Both rules and risk-sharing are essential in the EU(EA) --non-EA member states are vitally interested in a good functioning of the EA--
The ELEC event in Romania this year occurs a short while after the European Parliament/EP elections. A piece of good news is that those who oppose the European Project did not get the upper-hand. But the EP will be more divided and consensus harder to build. The EU is facing huge challenges against the backdrop of the erosion of multilateralism in world arrangements, trade conflicts, much strain in the transatlantic relationship, social and political fragmentation, and, not least, an euro area that still needs repair.
Another piece of good news is that Romanian citizens have indicated glaringly their loyalty toward a Union that is meant to foster economic convergence, uphold fundamental liberties and defend its democratic credentials around the world. In this context should be judged the Romania’s aspiration to join the euro area/EA.
Let me start by saying that Romania is not procrastinating about joining the euro area; the debate here is not whether to join, but under what terms. This is the rationale which prompted the formation of a National Commission for adopting the euro in April last year. Governor Isarescu is one of the two vice-chairmen of the Commission while the Prime-minister and the President of the Romanian Academy preside it. All political parties are represented in this Commission, as well as civic organisations and other main stakeholders.
At the behest of this Commission, a thorough report was worked out and an accompanying plan as well. Basically, the Report asks for achieving a critical mass of real convergence, solid public finances, and capacity to control external imbalances. The Report foresees accession by the middle of the next decade provided basic conditions are met.
I am a member of this Commission and I have been deeply involved in the working out of the two documents –together with colleagues of mine from the National Bank and other experts. Let me share with you a few thoughts of mine on EU accession and the functioning of the single currency.
New Member States (NMS) are bound by the EU accession treaties to join the euro area (EA) eventually. But the financial crisis and the sovereign debt crisis have indicated that accession in the single currency area is not to be done irrespective of circumstances.
The NMS that have larger, not currency-board based economies, are quite vague about their timetables for accession; the official view is that more real convergence is needed to this end. Bulgaria, which has a currency board, asked to enter into the Exchange Rate Mechanism2/ERM2. Croatia has targeted 2022-2023 as an accession moment.
Can “optimal” euro area accession terms be defined if straightforward political calculations are put aside? Do development gaps matter for accession? What about the impact of production chains? Does the functioning of the EA matters? Lessons from the sovereign debt crisis in the EA and worldwide experience seem to give an affirmative answer. But these policy issues are still controversial, not least in the NMSs. A role in this debate is presumably played by the middle income trap challenge. Destabilizing capital flows, which complicate the conduct of autonomous monetary policies, have also to be considered. The Exchange Rate Mechanism (ERM) experience of the past decades is a reminder of the power of destabilizing capital flows. And quite likely, this experience reinforced the rationale for the creation of the EA, aside from its political dimension. But eliminating the currency risk does not eliminate the “redenomination risk” in a monetary union wherein heterogeneity and divergence are not kept in check.
The Treaty of Maastricht does not establish a clear timetable for EA accession; the Treaty says, however, that each Member State has to reach lasting convergence to participate in the final stage of The European Monetary Union (EMU); this wording alludes to ex ante real and institutional convergence. And entering the ERM2 (and staying there, successfully, for at least two years) is sine qua non for joining the EA; this implies solid public finance and capacity to control external imbalances. In addition structural reforms have to be implemented with a view of fostering a more robust economy and provision of essential public goods.
Please, allow me to say a few words on what I deem to be essential for a proper functioning of the euro area; I will refer basically to risk-sharing and risk-reduction.
Risk reduction and risk sharing
Some MSs highlight the need to reduce NPL stocks (a legacy problem) as a risk reduction measure, prior to implementing a risk-sharing scheme (EDIS --a collective deposit insurance scheme); which does make sense.
But, over time, the flow of non-performing loans hinges, essentially, on economic performance, and not on a particular level of NPLs. In the absence of mechanisms and instruments that foster economic convergence in the EA, NPL stocks at national level would tend to diverge widely again.
