Sovereign Debt Crises in the US and the Eurozone:Potential Regional Impacts on Asia

Financial volatility has returned to the global marketplace amid escalating sovereign debt problems in the United States (US) and the Eurozone countries. Intense political wrangling over the US' debt ceiling, the subsequent downgrading of the US' credit rating, and fears of contagion in the Eurozone have created significant uncertainties in the market. The World Bank's Robert Zoellick has warned that markets are now entering a "new danger zone," while other analysts have raised the possibility of yet another global recession.

2. The US has recently committed to a fiscal consolidation plan, while the European Union has adopted a comprehensive package that features new financing as well as greater flexibility for the European Financial Stability Facility (EFSF). These efforts notwithstanding, the risk of debt crises and contagion remains very real, particularly with recent developments in Greece and Italy. For as long as concerns about achieving fiscal discipline and restoring growth in these economies persist, markets are likely to remain vulnerable to shocks in the near term.

3. A further deterioration in the debt positions of these economies will have serious regional spillover effects on Asia's macroeconomic management and growth prospects. Even if a full-blown debt crisis were averted, a further contraction in these economies as a result of weak fundamentals and fiscal tightening will have an impact on regional growth.

4. What are the short- and medium-term impacts on Asia of the sovereign debt crises in the US and Eurozone? Can Asia, as a region, withstand another downturn in these economies, and to what extent can Asia rely on its own internal strength for growth? How can Asia strengthen its own drivers of growth and that beyond its own border, for example, by emphasizing on efforts to strengthen trade within Asia (intraregional trade) and with other emerging markets? What are the short- and medium-term policy choices available, and what regional approaches should Asian countries take in mitigating these impacts?

5. This S-PATA will seek to answer these questions from a regional perspective by assessing how debt crises in advanced economies may be transmitted to Asia. While it will also explore national policy options to the extent feasible, it will focus on regional measures for managing the macroeconomic impacts of such crises.

6. This S-PATA will build on research being undertaken by the Office of Regional Economic Integration (OREI) on these issues, as part of its ongoing work on the Asia Economic Monitor and the Asia Capital Markets Monitor, and its research program for 2011 2012 on Growth Rebalancing (attached).

Asian Development Bank.Project Number 45291- 01

Sovereign Debt Crises in the US and the Eurozone: Potential Regional Impacts on Asia :  Regional

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European Council.Statement by the Euro Area Heads of State or Government

EUROPEAN COUNCIL.Brussels.Press.9 December 2011. The European Union and the euro area have done much over the past 18 months to improve economic governance and adopt new measures in response to the sovereign debt crisis. However, market tensions in the euro area have increased, and we need to step up our efforts to address the current challenges. Today we agreed to move towards a stronger economic union. This implies action in two directions:

- a new fiscal compact and strengthened economic policy coordination;

- the development of our stabilisation tools to face short term challenges.

A reinforced architecture for Economic and Monetary Union

1. The stability and integrity of the Economic and Monetary Union and of the European Union as a whole require the swift and vigorous implementation of the measures already agreed as well as further qualitative moves towards a genuine "fiscal stability union" in the euro area. Alongside the single currency, a strong economic pillar is indispensable. It will rest on an enhanced governance to foster fiscal discipline and deeper integration in the internal market as well as stronger growth, enhanced competitiveness and social cohesion. To achieve this objective, we will build on and enhance what has been achieved in the past 18 months: the enhanced Stability and Growth Pact, the implementation of the European Semester starting this month, the new macro-economic imbalances procedure, and the Euro Plus Pact.

2. With this overriding objective in mind, and fully determined to overcome together the current difficulties, we agreed today on a new "fiscal compact" and on significantly stronger coordination of economic policies in areas of common interest.

3. This will require a new deal between euro area Member States to be enshrined in common, ambitious rules that translate their strong political commitment into a new legal framework.

A new fiscal compact

4. We commit to establishing a new fiscal rule, containing the following elements:

• General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP.

• Such a rule will also be introduced in Member States' national legal systems at constitutional or equivalent level. The rule will contain an automatic correction mechanism that shall be triggered in the event of deviation. It will be defined by each Member State on the basis of principles proposed by the Commission. We recognise the jurisdiction of the Court of Justice to verify the transposition of this rule at national level.

• Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.

• Member States in Excessive Deficit Procedure shall submit to the Commission and the Council for endorsement, an economic partnership programme detailing the necessary structural reforms to ensure an effectively durable correction of excessive deficits. The implementation of the programme, and the yearly budgetary plans consistent with it, will be monitored by the Commission and the Council.

