EFSI Digest

The guidelines to contribute to HKU Economic & Finance Students Intelligences publications

3 steps to publish your article

I. Send us an email outlining your proposed topic; a. For us to prevent conflicting topics II. Send us your piece, please bear in mind the following; a. Your document should be in Word format b. It shall contain 600 to 1100 words i. If more, make it two separate articles, each having its own intro and concluding paragraphs c. Highlight 3 economic concepts worth explaining i. Please refer to the article below ii. You may translate the terms in Mandarin Chinese. 1. If not, our editorial team will provide a translation d. State your sources i. e.g. Reuters, IMF, the economist e. Optional i. If you add graphs, figures or tables, state the source clearly ii. Provide a short reading list for the readers interested in understanding the issue at a deeper level f. Mention your full name, age, school & course of study

III.

Our editorial team will carefully read your contribution and you will hear from us in a week time a. If modifications are necessary, we will send you the new document for your approval before publication b. In any case, you will receive a detailed feedback of your work

APPENDIX: Your article should be sent in the following format:

Future of the Eurozone1

Euro: Flawed beginnings

Less than 15 years from its birth, the Euro has imposed large economic costs. This comes as no surprise for economists who had foreseen the risks of imposing a common currency on a heterogeneous group of countries. These problems are compounded by a lack of common fiscal union and a political will amongst members to subvert national interests for the interests of Europe. Even though Eurozone trade has increased with the elimination of trading costs associated with having multiple currencies, this has been overshadowed by bigger problems such as unsustainable sovereign debts, fragile banking systems and persistent economic divergence within Europe.

Too important to fail

Despite these problems, the Euro is too important to fail. Talks of breakup of the Euro are nave and tend to overlook the economic costs involved in the process of returning to multiple currencies. The shear number of Euro members, the widespread use of Euro as a reserve currency and volume of trade within Europe will sustain the lifeline of Euro. To solve the Eurozone crisis, three issues should be addressed- tightening up fiscal discipline, improving banking regulations and promoting joint stability and growth at the European level. The golden key to solving these problems is a common European fiscal or federal union1 but this is unlikely in the next few decades due to a lack of a political will amongst European nations to surrender their fiscal sovereignty. Germanys strong opposition to a common Eurobond is testimony of this sentiment. Other measures have to be implemented in the mean time to ensure the sustainability of the union.

By Leslie Tay (Full Time MEcon student)

Improving Fiscal Discipline

The importance of fiscal discipline within the monetary union has long been recognized. The Stability and Growth Pact came into existence as early as 1997. It spelt out financial penalties for any country that has a budget deficit above 3% of its GDP or debt above 60% of its GDP. The No Bailout clause of the ECB meant that countries should be held responsible for its own fiscal policies. Unfortunately, such fiscal rules were not strictly adhered to and when France and Germany exceeded the set debt:GDP ratio (figure 1), no penalties were imposed.

Figure 1: Eurozone Debt as a percentage of GDP Source: European Commission

Europe has since recognized its failures and taken measures to tighten fiscal discipline. Mario Draghi, ECB President, has emphasized on numerous counts that Europe should do more with respect to fiscal consolidation and that the ECB will not be a lender of last resort. Earlier this year, European leaders have signed a new fiscal compact treaty agreeing to keep their annual structural government deficit below 0.5% of nominal GDP. A notable change is also the use of reverse qualified majority voting2 in deciding whether to place a country in excessive deficit procedure or to impose sanctions. This is a vital step as the former voting system meant that sanctions were often avoided for fear of straining diplomatic relations. Despite these measures, European leaders should recognize that these treaties often contain threats that are not credible. In the medium and long run, the EMU should work towards designing a credible exit strategy. This

concept is akin to banks writing living wills and allows an orderly exit of a weaker nation without compromising the entire Euro bloc. The exit strategy should include detailed timelines and clauses specifying how assets and liabilities will be denominated and how inflation and budget deficit will be kept in check. Separately, the EMU should also design incentives to reward countries that adhere strictly to the fiscal compact. One method of doing so is the blue bond proposal in which good debts are pooled together separately from debts that have flouted the fiscal compact rule. Blue bonds serve as the European counterpart to US T-Bills and would provide a steady flow of capital to EMU members with good behavior. This proposal essentially creates two separating equilibriums3 but runs the risk of cutting off capital to countries when it needs it the most. As such, it is not meant to be a complete solution, but it certainly reduces moral hazard and prevents a race to the bottom pooling equilibrium.