One can imagine a diversification of banks’ loan portfolio that would diminish the threats posed to their balance-sheets by activities in weaker economies. However, a complete decoupling of banks from weaker member states’ economies is not realistic and not welcome, and contagion effects can still be significant. A decoupling would cause further fragmentation in the Union/EA –where finance is largely bank-based.
If Banking groups diversify their government bond portfolios while considerable competitiveness gaps persist among member states, and if sovereign bond ratings were no longer “risk-free”, a strong preference for holding safer bonds would ensue.
European “safe assets” and financial integration
It is hard to question the view that Eurobonds, as risk-pooling assets, would make the EA more robust. But, mutualisation of risks is rejected for fear of a “transfer union”. Hence came the idea of a synthetic financial asset (sovereign bond-backed securities – SBBS), which is derived from the pooling and slicing of sovereign bonds into tranches: a senior one (deemed to be equivalent in strength to the German Bunds), a mezzanine (medium-risk) tranche, and a junior (seen as highly risky) tranche, with the latter bearing the brunt of losses in case of default.
But SBBS pose a huge problem: the supply of senior tranches depends on the demand for junior tranches, and this demand is likely to fall dramatically during periods of market stress, when some member states’ market access may be severely impaired. And it goes without saying that the value of “safe assets” is tested during period of turmoil. I hardly see how a true joint safe assets does not involve mutualisation of risks.
Capital Markets Union (CMU) and Banking Union(BU)
Would CMU and BU overcome market fragmentation and economic divergence in the absence of arrangements that would enable accommodation of asymmetric shocks and foster economic convergence?
Some argue that a complete BU (and CMU) would dispense with the need of public risk-sharing.
- But is it sufficient for a robust EA that risk-sharing applies to finance only?
- And would private risk-sharing be sufficient to cope with systemic risks? What about the LoLR function in capital markets in view of the expansion of shadow-banking?
- Would a collective deposit insurance scheme (EDIS) involve private money only” I doubt it.
- Fiscal risk-sharing may be needed in worst case scenarios .
However, fiscal integration is the biggest hurdle to overcome in the EA since it calls for institutional integration and a significant EA budget. And the latter leads to a huge political conundrum. Here lies a deeply going incompleteness in the design of the EA, in the spirit of Dani Rodrik’s trilemma –that there can be no integration in cohabitation with an autonomous economic policy and democratic accountability at national level; something must be given up.
The fact is that unless financial integration is accompanied by policy arrangements and mechanisms that combat growing divergence between member states, extremism, populism, Euroscepticism will live on.
The progress of the EA, of the BU, demands a reconciliation between rules and discipline on one hand, and risk sharing (private and public) on the other. But an adequate calibration between rules and risk-sharing, between private and public risk-sharing, is an open question. Arguably, only private risk-sharing schemes (CMU) would not make the EA more robust. Financial markets are too fickle and produce systemic risks recurrently.
Unless it will get adequate risk-sharing schemes, the EA will continue to be rigid and prone to recurrent tensions and crises.
On a final note, reforms in the EA should consist of:
- liquidity assistance available during times of market stress;
- schemes to cushion asymmetric shocks, such as an unemployment benefit scheme;
- sovereign debt restructuring should not be triggered automatically (automaticity as a condition for ESM support programmes), for it may cause panic in the markets, more fragmentation;
- rules for adjusting imbalances should not be pro-cyclical (a revision of the GSP rules makes sense);
- the macroeconomic imbalance procedure (MIP) should operate symmetrically, for both large external deficits and surpluses countries;
- a euro area-wide macroeconomic policy that should reflect in the fiscal policy stance over the business cycle;
- investment programmes that foster economic convergence;
- no de-reregulation of finance (as it is attempted in the US currently)
Let’s not fool ourselves, a hit will come sooner or later and the ECB and national governments must not be found unprepared.
I hope EU leaders will make the right decisions so that the Union gets more robust. In Romania we need to make our economy more robust in order to enter ERM2 and, afterwards, join the euro area.
Thank you for your attention
Banca Națională a României, București, 3 iunie 2019