• A mechanism will be put in place for the ex ante reporting by Member States of their national debt issuance plans.

5. The rules governing the Excessive Deficit Procedure (Article 126 of the TFEU) will be reinforced for euro area Member States. As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed. Steps and sanctions proposed or recommended by the Commission will be adopted unless a qualified majority of the euro area Member States is opposed. The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60% needs to be enshrined in the new provisions.

6. We will examine swiftly the new rules proposed by the Commission on 23 November 2011 on (i) the monitoring and assessment of draft budgetary plans and the correction of excessive deficit in euro area Member States and (ii) the strengthening of economic and budgetary surveillance of Member States experiencing or threatened with serious difficulties with respect to their financial stability in the euro area. We call on the Council and the European Parliament to rapidly examine these regulations so that they will be in force for the next budget cycle. Under this new legal framework, the Commission will in particular
examine the key parameters of the fiscal stance in the draft budgetary plans and will, if needed, adopt an opinion on these plans. If the Commission identifies particularly serious non-compliance with the Stability and Growth Pact, it will request a revised draft budgetary plan.

7. For the longer term, we will continue to work on how to further deepen fiscal integration so as to better reflect our degree of interdependence. These issues will be part of the report of the President of the European Council in cooperation with the President of the Commission and the President of the Eurogroup in March 2012. They will also report on the relations between the EU and the euro area.

Stronger policy coordination and governance

8. We agree to make more active use of enhanced cooperation on matters which are essential for the smooth functioning of the euro area, without undermining the internal market.

9. We are committed to working towards a common economic policy. A procedure will be established to ensure that all major economic policy reforms planned by euro area Member States will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices.

10. Euro area governance will be reinforced as agreed at the Euro Summit of 26 October. In particular, regular Euro Summits will be held at least twice a year.

Strengthening the stabilisation tools

11. Longer term reforms such as the ones set out above must be combined with immediate action to forcefully address current market tensions.

12. The European Financial Stability Facility (EFSF) leveraging will be rapidly deployed, through the two concrete options agreed upon by the Eurogroup on

29 November. We welcome the readiness of the ECB to act as an agent for the EFSF in its market operations.

13. We agree on an acceleration of the entry into force of the European Stability Mechanism (ESM) treaty. The Treaty will enter into force as soon as Member States representing 90 % of the capital commitments have ratified it. Our common objective is for the ESM to enter into force in July 2012.

14. Concerning financial resources, we agree on the following:

• the EFSF will remain active in financing programmes that have started until mid-2013 as provided for in the Framework Agreement; it will continue to ensure the financing of the ongoing programmes as needed;

• we will reassess the adequacy of the overall ceiling of the EFSF/ESM of EUR 500 billion (USD 670 billion) in March 2012;

• during the phasing in of the paid-in capital, we stand ready to accelerate payments of capital in order to maintain a minimum 15% ratio between paid-in capital and the outstanding amount of ESM issuances and to ensure a combined effective lending capacity of EUR 500 billion;

• euro area and other Member States will consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community.

15. We agree on the following adjustments to the ESM Treaty to make it more effective:

• Concerning the involvement of the private sector, we will strictly adhere to the well established IMF principles and practices. This will be unambiguously reflected in the preamble of the treaty. We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardised and identical Collective Action Clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds.

• In order to ensure that the ESM is in a position to take the necessary decisions in all circumstances, voting rules in the ESM will be changed to include an emergency procedure. The mutual agreement rule will be replaced by a qualified majority of 85 % in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened (subject to confirmation by Finnish parliament).

16. We welcome the measures taken by Italy; we also welcome the commitment of the new Greek government, and of the parties supporting it, to fully implement its programme, as well as the significant progress achieved by Ireland and Portugal in implementing their programmes.

* * *

Some of the measures described above can be decided through secondary legislation. The euro area Heads of State or Government consider that the other measures should be contained in primary legislation. Considering the absence of unanimity among the EU Member States, they decided to adopt them through an international agreement to be signed in March or at an earlier date. The objective remains to incorporate these provisions into the treaties of the Union as soon as possible. The Heads of State or Government of Bulgaria, Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland, Romania and Sweden indicated the possibility to take part in this process after consulting their Parliaments where appropriate.

http://www.consilium.europa.eu//uedocs/cms_data/docs/pressdata/en/ec/126658.pdf

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EU leaders to focus on reviving economy

07/12/2011. Stronger economic governance in the eurozone will be the focus of leaders' discussions on 8-9 December in Brussels – alongside energy and the prospect of new countries joining the EU. EU leaders will review the overall economic situation in Europe and measures to boost growth and jobs.

