With the creation of the Economic and Monetary Union (EMU) there was a boom in the capital that started to flow from the core advanced economies of Europe to the periphery of the euro area. Greece, Ireland, Spain, Portugal and Italy (GIIPS) seemed to offer attractive investment opportunities relative to the emerging economies and the elimination of the exchange rate risk benefited borrowers and lenders.
However, with the birth of the financial crisis in 2007/2008, the GIPPS faced a “sudden stop” in their capital inflows and such an effect forces a dramatic and rapid reversal in the current account position of the countries. Nonetheless, such capital inflows and subsequent “sudden stop” of lending also occurred, in a greater dimension, in new EU member states essentially Bulgaria, Estonia, Latvia and Lithuania, the BELL, which had fixed their exchange rate to the euro. Countries like the latter experienced larger capital inflows mostly because their expected growth was larger than the one expected in the GIIPS. These expectations endured for some time since the capital inflows helped the economy to expand.
So, it is interesting to analyze which of the two groups of countries was able to adjust better to the “sudden stop”. Moreover, did the existence of the euro led to a “better” or “worst” adjustment process?
Since there is little difference between a fixed exchange rate regime and a monetary union, at first sight, it would seem reasonable to claim that the adjustment of both groups had to be similar. However, what we observe is that the adjustment was indeed different, mainly because of three aspects: availability of domestic credit, fiscal policy and ownership of banks.
In comparison to the GIIPS, the BELL are highly open small and exceptionally flexible economies, they had no debt shocks when the capital inflows began, but they experienced larger inflows and also very important is the fact that they had no domestic banks.
Moreover, there is another difference, probably the most important, that should be highlighted: the institutional setting. The main difference between the two groups is that the periphery countries had a lender of last resort, the ECB, while the BELL did not have a similar institution. While the Baltic States only had the IMF support, which just intervened to offer balance-of-payments assistance, the euro area countries had the support of the IMF along with the intervention of the ECB and the European Financial Stability Facility, whose actions are more extensive than the IMF intervention. So, this setting makes the adjustment particularly different.
What has been proved is that the adjustment was sharper and shorter in the BELL. Indeed, the BEEL managed to reverse an account deficit of about 20% of GDP in 2007 into a small surplus in 2009, while the GIPPS continued to face a current account deficit. The main reason for the greater improvement in the current account of the BELL is in the reaction of consumption, which was quicker and larger in the BELL. In the GIIPS, however, the reaction is extended over a longer period.
Furthermore, when the supply of private credit from abroad stopped, the subsequent stop in the availability of credit at home and the price increase was greater outside the EMU than inside. This happened because the availability of refinancing from the ECB provided a continuing flow of funds and permitted banks in peripheral euro countries to keep their interest rates at low levels. Thus, private demand has adjusted much less inside than outside the EMU.
Another reason why the adjustment in the BELL group has been much shorter and sharper seems to be related to the fiscal policy. The Baltic States went through a unique adjustment between 2008 and 2009, with the policy strategy relying heavily on a contractionary fiscal policy. Once again, the reaction in the countries within the EMU was different. The ECB took care of the liquidity problems and the EMU countries were able to avoid a strict fiscal policy, and when their economies contracted the automatic stabilizers were allowed to work in full.
The third factor explaining the different adjustment length and strength is the structure of the banking industry. The foreign ownership of banks in the BELL played an important role in the crisis as it provided increasing supply of cross-border credit funded by parent banks. In contrast, since in the euro zone domestic banks dominated the sector, the banking crises led to large legacy costs. These facts explain partially why the BELL, unlike most of the GIIPS, experienced only limited outflows of capital and not a full-scale banking crisis.
In conclusion, the quicker adjustment in the BELL had its roots in the lower availability of domestic credit along with a tight fiscal policy and foreign ownership of banks.
All in all, we can say that the existence of the EMU makes a difference when facing a sudden stop. Its existence has, as almost everything in the world, advantages and drawbacks (there is always the other side of the coin). However, when it comes to the adjustment when there is a sudden stop, the disadvantages seem to outweigh the benefits. In particular, the delay in the adjustment has only costs. While the shorter and sharper adjustment outside EMU had the advantage of accumulating less debt over the years and it led to lower losses of output and to lower increases in unemployment, the GIIPS faced a higher accumulation of foreign debt and a worse macroeconomic performance (higher unemployment and higher losses of output).
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Main Reference/ figures reference:
“Country adjustment to a ‘sudden stop’” by Daniel Gros and Cinzia Alcidi, April 2013 http://ec.europa.eu/economy_finance/publications/economic_paper/2013/pdf/ecp492_en.pdf