, while allowing the core to accelerate moves toward the kind of fiscal union that is needed to underpin the long-term viability of the common currency. This kind of partial breakup of the single currency would be traumatic and complicated. But it would not mark the demise of the euro. On the contrary, it would put it on a stronger footing. That which does not kill us makes us stronger.
CHAPTER 6
REBALANCING GROWTH IN CHINA: THE ROLE OF THE YUAN IN THE POLICY PACKAGE
ANOOP SINGH AND PAPA N'DIAYE1
“We need to quicken the pace of internationalization of our capital markets to improve the global status of the yuan.”
—Yi Gang, Deputy Governor, People’s Bank of China, March 2011
The Chinese economy has achieved a remarkable transformation over a span of three decades to become the world’s second largest economy. More than 380 million jobs have been created, and about 500 million people have been lifted out of poverty. This great achievement reflects years of reforms to open up the Chinese economy and make it more market-oriented, particularly to encourage the production of tradable goods. This has allowed China to better exploit its comparative advantages and benefit from the economies of scale afforded by global markets. However, the economy’s size and large presence in world markets today mean that this outward growth strategy is approaching high levels by historical standards and could run into natural limits. In addition, China’s heavy orientation toward the production and export of tradable goods has come at the cost of a smaller nontradable sector, particularly services, and low private consumption, as households’ savings have been mobilized through the banking system and transferred to corporations through low-interest-rate loans.
Continuing the current growth model translates into maintaining the transfer of resources from households to corporations and preserving a playing field that is highly favorable to the tradable sector—a task that has become increasingly challenging since the global financial crisis broke out. Indeed, the global financial crisis has put an end to the credit-fueled consumption boom that started in the United States and other advanced economies in the early 2000s. Lasting damage to households’ and financial institutions’ balance sheets, the need for sizable fiscal consolidation in the future, and likely steps toward more stringent financial regulation all forecast that domestic demand in these economies is unlikely to return to precrisis growth rates. Weaker growth in the advanced economies would mean that an important source of demand for China’s exports remains subdued.
The imperative to change China’s growth model is well recognized by the Chinese government. Since the onset of the global financial crisis, the government has made commendable progress in expanding social safety nets and allocating greater resources to pension, healthcare, and education systems. This should help boost private consumption by lowering precautionary savings, but more needs to be done to promote a sustained rebalancing of the Chinese economy.
In particular, the authorities recognize that exchange-rate appreciation is a key ingredient in the transformation of China’s economic growth model. The undervaluation of the currency has been holding back progress in other areas that would further promote economic rebalancing. For example, an undervalued currency creates distortions in relative prices that typically act as headwinds to the government’s efforts to raise household income and to develop the service sector. In addition, it reduces the capability of running a more proactive and independent monetary policy with higher real interest rates. Higher domestic interest rates would better price capital and allow its more efficient allocation, while promoting financial intermediation in a more inclusive way by providing greater returns to small depositors. At the same time, the significant and sustained need to absorb liquidity from large-scale foreign currency intervention that China has experienced constrains the government’s ability to move ahead with financial li
beralization. Liberalizing the financial sector in an environment with excess raises the risks of bubbles and other imbalances in asset and goods markets that could translate into greater macroeconomic volatility.
This chapter reviews the main imbalances of the Chinese economy, the reforms needed to address them, the role of the yuan, and the benefits of rebalancing growth.
What Are the Imbalances in the Chinese Economy?
China’s dependence on external demand is larger than the OECD (Organisation for Economic Co-operation and Development) average, investment is above most benchmarks based on international comparisons and model-based estimates, and private consumption is at one of the lowest levels in the world and is too low given China’s level of development. These factors are reflected in China’s large current account surplus.
China Has a Large Dependence on External Demand
China’s growth relies heavily on external demand, and this dependence has increased in recent years. During 2001–2009, net exports and investment by private and public entities in areas predominantly linked to building greater capacity in tradable sectors accounted for more than 60 percent of China’s growth, up from 40 percent in the 1990s (see Figure 6-1). This is much larger than the 2001–2008 average for the G-7 (16 percent), the euro area (30 percent), and the rest of Asia (35 percent).
Figure 6-1 Contribution to Growth
(Percent of Total GDP Growth)
However, gross trade flows may overstate China’s external dependence, since they don’t take into account the growing significance of cross-border supply chain networks through vertical integration. This refers to an organizational production structure that extends over several stages of manufacturing, transforming raw materials and other inputs into final goods. Its significance is that actually, a smaller share of domestic value added is included in exports than is suggested by the gross trade figures. Indeed, China imports significant amounts of raw material, intermediate goods, and capital goods from commodity producers and the rest of Asia that go into the production of final consumption and capital goods, which are mainly destined for mature markets, such as the United States, the euro area, and Japan. And, in that process, China adds a limited, albeit increasing, share of value added. But even so, alternative measures of exposure based on the share of value added linked to external demand show China’s high dependence on external demand. The latest International Monetary Fund (IMF) staff estimates of the contribution of external demand to China’s value added range between 25 percent and 40 percent when the investment related to exports is taken into account (see Figure 6-2).2