They will consider proposals to monitor draft budgets and cut deficits for all eurozone countries – with even tighter economic and budget surveillance for countries facing serious financial instability or needing bail-outs.

Treaty change

Leaders will also examine the potential benefits of joint eurozone bonds, for instance whether they would help reduce and stabilise the interest rates countries have to pay to borrow money.

The Commission has put forward 3 options for these so-called stability bonds , with an analysis of financial and legal implications. An amendment to the EU's Lisbon Treaty – which governs how the Union functions – might be required.

Energy plan

Safe, secure, sustainable and affordable energy is high on this European Council's agenda.

Leaders will consider energy-saving and efficiency measures that would set legally binding requirements for EU countries to improve energy efficiency at all stages – production, distribution and final consumption.

This would provide significant financial, economic and employment benefits – and help consumers reduce their energy bills.

EU leaders have also called for a single energy market by 2014, enabling energy to be bought and sold more freely across national borders. An open market with smart, integrated infrastructure would be more competitive.

New EU members

Also on the table is the possibility of admitting new countries into the EU, a plus for the Union's strategic interest, security and prosperity. The Commission has recommended that negotiations be opened with Montenegro. It has also proposed granting EU candidate status – the first step in the process – to Serbia.

Meanwhile, Croatia is in the final stages of becoming the EU's 28th member. The EU concluded negotiations in June, paving the way for the signature of the accession treaty on 9 December.

Croatia will soon hold a referendum to decide if the country will join the EU on 1 July 2013.

The enlargement process - a positive stimulus for Europe

Agenda – European Council meeting 8-9 Dec.

Related Links

• An agenda for growth

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Euro area unemployment rate at 10.3%, october 2011

Eurosta.176/2011.30 November 2011. The euro area1 (EA17) seasonally-adjusted unemployment rate was 10.3% in October 2011, compared with 10.2% in September. It was 10.1% in October 2010. The EU271 unemployment rate was 9.8% in October 2011, compared with 9.7% in September4. It was 9.6% in October 2010.

Eurostat estimates that 23.554 million men and women in the EU27, of whom 16.294 million were in the euro area, were unemployed in October 2011. Compared with September 2011, the number of persons unemployed increased by 130 000 in the EU27 and by 126 000 in the euro area. Compared with October 2010, unemployment rose by 440 000 in the EU27 and by 367 000 in the euro area.

These figures are published by Eurostat, the statistical office of the European Union.

Among the Member States, the lowest unemployment rates were recorded in Austria (4.1%), Luxembourg (4.7%) and the Netherlands (4.8%), and the highest in Spain (22.8%), Greece (18.3% in August 2011) and Latvia (16.2% in the second quarter of 2011).

Compared with a year ago, the unemployment rate fell in twelve Member States and increased in fifteen. The largest falls were observed in Estonia (16.1% to 11.3% between the third quarters of 2010 and 2011), Lithuania (18.3% to 15.0% between the third quarters of 2010 and 2011) and Latvia (19.3% to 16.2% between the second quarters of 2010 and 2011). The highest increases were registered in Greece (12.9% to 18.3% between August 2010 and August 2011), Spain (20.5% to 22.8%) and Cyprus (6.0% to 8.2%).

Between October 2010 and October 2011, the unemployment rate for males increased from 9.9% to 10.0% in the euro area and from 9.6% to 9.7% in the EU27. The female unemployment rate increased from 10.4% to 10.6% in the euro area and from 9.7% to 9.9% in the EU27.

In October 2011, 5.482 million young persons (under-25s) were unemployed in the EU27, of whom 3.338 million were in the euro area. Compared with October 2010, youth unemployment increased by 222 000 in the EU27 and by 141 000 in the euro area. In October 2011, the youth unemployment rate was 22.0% in the EU27 and 21.4% in the euro area. In October 2010 it was 20.9% and 20.6% respectively. The lowest rates were observed in the Netherlands (8.2%), Germany (8.5%) and Austria (9.1%), and the highest in Spain (48.9%) and Greece (45.1% in August 2011).

In October 2011, the unemployment rate was 9.0% in the USA. In September 2011, it was 4.1% in Japan.

More

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Estonia. Staff Report for the 2011 Consultation IMF

November 29, 2011.Country Report No. 11/333. Estonia has experienced a sharp export-led recovery in its first year in the euro area.But price pressures have emerged—largely reflecting global food and fuel prices—and unemployment, while declining, has remained high with increasing long-term joblessness. In 2012, the economy is set to slowdown in line with weakening export markets but the output gap will continue to close. With increased downside risks, Estonia faces the continuing challenge to implement policies preserving macroeconomic policy credibility, while enhancing sustainable growth.

