International macro-economics

Introduction and Background

From the end of June to early October the nominal, effective exchange rate of the euro, as measured against the currencies of 20 of the euro area's most main trading partners, depreciated amid rather high volatility. On 5 October, the nominal, effective exchange rate of the euro was 3.7% below its level at the end of June 2011 and 1.9% below its average level for 2010 (see Chart 5). In bilateral terms, over the past three months the euro has depreciated against most leading currencies. Between 30 June and 5 October, the euro declined against the Japanese yen by 12.0%, the Chinese renminbi by 9.0% and the US dollar by 7.7% and the pound sterling by 4.4%.

Discussion

Portugal, Ireland, Italy, Greece and Spain, are the most indebted countries in the Euro. Fears are spreading in financial markets, raising interest differentials (350 basis points for Greece, and more than 150 points for Ireland), and CDS premia on sovereigns' default, weakening the Euro, down 9% from December, and sending shivers across European equity markets. Are these fears well or ill-founded? What lessons can we learn from past crises?

The nearest European crisis, the currency crisis of 1992, witnessed speculative attacks against “weak” currencies and led to the ejection of the Italian Lira, the British Pound, the Spanish Peseta, the Swedish Krona, from the European Exchange Rate Mechanism, the system of pegs to the Deutsche Mark. The “attacked” countries managed to devalue their way out of the recession. The problem today is exactly that the Euro makes this impossible. Given that PIIGS' debts predominantly denominated in Euros, a devaluation with opting out would lead straight to default.

More interesting is the comparison with the debt crises of emerging markets. Put simply, debt crises come in three “pure” types: solvency crises (signaled by a high ratio of external debt to GDP, and a high ratio of public, external debt to tax revenues); liquidity crises (that occur when, external debt concentrated at short maturities, and typically signaled by high external financing requirements, short-term debt and current account deficit, relative to reserves); “macro-exchange rate” crises that typically follow, a sharp recession and an overvalued real exchange rate (Paolo, 2010).

Table 1 shows the indicators of vulnerability for the PIIGS in 2009. Imbalances are macroscopic. The case of Ireland is the most serious, because it shows symptoms of all the three crises types, solvency, liquidity and recession-overvaluation. The Irish, foreign debt is equal to 9 times (!) GDP, the public sector external debt is more than twice the fiscal revenues, the reserves of the Bank of Ireland covering only a 460th (!) of financing requirements, the real exchange rate has appreciated by 13% since 2005, GDP has fallen by 7.5% in 2009. The Italian case is the least bad (Paolo, 2010).

Note that fiscal imbalances, certainly a risk factor for all countries, are due largely to the recession. For example, Spain in 2007 had a budget surplus of about 2% of GDP, while in 2009 finds itself with ...