International Financial Institutions and Policy - Essay Example

International Financial s and Policy Introduction The Eurozone crisis de s the on-going financial difficulties within the euro area that was triggered by the 2008 global economic downturn. The economic crisis cannot be blamed entirely for the present situation afflicting the euro area since it can be found in the asymmetrical nature of the monetary union. The EU’s Economic and Monetary Union (EMU) incorporates the coordination of economic and fiscal policies, a widespread monetary policy, and a shared currency, the euro (Dinan 2004, p.234). The situation within the Eurozone deteriorated in 2010 when Greece suffered a significant financial crisis. Following concerns that other weak Eurozone states, European Financial Stability Facility was initiated to avail loans to struggling Eurozone states (Holinski, Kool and Muysken 2012, p.2). The size of the rescue fund was enhanced from €500billion to €800billion so as to accommodate the increasing need for the loans. A Brief Overview of Economic and Monetary Union The Maastricht Treaty (1992) transformed EMU to be part of EU law and outlined a plan for a single currency to be instituted in 1999. In order for countries to be part of EMU, they had to satisfy certain rules such as agreeing to maintain the exchange rates in line with Exchange Rate Mechanism (ERM) and ensuring that government borrowing and spending are contained with low inflation and low interest rates (Grauwe 2012, p.231). The fixing of interest rates meant that the countries had to hand over the power to set the interest rates to the European Central Bank. Three member states Sweden, Denmark, and Britain were not part of the final stage of EMU. All new members joining the euro are expected to fulfil essential monetary and budgetary conditions, except the UK and Denmark that have negotiated an “opt-out” clause. Since the formation of the euro, the markets have been cautious regarding the single currency with some members reportedly failing to stay within the SGP rules (Grauwe 2012, p.232). The Economic Monetary Unit (EMU) was launched to avail prosperity and stability across Europe and forms a cornerstone of the European Union. EMU faces significant challenges one of them being that the euro region is diverse. However, national policies cannot be considered in segregation if their effects rapidly spread to the euro area as a whole. Sustaining a suitable level of competitiveness, coordination, and convergence to guarantee sustainable growth devoid of large imbalances is critical. In general, closer EMU incorporation will stipulate a stronger democratic basis and wide support from citizens. This can be attained via a combined financial framework to guarantee financial stability and minimize cost of bank failures; and an integrated budgetary framework to guarantee effective fiscal policy at both national and European levels (Grauwe 2012, p.233). The benefits advanced in support for EMU comprises of four critical elements: the reduction in transactions cost of changing currency; the minimization of exchange risk leading to enhanced trade and foreign investment, and to a lower risk-premium embodied within the cost of raising capital; enhanced transparency in price comparison; and, the political gains derived from closer union and cooperation delivered by enhanced closeness of economic relationships within EMU (Groeneveld 1998, p.10). How EMU Measures have Led to Improved Financial Integration The pursuit of a single currency is informed by the notion that abandoning national currencies would enhance the operation of a single market. This demands that EU become an “optimal currency area” that successfully functions as one economy. EMU can be perceived as making national governments to surrender their monetary power to ECB (Giordano and Persaud 1998, p.5). The economic and monetary union EMU measures have yielded to enhancement of financial integration thus rendering the trade within the Eurozone to become cheaper and easier. This in turn, enhances confidence among the investors. The Maastricht Criteria The Maastricht criteria outlines five convergence criteria that ought to be fulfilled prior to an EU member state adopt the euro, namely: price stability whereby the inflation rate ought to be no more than 1.5% points above the previous year’s rate; budget deficit in which the national deficit ought to be below the lowest 3% of GDP; debt in which the national debt should not be more than 60% of GDP; interest rates whereby long-term should not exceed 2% points above the previous year’s rate within the EU countries with the minimal rates; and, exchange rate stability whereby the national currency rate should be in line with the authorized fluctuation margins (Dinan 2004, p.245). The intended benefits of the process of economic and monetary union (EMU) details pursuit of effective European and national policies that delivers vital public functions such as stabilization of economies and banking systems, shielding citizens from the impacts of unsound economic and fiscal policies, and to guarantee high level of growth and social welfare (Degrauwe 2007, p.244). The Maastricht Treaty features a general clause detailing those economic policies should be perceived as a matter of shared concern and coordinate within the EU Council of