Fiscal policy: Estonia’s enviable fiscal position will remain strong even though a deficit of about 2¼ percent of GDP will emerge in 2012. This will imply a fiscal stimulus at a time when a neutral stance would be appropriate. Adhering to the budgetary allocations would be appropriate. Should downside risks materialize, automatic stabilizers should be allowed to operate while preserving credibility. Looking forward, the authorities’ medium-term target of a small surplus can be supported by a fully fledged multi-year fiscal framework, which would allow fiscal buffers to be rebuilt.

The financial sector: On balance, risks to the financial sector appear manageable. But potential contagion from the euro area or parent banks requires continued vigilance. Further improvements in cross-border supervision and crisis resolution, preparing for Basel III, and continuing efforts to increase deposit guarantees will be essential. Also, reforms expediting Estonia’s bankruptcy process are necessary.

Long-run growth: Besides safeguarding Estonia’s competitiveness, increasing sustainable long-run growth will require moving up the value chain, addressing long-term unemployment, and enhancing human capital. Fostering a business-friendly environment by building R&D capability and enhancing cross-border infrastructure can attract tradable sector FDI. Further improvements in vocational training and higher education can alleviate long-run unemployment and boost human resources.

International Monetary Fund Country Report No. 11/333.November 9, 2011

Republic of Estonia. Staff Report for the 2011 Consultation IMF

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Cyprus:2011 International Monetary Fund Consultation

International Monetary Fund.November 29, 2011. Country Report No. 11/331.The economy is still burdened by the legacy of the imbalances that preceded the global crisis, including high leverage of the private sector and a real estate boom. A worsening outlook for global growth, unsettled financial conditions in the euro area, and the large exposure of Cypriot banks to Greece have created new obstacles to recovery. Meanwhile, deterioration in public finances has taken a toll on investor confidence. As a result of these factors, Cyprus has lost access to sovereign debt markets.

The two key challenges are to put in place a large and credible fiscal consolidation that will reverse the increase in the public debt ratio and help restore investor confidence; and to ensure that the banks and their supervisors are well-prepared to respond to possible adverse developments. Even with these actions, it may take time to regain market access, and covering public financing needs in the period ahead will be challenging.

The authorities are focused on implementing strong fiscal consolidation measures that would culminate in a balanced budget by 2014, and on closely monitoring developments in the financial sector while stepping up their contingency planning. They are hopeful that they will be able to borrow from non-market sources, which would provide a bridge until they can regain market access.

Cyprus: 2011 Article IV Consultation - Staff Report; Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Cypruss

IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus

Public Information Notice (PIN) No. 11/145. November 29, 2011

On November 18, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Cyprus.¹

Background
The Cypriot economy faces strong headwinds and downside risks due to financial turbulence in the euro area, the large exposure of Cypriot banks to Greece, and the need for substantial fiscal consolidation to stabilize public finances. Reflecting these developments, the government has lost access to international capital markets and confronts the challenge of accessing financing to meet its fiscal needs in 2012 and beyond.

Following a weak recovery in 2010, staff expects no economic growth this year and a modest contraction in 2012. Factors that will weigh upon growth include tight credit and a climate of uncertainty, continued downsizing of the construction sector after past excesses, slowing external demand, and planned fiscal consolidation. Downside risks are dominant, in light of the potential for external conditions to worsen and for adverse feedback loops between fiscal imbalances and bank balance sheet vulnerabilities.

Fiscal balances have deteriorated sharply over the past three years, reflecting in large part underlying structural factors. Adjustment measures planned for 2011 fell short of target, and staff expect the deficit to widen to some 7 percent of GDP in 2011. The authorities have renewed their commitment to restore sound public finances. They have passed a first package of adjustment measures and are seeking passage of a second and larger set of measures that would yield fiscal savings of some 4 percent of GDP in 2012, if fully implemented. Additional measures will be required to reduce the deficit further and achieve the government’s target of a balanced budget by 2014. Over the longer-term, the public pension system will generate another source of fiscal pressures, as population aging and rising dependency ratios feed through to large increases in pension outlays.

The large banking sector, with assets totaling over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

Executive Board Assessment
Executive Directors noted that Cyprus faces daunting economic challenges in the face of faltering external demand, growing exposure to the turmoil in the euro area, particularly in Greece, and worsening domestic financial conditions. Directors thus urged the authorities to act forcefully to restore sound public finances and safeguard the stability of the banking system. Steadfast implementation of fiscal and structural reforms on several fronts would also be critical for a return to durable growth over the medium term.