Better Banking System European banks have grown vulnerable as a result of the vicious cycle between banks and sovereigns. Prior to the crisis, banks tend to hold a significant amount of government bonds that were often regarded as safe assets (figure 2). They suffered a big blow when analysts began to question the ability of sovereigns to repay debts. Loose banking regulations also meant that banks overextended credit without scrutinizing the accompanying risk, resulting in real assets bubbles and risky speculative activities. When markets crashed, the balance sheet of banks became dangerously thin and banks experience difficulties in accessing the credit markets, making them susceptible to runs. These sentiments were fuelled by pro-cyclical banking regulations. Without the ECB acting as a lender of last resort, national governments begin to bail out banks using their national budget, but this creates a vicious cycle as the credibility of their sovereign bonds, which ultimately sit in the books of bank assets, lowers. Correspondingly, banks cut down lending in the hope of meeting required capital ratios, diminishing the growth prospect of the troubled economy, thus completing the vicious cycle.

Figure 2: Banks holdings of Eurozone government securities Source: ECB

Europe has taken action by relooking into financial regulations and considering the prospects of a banking union. The question however lies in the completeness of these solutions, as the EU has been known for stopping short of what is needed due to political reasons. In any case, banks regulations like Basel III and Deposit Insurance Scheme will go a long way in stabilizing the banking sector. The EU has also committed itself to adopting legislation for bank recovery and resolution. The EZ Banking Union, if implemented successfully, will allow better risk pooling as well as give the ECB greater power and autonomy in supervising banks in Europe, especially the macroprudential aspects, given that most banks have cross-borders operations.

Promoting Stability and Growth The EU should take steps to facilitate economic convergence in the long run. Whilst economic divergence is not detrimental per se, persistent economic divergence is. Current and capital account imbalances should be a norm within Europe given the different states of economy (Figure 3). But these imbalances should be driven by investments and factor movements rather than by speculation in asset prices that results in unsustainable household and corporate debts. European leaders should work towards sustainable growth and cooperate on measures that would improve their joint productivity and competitiveness. Surplus countries should take steps to boost domestic demand and continued productivity whilst deficit countries should work towards making their economies more competitive by restructuring their macroeconomic policies, labour markets, and goods markets. The Stability and Convergence programme and Europe 2020 strategy are signs of a good start.

Figure 3: Eurozone current account surplus and deficits Source: European Commission

To salvage the Euro and EU, it is essential that leaders act on these three issues quickly. Ultimately, European leaders should recognize that in order to make the Eurozone sustainable, a complete union is needed- both in politics and economics. Rather than being forced by circumstances, it may be wise for leaders and citizens to acknowledge that this is the fate of Europe ever since they chose to adopt a common currency.

1Federal

Union: A political union in which members are bounded together by covenant with a governing representative head. Sovereignty is constitutionally divided between a central governing authority and individual states.

Reverse qualified majority voting: Under the reverse qualified majority voting (RQMV) procedure, a Commission recommendation is deemed to be adopted unless the Council decides by qualified majority to reject the recommendation within a given deadline that starts to run from the adoption of such a recommendation by the Commission.
2

3 Separating

equilibriums: Separating equilibrium occurs when policies are priced fairly according to the risk types. In the insurance context, high-risk individuals are given full coverage at a higher premium rate whilst low risk individuals are given partial coverage. Similarly, in this context, red bonds are pooled separately from blue bonds with the former having a higher risk of default.

Sources: European Commission, European Parliament, ECB