Ministers. The underpinning philosophy centred on safeguarding what economists’ labels as “fiscal dominance” or the misjudged policies of governments instituted to interfere with central bank’s objective: protecting price stability. The lack of a surveillance mechanism that enables speedy detection of macroeconomic imbalances and subsequent resolution shapes another weakness of the Maastricht framework. As such, countries that manifested high inflation rates plus exchange rate devaluations gained, at the beginning of EMU, from unprecedented minimal levels of real interest rates. Another shortcoming of the Maastricht framework was its failure to deal with bank-sovereign nexus. In the event that systematically significant banks run into trouble, governments are anticipated to step in and avail fiscal support so as to control the spill-over, besides banks are mainly the biggest holders of government debt (Dinan 2004, p.246). The nexus between banks and the governments can yield to a disastrous downward spiral. The downward spiral has also orchestrated the fragmentation of capital markets as banks attempt to retreat to their domestic markets. A fundamental weakness of the Maastricht Treaty was it’s overly reliance on the notion that market discipline and peer pressure would avail adequate incentives for national policy makers to undertake sound fiscal and economic policies. Sources of Current Account Imbalances between Countries of the Euro Zone The currency performed considerably well until the onset of the global economic downturn that started in 2008. Although, many countries globally were affected by the recession, Eurozone members who had weaker economies such as Ireland, Spain, Italy, Greece, and Portugal struggled to pay back their debts, which, in turn, severed confidence within the Euro (Lane 2012, p.49). The functioning of the currency union may have significantly amplified imbalances within the euro area. Despite attempts to oversee nominal exchange rates, real exchange rates have continued to differ as inflation rates have varied across countries. Higher inflation within the peripheral countries has yielded in appreciation of their real exchange rates beyond the anticipated that has eroded their competitiveness and their external trade (Lane 2012, p.50). Indeed, the present imbalances within the euro derive from the adverse fluctuations in real exchange rates. By the time of the eruption of the 2008 financial crisis, some of the euro area Members States had amassed considerable private and public debts, decline in competitiveness, and macroeconomic imbalances. This made the euro area members to be principally vulnerable when the financial crisis struck, with the spreading of substantial contagion impacts across the euro area once it turned into a sovereign debt crisis (Degrauwe 2007, p.245). The build-up of these susceptibilities was partially owing to an inadequate observance of and value for the established rules underlying EMU as outlined within the Stability and Growth Pact. In a significant way, these susceptibilities emanated from constituents of the initial institutional setup of EMU, mainly due to the absence of a tool to respond to systematically macroeconomic imbalances. Weaknesses in the Initial Design of EMU and Adherence to Rules EMU is distinct among contemporary monetary unions since it combines a centralized monetary policy with decentralized responsibility for the bulk of economic policies, notwithstanding subject to constraints in respect to national budgetary policies. Converse to other monetary unions, there is no centralized fiscal policy role and no consolidated fiscal capacity. It has been concise that since the initiation of the euro that has enhanced interdependence of its Member States translated that sound budgetary and economic policies were of significance. The SGP laid down the rules overseeing the coordination of budgetary policies, besides laying down measures to take action against Member States that fail to comply with the set rules (Eichengreen 2008, p.219). The Problems of a ‘one size fits all’ Monetary Policy One size fits all monetary policy has a number challenges, for instance, the ECB was recently forced to hike ECB its interest rate for the first time since the commencement of the global economic downturn. In comparison to a simple rate rule, the increase appears in line with the euro area’s growing economic recovery and increasing inflation. Nevertheless, economic conditions differ significantly among the countries within the euro area and ECB’s fresh target rate may not be appropriate for all of the countries. For instance, in 1999 when euro was being adopted, Ireland had a growth rate of close to 10% while Germany had a growth rate of about 3%. The core question in this case centres on whether ECB should respond to Germany or Ireland when establishing its interest rates (Lane 2012, p.51). One size cannot fit all in cases where economic conditions differ markedly between any two member states of a monetary union. This explains why euro area faces challenges with its “one-size-fits-all” monetary policy since majority of its Member States economic conditions differs dramatically owing to massive macroeconomic imbalances (Peersman and Frank 1999, p.85). The tensions witnessed within a monetary union is highly likely to be greater compared to tensions