Directors agreed that an ambitious and credible fiscal adjustment is essential to regain access to the international capital markets and put the public debt ratio on a downward path. They supported the authorities’ plans to achieve fiscal balance over the next three years as an appropriate strategy for undertaking the necessary fiscal correction without unduly damaging growth prospects. Directors considered that front-loading the adjustment with measures to reverse recent increases in public sector wages and poorly targeted transfers would provide a credible signal of the authorities’ commitment to medium-term consolidation and bolster investor confidence. Reforms of the cost-of-living allowance system would also be important for achieving the fiscal targets and improving real wage flexibility and competitiveness.

Directors underscored the importance of other fiscal reforms to underpin the consolidation efforts. Priorities should include the introduction of a medium-term budget framework and the adoption of fiscal rules consistent with EU directives. Directors also highlighted the need for reforming the national pension and healthcare systems, which threaten to put unsustainable pressures on the budget as the population ages.

Directors expressed concern about the vulnerabilities arising from Cyprus’s large banking sector and the possibility of adverse feedback loops with the public finances and the real economy in the context of weakening balance sheets. They stressed the importance of building prudent capital buffers and of ensuring adequate liquidity in the financial system. These actions should be supported by contingency planning and the immediate passage of legislation to provide the authorities with full powers to recapitalize or resolve banks, if necessary. Cooperative credit institutions should also be watched closely and brought under the same regulatory and supervisory frameworks as banks.

IMF Executive Board Concludes 2011 Article IV Consultation with Cyprus

European Union. An agenda for growth

Package of economic and budgetary recommendations sets priorities for 2012 and includes new measures to reinforce eurozone financial governance and stability. Governments need to put public finances in order and make structural reforms to boost growth and jobs, says the Commission in its 2012 growth survey .

The survey marks the start of the second “European semester”, an annual 6-month cycle during which governments benefit from the input of their EU peers as they formulate national budgetary and economic policies.

It calls on governments to focus on 5 priorities and related measures. These include:

• implementing growth-friendly budget policies – tailor public investment and tax approaches to each country’s needs

• restoring loan activity to pre-crisis levels – ease banks’ access to funding, support SME's access to finance and develop a new European venture capital regime

• promoting growth and competitiveness – focus on the digital economy, the common market for services and external trade, fast-track related EU proposals

• tackling unemployment and the social effects of the crisis – promote business creation and self employment, improve welfare systems to take care of the most vulnerable

• modernising public administrations – reduce red tape, promote e-government, and cut the start-up time for new businesses to 3 days

Stronger economic governance

This year’s package includes 2 new proposals that build on measures taken in the wake of the financial crisis to improve economic governance and help control public debt.

One proposal  would require eurozone countries to present their draft budgets at the same time each year. The Commission could then issue an opinion on them, if necessary, and ask governments to revise them in line with their eurozone obligations.

The second  would enhance surveillance for eurozone countries being supported by financial assistance or that are threatened by serious financial instability.

Reinforcing financial support

The Commission is also launching a public consultation (deadline 8 January 2012) on whether the eurozone should be able to collectively issue bonds to raise money for countries with debt problems. The revenue would bolster the eurozone’s bailout fund.

A discussion paper  presents options for launching such “stability bonds”. Any move toward jointly issued bonds would only be feasible if the eurozone also took measures to reinforce budgetary discipline, says the Commission.

More on the 2012 growth survey and related proposals

2012 Growth Survey

The Eurozone Crisis: How Banks and Sovereigns Came to be Joined at the Hip

We use the rise and dispersion of sovereign spreads to tell the story of the emergence and escalation of financial tensions within the eurozone. This process evolved through three stages. Following the onset of the Subprime crisis in July 2007, spreads rose but mainly due to common global factors. The rescue of Bear Stearns in March 2008 marked the start of a distinctively European banking crisis.

During this key phase, sovereign spreads tended to rise with the growing demand for support by weakening domestic financial sectors, especially in countries with lower growth prospects and higher debt burdens.

As the constraint of continued fiscal commitments became clearer, and coinciding with the nationalization of Anglo Irish in January 2009, the separation between the sovereign and the financial sector disappeared.

Author/Editor: Mody,Ashoka;Sandri,Damiano.Authorized for Distribution: November 01, 2011.Series:Working Paper No. 11/269
This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

The Eurozone Crisis: How Banks and Sovereigns Came to be Joined at the Hip