in a single country. The Euro area has demonstrated that one-size-fits all interest rate cannot effectively suit 17 diverse economies. One-fits-all monetary policy generates strains that may eventually prove to be insurmountable. Each country is better placed setting its own interest rates at levels that are suitable for or that mirrors its local economic conditions (Peersman and Frank 1999, p.86). Within the euro area, language, cultural, and structural hurdles constrain labour movements thereby creating diverging economies. This became even more evident during the 2008 global financial downturn and the sovereign debt crises as manifested in distribution of the unemployment rates. The euro area is far from optimal currency area as it Member States manifest diverse business cycles and have inadequate economic shock absorbers (Wynne and Koech 2012, p.1). Policy Measures Advanced to Counter the Euro zone Debt Crisis Issues at the heart of the challenges encountered by the euro area since 2008 include: a) The SGP was inadequately observed by the Member States and was deficient in robust mechanisms to guarantee sustainable public finances. The enforcement section of the preventive arm of the SGP that demands that member states uphold a strong underlying budgetary position failed to utilize periods of steady growth to track ambitious fiscal policies. Simultaneously, the debt standard of the Treaty was not rendered operational within the corrective arm of the SGP (Wynne and Koech 2012, p.2). b) The organization of national economic policies further than the budgetary area depended on soft instruments such as peer pressure and recommendations, and possessed a restricted impact on the action of individual euro area member states. Hence, the instrument was too frail to counteract the progressive access of competitiveness gaps and growth divergences between Member states. c) Financial markets play a significant function in fashioning incentives for countries to run stable public finances, by pricing the risk of default into the rate at which sovereigns can borrow money. The global easing of inflationary pressures in late 1990s led to a rapid and consistent expansion of money supply to central banks. In parallel, with the inception of the euro the European Central Bank (ECB) depended on national bonds for its open market operations, hence bestowing upon them the top-quality status demanded for central bank collateral. The outcome was strong yield convergence, significantly constraining market discipline, irrespective of differences within national budgetary performances. This contributed, inter alia, to the considerable investments on sovereign bonds availed by banks. Euro area economies in a recurring expansion and with considerably higher inflation rates tended to have low or negative real interest rates, which led to strong credit expansion eventually fuelling considerable housing bubbles (Wynne and Koech 2012, p.2). d) The initiation of EMU led to injected pace in financial integration, which opened prospects for portfolio diversification. It also hastened the transmission of shocks across national borders. The asymmetry between integrated financial markets and financial stability architecture yielded in insufficient coordination among the relevant authorities at every phase of the present crisis (Wynne and Koech 2012, p.3). The EMU framework depends on a stringent separation between monetary policy, on one hand and fiscal economic policies, on the other hand. Conditionality is a critical part of the activation of the OMT and serves to minimize moral hazard by government as well as safeguarding the independence of ECB in discouraging fiscal dominance. The monetary policy function is undertaken by the ECB under a concise mandate: sustaining price stability within the medium term. In order to attain this objective, the ECB has been awarded full political and operational independence. Since the onset of the debt crisis, ECB has responded forcefully as reflected by its lowering its policy rate from 4.25% to 0.75%. Nevertheless, the widening fragmentation of capital markets has yielded to a complete evaporation of certain financial markets segments, thus damaging the monetary transmission channel within the euro area (Eichengreen 2008, p.220). Informed by these developments, ECB has focused on “non-standard” measures to ensure the successful diffusion of its sound monetary policy across its member states. The ECB has adjusted its allotment procedure, as well as its collateral policy, in addition to lowering the rate of minimum reserve requirements and heralding long-term refinancing operations. Similarly, ECB has also opted to automatic purchase of bonds within secondary markets. Subsequent to the Securities Market Programme whose operation has been terminated, ECB’s governing council discussed modalities for undertaking Outright Monetary Transactions (OMTs) within secondary markets for sovereign bonds in euro area (Gros and Thygesen 1998, p.35). The OMTs will allow the ECB to tackle severe distortions within government bond markets that emanate from alarm raised by investors regarding the reversibility of the euro area. Monetary union is in some instances misjudged as an exchange rate system in which member countries can subscribe and leave just as was the case in ERM. Such a view of reversibility would mean that, eventually, one euro will not have the same worth in different Euro countries. This view is essentially flawed since the euro is irrevocable (Gros and Thygesen 1998, p.36). Guided by the OMTs, under appropriate situations, EMU will now possess a fully efficient backstop to averting harsh scenarios that may present severe consequences for price stability within the Eurozone. An essential condition for the OMTs details that the concerned country should adhere to stringent and effective conditionality tied to appropriate program as per EFSF and the ESM. IMF plays a part in the designing and monitoring of the conditionality. The OMTs represents an instrument within the ECB’s toolbox to aid it accomplish its mandate of maintaining price stability. As a result, OMTs are beneficial to the monetary authority in that it awards power to control credit conditions within the Eurozone, and in so doing keep inflation stable in the medium term (International Monetary Fund 2012, p.50). The Consequences of Low or Negative Real Interest Rates in the Peripheral Economies Since nominal exchange rates are fixed within the currency union, higher inflation within a member state produces a real exchange rate appreciation in the country, which in turn, is probable to yield in a loss of competitiveness and a widening external deficit. The inflation criterion entailed within the Maastricht Treaty was directed at circumventing this adverse effect, by demanding a convergence in inflation rates before the monetary union. Financial integration emanating from the monetary union tended to minimize the cost of capital and encourage investment in peripheral countries, while low nominal and real interest rates minimized their savings. Trade imbalances significantly broadened among euro area countries after the inception of the single currency (International Monetary Fund 2012, p.51). Economic Adjustment programme for Portugal: OMT Portugal has accepted the conditions laid out in the European Stabilization Mechanism and subsequently agree to the reform programme for OMT. From 2009 onwards economic alarms increased centring on the sustainability of Portugal’s public finances coupled with consistent dowgradings of the country’s credit ratings (OECD 2012, p.11). The government debt rose to 93.3% of GDP with the banking sector being progressively dependent on the Eurosystem for funding. Just as in Greece, Portugal government attempted to induce austerity measures were intensely opposed by the public and the opposition. Portugal agreed a loan agreement with the EU Council and the IMF that covers the period 2011-2014 for up to €78bn. Portugal’s European partners will avail up to €52bn (€26bn under the EFSM and a further €26bn under the EFSF (International Monetary Fund 2012, p.52). OMT has aided to relieve tensions and discourage speculation. Portugal has been able to score good marks from its bailout partners for conforming to the strict conditions of a rescue package. As such, Portugal has made significant progress to the extent of gaining full market access and effective tackling of it debt crisis. Undertaking of agreed policies has aided to restore confidence by addressing market tensions. Portugal has demonstrated considerable performance under its program manifested by its recent successful bond exchange mirroring its maturity profile (OECD 2012, p.13). The undertaken measures have rendered enhancements on long-standing competitiveness, while the primary fiscal balance is within an improving path. Most importantly, Portugal has received wide political backing for the program, which is critical to the success of the instituted programs. Conclusion The current crisis within the Eurozone can be considered as the outcome of lack of incentives within the Maastricht Treaty to undertake sound fiscal, economic, and financial policies, which can only be addressed by member states rather than the ECB. Hence, the solution to crisis lies, first and foremost, is with the governments, either individually or collectively. Since the onset of the crisis, the member states have instituted several critical measures designed to reinforce the institutional framework of EMU. EMU should actively seek to consolidate cooperation and integration within the financial, fiscal, and economic sphere in order to succeed in resolving the debt crisis. Overall, the Maastricht framework has proved incapable of dealing decisively with the high level of economic and financial integration within the euro area. References List Degrauwe, P. (2007). Economics of monetary union. Oxford, Oxford Univ. Press. pp.244-250. Dinan, D. (2004). Europe recast: A history of European Union. Boulder, Lynne Rienner. pp.234-246. Eichengreen, B. J. (2008). Globalizing capital: a history of the international monetary system. Princeton, Princeton University Press. pp.219-225. Giordano, F. & Persaud, S. (1998). The Political Economy of Monetary Union: Towards the Euro. London, Taylor & Francis Group. pp.5. Grauwe, P. D. (2012). Economics of Monetary Union. Oxford, Oxford University Press. pp.231-233. Groeneveld, J. (1998). Inflation Patterns and Monetary Policy: Lessons for the European Central Bank. Cheltenham, Edward Elgar. pp.10. Gros, D. & Thygesen, N. (1998). European monetary integration. London, Longman. pp.35-40. 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